How Western economies develop in the years ahead depends very much on why we think we are in this mess – and whether we believe in spontaneous forces of recovery or the need to build anew. There is a now familiar roll call of villains, ranging from irrational bonuses to sleepy regulators – not to forget the extraordinary international financial relationships that created such a formidable build-up of liquidity. All have to be addressed.
Lack of commitment
But there is one factor that has attracted too little comment. The financial system grew too complex because it actively shirked its responsibilities to committed ownership. Instead it vastly magnified financial transactions, much of whose purpose was to reduce commitment, but whose fees and commissions represented both an excessive tax on the real economy and ultimately a source of instability in its own right.
It is vital that this changes. But it is also time to stop kicking the entire banking system, even if some individual bankers deserve coruscating criticism (and perhaps police questioning). For it is vital that the financial system sustains itself and maintains the existing volume of credit, and new credit flows, rather than shrinks them in response to punitive regulation and lectures about returning to less risky traditional banking.
We need our financiers to take risks more than ever, in a regulatory context that encourages more sustainable business models. The gross domestic product (GDP) of each G7 country will decline in 2009 for the first time since 1945. We do not need matters to grow worse.
The heart of the crisis was the mania for securitisation and the false belief that risk could be insured against through tradable derivatives – credit default swaps (CDSs). As securitisation became more and more fashionable and the credit rating agencies got ever more ready to award high credit ratings to structured investment vehicles holding tranches of ever more dubious debt, so the financial system became ever more vulnerable to a decline in underlying asset prices.
Collapse of trust
When the decline struck, nobody knew who held how many risky securities and how good the insurance via CDSs was. Fear struck and trust collapsed. In the event, the system has accepted $2800bn of mark-to-market losses in the debt market, according to the Bank of England. Interbank lending froze – and it is only just unfreezing, courtesy of government guarantees. Banks have been recapitalised with public funding throughout the G7. Liquidity running into trillions of dollars has been injected into the system. And still it totters. There will be more failures and shocks before the story is over.
But securitisation was not the only culprit. There has been too much leverage against too little capital. The development of a $360,000bn-plus market in derivatives in the so-called shadow financial system – compared with a world GDP of $60bn and world share value of $40,000bn – has also been a source of instability. It has caused violent movements in share prices, currencies, commodity and bond prices as the bets on these real financial variables dwarfs the turnover in the assets themselves. This is mayhem.
I agree that securitisation at its best is a technical way in which the owner of assets can hedge the risk by selling some of them on and assuming different ones to get a more even balance of risk. In this sense, securitisation is an important new innovation; as is the capacity to extend insurance into banking and lay off loan default risk. Any reform now needs to respect and retain these innovations.
What went wrong is that financiers went wild. Securitisation passed from being a means for owners to legitimately hedge risk to a more general retreat from any of the responsibilities of ownership. A bank owns a relationship with its borrowers. But banks began to think less of the ‘owned’ relationship and more of how they could generate fees from commoditising the relationship into a tradable transaction – securitisation. And worse, squaring and cubing the income streams in collateralised debt obligations not only made the securities harder to value, they also became a means of smuggling low-value income streams into higher-rated ones.
The lack of ownership commitment has become an epidemic. It manifests itself as the practice of lending shares in exchange for a fee to short sellers. It is the practice of ‘rehypothecating’ assets bought with loans that a bank has provided a hedge fund in order to lend against them again. It is contracts for difference. It is tradable CDSs. It is the mania for bids and deals in which the wider public is told that ‘ownership does not matter’. It is the private equity industry regarding companies as vehicles for leverage and mountainous returns to private equity partners. It is a financial system that focuses entirely on transactions, leverage and deal flows – and not the needs of the underlying real economy it exists to serve.
Reintroduction of ethics
There are many dimensions to reform, which I will not rehearse here once again. But, the prime objective has to be to reintroduce ownership and the accompanying ethics of responsibility, commitment and trust back into the system. It has been allowed to become overly transactional. It must be re-biased towards committed ownership.
There are pros and cons of any reform, but some that must be considered include: loans and shares should not be lent to third parties for fees; unless proof of long-term ownership can be demonstrated, the dealer should forfeit rights to any sales proceeds. Short selling and rehypothecation should be banned. Owners of contracts for difference should have to declare their identity and purpose in buying assets indirectly; short-term trading should be subject to a transactions tax. Organisation for Economic Co-operation and Development (OECD) governments should declare that the same disclosure rules and requirements will be made of all tax havens. The presumption should be that non-compliance implies guilt. All bonuses in financial services should be paid on the basis of five-year performance – long enough to see if performance is genuinely ‘alpha’. One-year bonuses should be subject to severe marginal tax rates.
Resist revenge
Above all, we have to be generous to a stricken financial system. It grew too large. It paid itself too much. It became a tax on the real economy. It neglected its ownership responsibilities and insisted it should be lightly regulated. It has brought the world to the edge – and the instinct for revenge, as with reparations from Germany after the First World War, is powerful – thus the language of salary caps, punitive dividends on preference shares and regulation to deliver high-risk aversion.
But it must be resisted. Our attitude should be very much more like the Americans and the Marshall Plan post-1945. We need to rebuild the financial system and it cannot be done without the state and taxpayers’ money. It may be necessary to arrest some leading financiers and organise some show trials; but just as after the Second World War it was in our self-interest to be generous to Germany, so we must now be generous to finance. We need credit and finance to take risks, and we need to sustain some of the innovations of the past few years. The alternative is the all too real prospect of a world recession, even depression. And there are only months left in which to act.
Will Hutton is a political commentator and author, whose books include The State We’re In, The World We’re In and The Writing On The Wall: China and the West in the 21st Century.
