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Is Financial Titanic II on the water?

While stock markets across the world rallied over recent weeks, there were dangerous signs that large financial institutions across the globe were returning to "business as usual" in terms of the “equity culture” that led to the financial crisis of 2007/2008 in the first place. There are serious warning signals that, unless some fundamental restructuring in the financial industry takes place soon, the world may well be on its way to the next major crisis.

In the United States, President Barack Obama, in proposing a fee on the country’s largest banks, voiced his frustration with the return to “massive profits and obscene bonuses” at firms that a few months ago had to be bailed out.

In Paris, the Organisation for Economic Co-operation and Development (OECD) warned that “the risk now is that the respite for the crisis achieved through support may lead to complacency and a refusal to acknowledge how much damage the 'equity culture' in banking may have done this time and – left unconstrained – may do again in the future.”
Wall Street has rebounded during recent weeks, raking in bumper profits. This has helped many of the banks repay their financial bailout funds, freeing them of government rules on compensation and allowing them to pay out major staff bonuses.

President Obama last week proposed that Wall Street banks pay up to $117 billion to reimburse the US treasury for the financial bailout. He said he was determined to  recover “every dime” that was spent by the US government to rescue the financial sector from its worst crisis in more than 70 years.

It is reported that the White House is hoping that the fee he will be proposing in his budget for the fiscal year 2011, to be introduced in February, will also help to reduce the ballooning US budget deficit.

While the levy will recoup losses from the rescue of US banks under the Troubled Asset Relief Program (Tarp), it will do very little if anything to address the underlying factors that led to the crisis in the first place.

From the OECD report, it is clear that much more will need to be done, and not only in a single national jurisdiction to safeguard the international financial system from a recurrence of a similar crisis in the future.

“The world outside of policy-making is waiting for a fundamental reassessment of banks’ business models: what banks are supposed to do and how they compete with each other. It is the ‘elephant in the room’ on which some policy-makers have not yet had the time or inclination to focus,” the report states.

The “too big to fail” problem, where the failure or possible failure of a single or a group of financial institutions brings serious systemic risks, is one of the main focuses of the report.

It emphasises not only the need for transparent and comparable accounting rules and for the improvement of corporate governance, but also supports the imposition of a group leverage ratio to provide a binding capital constraint – which the Basel risk-weighted rules have been unable to achieve – and proposes a non-operating holding company structure (NOHC). These reforms are essential to deal with contagion and counterparty risk, which are so integral to the 'too big to fail' issue, it is stated.

Echoing what is presently happening in the US financial market, the report states that “in principle, sound corporate governance and a strong risk-management culture should enable banks to avoid excessive leverage and risk-taking. But human nature being what it is, there are likely always to be some players eager to push complex products and trading beyond the sensible needs of industry and long-term investors in order to drive profits.

“Indeed, right now such activity is driving the rapid profit growth of some banks, with little having been learned from the past.”

The report goes on to state that “as the system will always be hostage to the ‘gung-ho’ few, the question is whether there is a better way, via leverage rules or rules on the structures of large conglomerates, to ensure volatile investment banking functions do not dominate the future stability of the commercial banking and financial intermediation environment that is so critical for economic activity.”

The report emphasises the fact that “more lifeboats are not enough”, and states that the mood in the world of ordinary investors can be illustrated by a statement from a well-respected fund manager/commentator who wrote: “I can imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship’s construction, of the company’s policy, or of the captain’s competence. ‘No one could have seen this coming’ would have been the constant refrain.

"Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today, with our efforts to redesign the financial system in order to reduce the number and the severity of future crises.”

The full OECD report can be downloaded at www.oecd.org/dataoecd/13/8/44357464.pdf

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