Volume 5 APRIL 2009
Feature articlesThe causes and consequences of the current financial turbulence
Reversing the divergence of the bottom billion
Reflections on microeconomic policy frameworks and a suggestion about fairness
What's been happening to United States income inequality?
Occasional Addresses
Navigating the world of opportunity
How your university experience will shape your future life and career
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A tumultuous year
The crisis in global financial markets has raised a welter of critical issues for financial institutions, regulators and governments that cover all aspects of the financial industry and approaches to macroeconomic policy
(pages 11-15 of printed journal)
Background - a euphoric period
Prior to the current crisis, a remarkable 14-year or so economic expansion had produced growth in virtually all parts of the world. This had been a euphoric period with the globalisation of world economies, the attendant reduction in trade barriers and the massive increase in goods coming from new powerhouse economies such as China. There were also huge capital flows from the Middle East, Asia and Russia. Growth regularly exceeded expectations, governments saw revenues bloated by asset prices and consumer price increases remained low. That prosperity blinded governments, the financial sector and the community to what are now clearly seen as warning signs.
In particular, too many cheered on asset price inflation. There seemed to be no asset untouched - homes and holiday houses, artworks, racehorses, yachts and companies all became more valuable. And we convinced ourselves that this was due to a new era of global economic interaction - and that it would somehow last forever. However, asset price inflation is and was inflation. It was overly accommodated by various monetary authorities who ignored the very clear signal that the economy and, through it, the financial sector was travelling far too fast - at a pace well in advance of proper understanding of the systematic risks.
During this period of world expansion, two industries did especially well - information technology and finance. They were globalised, relied on continuous innovation and grew swiftly in both the new and old economies. But, just as the 'tech boom' came to an abrupt end in 2000-01, we are now seeing a fundamental recalibration of the financial sector. Its long-term average share of total profits within the Standard & Poor 500 was around 15 per cent but peaked in the past few years at 21 per cent. The financial sector is now undergoing a correction which, by any terms, is a very major and painful one.
Not only in the world generally but also in the financial sector, recognition that a crisis was brewing was very slow. Even two or three years ago, people were lauding the low mortgage interest rates being provided to low-income earners in the US as allowing the disenfranchised to achieve home ownership. We also saw similar trends in Western Europe. There were a few voices that rightly warned about the massive increase in household, corporate and financial sector debt levels, but they were generally either disparaged or ignored.
Emerging problems
For the banking system, the full extent of the problem started to emerge in the northern summer of 2007. It was not so much that the mortgage-backed securities were starting to fail but that there was growing unease that the hedges put in place in the event of default were, at the very least, sub-optimal. The very size of the investment banks, the ever-expanding global stretch, the internal reporting of positions in net rather than gross terms and the complexities of management layers all made recognition of the problem that much more difficult. Adding to it was a lack of communication between banks because of their fear of being accused of anti-competitive behaviour.
Fear of breaching stringent reporting rules and Sarbanes-Oxley (SOX) structures1 also played a part. By contrast, in the 1980s and early 1990s, the regulatory authorities seemed to have had good communication with all the major financial institutions. The world and the institutions were less complex, and investment banks did not rely anywhere near as much on proprietary trading for income. This all made for an environment where central banks could oversee the industry at a national level in a more collegial way, and where problems could be more readily identified and discussed.
We cannot ignore, however, the fundamental change in the financial sector. In the 1990s, aided by globalisation and accommodative monetary conditions, investment banks grew dramatically. Moving into new markets, managers had to run increasingly complex and diverse businesses across more and more countries. Importantly, banks also started to rely heavily on proprietary trading, not just in fixed income but also in equities and exchange rates. There was also the rapid growth of complex financial instruments - also known as 'structured products'. They put far more risk on their balance sheets and this made investment banks far more vulnerable, as did the later move to place risk into off-balance sheet vehicles.
Early assessments in 2007 significantly underestimated the financial sector problem, which escalated sharply in 2008. Concerns about mortgage-backed securities emerged slowly, but then rapidly spread to the whole array of so-called sophisticated instruments. All this was brought into sharp relief by the need to mark-to-market2 instruments in increasingly illiquid markets. This led to a total breakdown in the confidence that had previously allowed banks to borrow and lend among themselves - and clients began to question the security of both their deposits and their relationships.
Because UBS listed on the New York Stock Exchange, I sign off many SOX accreditations for Global Asset Management; our internal and external audit processes have never been more intrusive; and the legal, compliance and risk area in the financial sector has grown more than any other. Nonetheless, the problems were all missed.
Risk management
For all the resources devoted to risk, I believe there had been an undue focus on operational risk and credit risk in the investment banks, while the gorilla of market3 risk was quietly eating all the bananas in the corner of the room. That was a fundamental problem. Few pointed to the over-arching market risks. We had become victims of undue reliance on quantitative measures of risk. But those measures were necessarily backward-looking, to an era that, in large part, no longer pertained in the financial sector. Securities had multiplied in their coverage, complexity and volume. But we were drawing on 20- to 30-year-old data to work out the probabilities of default.
We need to rethink risk management. The way forward for risk management should be a marriage of modelling based on past behaviours with far more forward-looking judgment. It should be not unlike how good macroeconomic forecasting is undertaken.
Similarly, we have to make sure risk management lies at the very heart of business management. I chair the Risk Committee of Global Asset Management every month and I do it in an intrusive and often obnoxious way. There is no alternative to really knowing your business in assessing risk. As CEO, when you know more about the businesses of your direct reports than they do themselves, then you have a risk issue! Risk is as much about people as about process - and that is especially the case when, as in Global Asset Management, we are operating in 27 countries with different cultures, regulatory regimes and market structures.
Some accuse the regulators of not recognising the problems. But it was an incredibly difficult task to be a regulator in this environment. The speed with which the financial sector grew, the globalisation of that financial sector and remuneration trends have meant that regulators often really struggle to hire - let alone keep - people who can keep abreast of the financial markets. We need to have good regulation and we need to pay those people appropriately; recognising that it is a small impost relative to the potential costs. We must also recognise that they alone cannot guarantee a trouble-free environment. Senior management and Board members need to be held personally accountable.
While much of the focus of regulation has been on capital adequacy, that needs to be broadened to include the size and the nature of the balance sheets, the concentration of risk and, most importantly, liquidity. We all took liquidity as a given but, as we have seen with confidence, it is one of the first things that dries up in a crisis.
We must also recognise that investors cannot be protected from poor decisions. The investment community must take responsibility to avoid stupid actions. Regulation in this regard must focus on better presentation of likely risks and, perhaps, a more formal and comprehensive acceptance by clients that they understand the risks.
After 20 years in the public service and now 15 years in asset management, I still raise an eyebrow at the remuneration practices in the financial sector. They have become bloated, very short-term in focus and fixed rather than variable costs. In many respects, the total remuneration has been well beyond what would be necessary to retain and motivate the key people - and this has cascaded throughout the organisation so that support and other staff are paid well in excess of what is needed for recruitment and retention. These remuneration practices are now under review - yet one of the things that has boosted this hike in remuneration levels, perversely, has been the pursuit of transparency in remuneration. It has provided a comprehensive databank that every CEO or senior executive can reference, pointing to competitors' remuneration levels, locally and globally - all providing a highest common denominator. A further observation on remuneration - we are prevented, in large part by SOX regulations and accounting conventions, from smoothing bonus pools from one year to the next. It seems crazy that, in good years, we could not bank some of the bonus pool for the next year.
Government rescues of banks have been very sad for all who prefer capitalism - whatever that means these days - but they were necessary. I saw the queues at banks and ATMs in London when Northern Rock crashed. The week when Lehman Brothers was allowed to collapse was truly frightening. The financial sector has a special place within our economy but I think the sector should be made to pay heavily for this. The current crisis will be with us for the next three years or more, and governments will increasingly run or influence banks for some time to come. Bankers who complain about this are being very hypocritical - there really is no alternative. It is the price they must pay for the greed, arrogance and stupidity of the binge of the past decade or so.
The Australian financial sector is better placed than elsewhere but we should not be too smug. We have had the benefit of living through our own corporate crisis in the 1980s and a very real banking crisis in the early 1990s. We have also had virtually three decades of good economic policy with our fiscal responsibility now standing us in a better position to face a possible recession, unlike much of Western Europe. We have learnt from all of this, and it is one of the reasons why our financial sector and the economy more generally still look pretty good from the other side of the world.
Finally, a comment on asset management. There is clearly a much-heightened aversion to risk that will remain for some time. That said, the asset management client community has been remarkably sophisticated in reacting to this crisis and it is a credit to trustees, consultants and the clients generally. The long-term growth of the asset management industry will not change. The ageing of the population will be an even bigger factor now because many will have to redouble their efforts to provide privately for their retirement savings. Governments will be even less able to support retirement incomes as the pressures on public finances intensify in a way not foreseen a year or so ago.
The industry still has a great future; but it has to learn from its experiences and become a little bit more sober and more humble. It needs to recognise there are very real social responsibilities. To the extent that asset managers under-perform, people suffer and governments face higher social welfare costs. We should expect more oversight by regulators and more focus on providing not just returns but also liquidity and security when needed.
1The Sarbanes-Oxley Act 2002, is a US federal law enacted following the Enron and other financial scandals, in order to raise corporate accounting standards.
2An accounting method of valuing a financial instrument based on its current price rather than on its cost.
3Risk arising from general economic changes that affect the market.