As someone who worked in banks and capital markets for many years but is now on the outside looking in, many people I know have been asking for my take on the seeming collapse of the existing financial and banking system. With so many talking heads already contributing to the cacophony of fact, rumour, opinion and innuendo surrounding the financial markets, I have been loathe to add to the noise.
However, in particular I have been struck by the sheer volume of spurious information and the overwhelming complexity of many of the explanations emanating from a seemingly endless array of ‘experts’. At the risk of falling into the same trap I think we (in the financial community) are at great risk of creating even greater confusion and mistrust: by talking too much about the trees, we have lost sight of the forest.
The key to understanding the current fracas is this:
[(Leverage + Short Term Funding)*Opaqueness]^Hubris = Explosive Risk
Activate said risk with an exogenous shock leading to a decline in asset values, and….
tick, tick, tick…BOOM.
This is not really hard to understand. Most people could get this if explained to them. Indeed, I tried to do just that over a year ago when Northern Rock was (one of the) first to fall victim to this toxic cocktail.
So why did all those ostensibly clever people running banks and such not know about and/or understand the equation above? Well, the short answer I would posit is that they did, or at least most of them did, and they either:
- (a) thought they were clever / nimble enough to get out quickly when the tide would turn
- (b) rationally (and cynically) traded their implicit free-ish option; ie the NPV of a few years of bonuses on steroids would compensate for the bust
- (c) figured it was easier to “keep dancing” than to explain to staff, customers and shareholders why they were missing the party
- or..(d) all of the above.
And it didn’t start out as a problem. Much of what went wrong started out as intelligent and robust financial innovation and smart management, creating real value. But it worked too well. Made too much money. And somewhere along the way, critical thinking was left in the dust. The ability to question the business model, to continue to innovate, to remain open-minded was mostly crushed by the profits juggernaut that seemed unstoppable.
And this proved fatal. Because also along the way – as with all industrial revolutions – the juice was arbitraged away. But no one wanted to admit this. Inventing new and better, more profitable ways to serve your customers is hard. Something to be avoided. Delayed at least. “The next guys problem.” Better, there was a built-in mechanism allowing one to ignore it. Just add a bit more leverage. Stretch the funding gap a week. A month. A year. Obfuscate both with some structuring. Toss in the hubris that inevitably emerges when people make millions and millions commanding the heights of the economy… Lather. Rinse. Repeat. And so you have the proverbial frog that cooked in a pot slowly but inexorably brought to a boil.
The business model, the compensation paradigm, the culture, all were predicated on scarcity – of information, of competition, of resources – that drove high margins. This was once true. It ceased being so (at least) several years ago. This is what I was trying to get at when I wrote these essays in 2002 and 2003 (!)
So why is this important? How does it help us move forward? First, we need to understand that the old way of doing things – the historical business model of banking – is (and has been for a few years) obsolete. That out of this obsolescence will rise a new and different approach to providing financial services and that many of the extraordinary innovations in finance and technology can truly help create great wealth in our economies and are not the problem but are – applied intelligently – part of the solution. In these very trying circumstances, my fear is that as a society we retrench into some sort of financial dark age. Especially since I am convinced that we now have all the tools at our disposal to create an epochal change in the financial services landscape, in particular I see the potential for a radical democratization of finance. The importance and effect of such a shift over the next 30-40 years would be analogous in its impact on our society as to the impact of the Protestant Reformation: removing the monopoly heretofore enjoyed by the financial papacy would I think create a less risky financial substrate for the global economy.
I don’t want to minimize or trivialize the current crisis. But there is reason for optimism amongst all this gloom. The best catalyst for change, the best bromide against inertia is of course catastrophic failure. I think we can all agree on that.