Last week marked the publication of our topical, and incredibly timely title: Routledge Library Editions: Banking and Finance. To celebrate, and to mark the title's launch, we are posting the results of our first author/reader Q&A.
Thank you to everyone who emailed questions. Two of the title's authors, Timothy Morris (Professor of Management Studies at the University of Oxford), and Nicholas Snowden (Senior Lecturer in Economics at Lancaster University) answer your questions below.
QUESTION 1: from David Millar
There appear to be two viewpoints on the behaviour of bankers leading up to the financial crisis:
1) They knew exactly what they were doing — they exploited the fact that they were too big to fail to take excessive risks knowing the downsides would be paid for by taxpayers.
2) They had no idea what they were doing, and it was a big accident.
Presumably the reality is a mixture of the two. Which does the author think is more dominant?
They knew nothing: some probably had no idea of the wider consequences of their actions and were subject to all sorts of biases in their decisions and actions and to self-serving myths such as the proposition that risk had been 'de-risked' through CDOs etc. This was reinforced by the delusions of experts who clearly misunderstood what risk meant and by regulators and other actors who bought the myth perpetrated by so-called experts, including many prominent academic economists who had been effectively 'captured' by banks.
With hindsight, the signals in the market seemed from early 2007 to indicate substantial over-heating/over-lending particularly to fund the American property market but the incentive models used in banks, plus the delusional assumptions about risk, plus the accounting models that allocated enormous profits for sub-prime lending, plus the hubris many senior bankers displayed which inhibited proper reflection were a poisonous cocktail which meant few banks corrected their behaviour.
They knew everything: I think some sensed this was a train out of control and things were turning very bad but I suspect no actors really grasped the scale and urgency of the sub-prime problems for the reasons I give above. I think few understood the concept of too big to fail at the time or worked on that assumption precisely because of the hubris that they presumed they could never fail: the secret of de-risking had been found. The problem now is that having learned that there is such a possibility [of being too big to fail] the logical consequence is that even more risky behaviour will occur [see Q2].
While many lost their jobs as a result of this shambles, mostly outside the banking system, and many others lost their homes and savings, few senior regulators, bankers, academic economists or politicians really took responsibility for their actions. Thus, too big to fail also applies to others who had responsibility for managing the wider financial system. [Timothy Morris]
QUESTION 2: from Alex Hunter
How do you feel the current crisis is shaping banks' views of what constitute sound financial strategies?
I have little insight into that except at the moment banks are re-building their balance sheets, partly under pressure from regulators and partly because they expect fall-out from Eurozone and other sovereign debt. I believe that the incentive models in banks remain fundamentally the same and that when the opportunity to lend expands there will be a return to more risky behaviour which regulators will always find difficult to constrain. My view is that the problem of 'too big to fail' has institutionalised moral hazard in banks and unless strong, credible signals to the contrary can be made, for instance by letting at least one more large bank fail, there will be a repetition of 2008. The money banks make comes predominantly from trading and that is an inherently risky [and largely socially useless] activity. [Timothy Morris]
QUESTION 3: from Tarquin Evans
How does it feel to be publishing a book about basic finance principles at a time in which these very same principles seem to be failing practitioners? (I am thinking of the current absence of a risk-free rate, fundamental ingredient of any capital budgeting exercise based on CAPM calculations)
In view of your question, it is perhaps fortunate for me that my own contribution is not a book of the type you describe. It examines an earlier episode of banking sector instability that seems in retrospect to have quite a lot in common with the post-Lehman experience. With the decades between these two market breakdowns having witnessed numerous banking sector disruptions, your question raises the issue of how much confidence we can have in valuation models from financial economics that are based on the underlying assumption of ‘efficient’ market pricing. My view is that models like the CAPM contain great insight and are well worth study, provided that a much stronger health warning is attached to the effect that these relationships are subject to potential breakdown in periods of market crisis – and, moreover, that such crises cannot be ruled out a priori! The nearest parallel would be Keynes’ observation that basic economic theory is invaluable provided that macroeconomic policies can be assumed to be working in the background to maintain full employment. [Nicholas Snowden]
QUESTION 4: from Amy Borthwick
Do you think that the current interventions by regulators and monetary authorities — e.g. restrictions on investment activity (think for instance of the higher reserve requirements for banks) or substantial price manipulations (QE)—might be sending the wrong signals to financial actors and, thus, leading to inefficient allocation of capital?
You raise the question of the unintended consequences of policy interventions, and the risks are clearly present in the current situation. The capital requirements imposed under the Basel Accords were a factor in the rapid development of the off-balance sheet activity that was later implicated in the financial crisis. Similarly, the enhanced capital ratios being imposed in its aftermath are tending to limit the willingness of banks to expand the size of their loan books at a time when macroeconomic considerations would favour their doing so. The effects of QE may include the stimulation of a search for yield, or the persistence of bank lending to ‘zombie’ companies, with attendant risks of resource misallocation. Nevertheless, it is important to bear in mind that policy interventions were prompted by a threatened collapse of financial intermediation, which, had it been permitted to occur, would have greatly aggravated the current human and resource waste represented by the present heightened levels of unemployment. [Nicholas Snowden]
QUESTION 5: from Julia Smyth
In the light of the financial crisis exposing the weakness of traditional risk models like VaR and CVaR, how have banks adapted their risk models to overcome these shortcomings?
While it is too soon after the event to provide a general answer, your question clearly troubles regulators. One of the problems with the banks’ VaR models, and the internal ratings based approaches to the evaluation of credit risk in general, was that the probabilities involved were estimated over ‘Great Moderation’ years that, in retrospect, turned out to be unrepresentative of what was to follow in 2008. The Basel Committee responded in 2009 with the proposal that ‘stressed inputs’ be used in the calculation of, for instance, counterparty credit risk. This idea that banks should calculate their risks based not on the normal run of events but also on the possibility of abnormal market conditions is also relevant to another problem. Internal ratings based approaches and VaR-type models contained inherently pro-cyclical elements. Credit risk tends to decline in a boom, as does the variability of bank earnings generally – with the inference that less capital was needed, or that banks would lend more aggressively. Greater losses in the downturn, by contrast, demanded that more capital be held, or that the loan book was curtailed. The stressed input basis for calculation is also intended to reduce this unwelcome tendency to aggravate the economic cycle. [Nicholas Snowden]
For further information on the collection, a detailed contents breakdown, or to order a copy, visit the following link: http://www.routledge.com/books/details/9780415520867/
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