10 Things to Remember About the Financial Collapse
In keeping with my recent interest in lists below are 10 things to remember about the financial collapse. The article, by Alan Blinder at Princeton, goes through the 10 most important things we learned from the financial crisis and laments that we have already forgotten most of them.
From the NY Times:
HEGEL once wrote, “What experience and history teaches us is that people and governments have never learned anything from history.” Actually, I think people do learn. The problem is that they forget — sometimes amazingly quickly. That seems to be happening today, even though recovery from the economic debacle of 2008-9 is far from complete.
Evidence of this forgetting is everywhere. The public has lost interest in the causes of the crisis; many, of course, are just struggling to get by. Unrepentant financiers whine about “excessive” regulation and pay lobbyists to battle every step toward reform. Conservatives bemoan “big government” and yearn to return to laissez-faire deregulation. Higher international standards for bank capital and liquidity have been delayed. I could go on.
Instead, let me try to encapsulate what we must remember about the financial crisis into 10 financial commandments, all of which were brazenly violated in the years leading up to the crisis.
1. Remember That People Forget
Treasury Secretary Timothy F. Geithner lamented last year that before the crisis, “There was no memory of extreme crisis, no memory of what can happen when a nation allows huge amounts of risk to build up.” He was right. As the renegade economist Hyman Minsky knew, it is normal for speculative markets to go to extremes. A key reason, Minsky believed, is that, unlike elephants, people forget. When the good times roll, investors expect them to roll indefinitely. When bubbles burst, they are always surprised.
2. Do Not Rely on Self-Regulation
Self-regulation of financial markets is a cruel oxymoron. We need zookeepers to watch over the animals. The government must not outsource this function to “market discipline” (another oxymoron) or to for-profit companies like credit-rating agencies. The Dodd-Frank Act of 2010 isn’t perfect, but it has the potential to change regulation for the better. But most of its reforms are still being phased in, and as the rules are being drafted, the industry (here and abroad) is fighting them tooth and nail and often prevailing.
3. Honor Thy Shareholders
Boards of public corporations are supposed to protect the interests of shareholders, partly by monitoring the behavior of top executives, who are employees, not emperors. In the years before the crisis, too many directors forgot those responsibilities, and both their companies and the broader public suffered from the malign neglect. Will they now remember? Some will — for a while. But sanctions on directors for poor performance are minimal.
4. Elevate Risk Management
One bitter lesson of the crisis is that, when it comes to risk taking, what you don’t know can hurt you. Too many C.E.O.’s let their subordinates ride roughshod over risk managers, tipping the balance toward greed and away from fear. The primary responsibility for keeping risk-management systems up to snuff rests with top executives and boards of directors. But the Federal Reserve and other regulators are now watching and mustn’t let up.
5. Use Less Leverage
Excessive leverage — otherwise known as over-borrowing — was one of the chief foundations of the house of cards that collapsed so violently in 2008. Overpaid investment “geniuses” used leverage to manufacture extraordinary returns out of ordinary investments. Bankers and investors (not to mention home buyers) deluded themselves into thinking they could earn high returns without assuming big risks. But leverage is like alcohol: a little bit has health benefits, but too much can kill you. The banks’ near-death experiences, plus preparation for higher capital requirements to come, are temporarily keeping them sober. But watch for the binge drinking to return.
6. Keep It Simple, Stupid
Modern finance profits from complexity, because befuddled customers are more profitable ones. But do all those fancy financial instruments actually do the economy any good?Paul A. Volcker, the former Fed chairman, once said the A.T.M. was the only beneficial financial innovation in the recent past. He may have exaggerated, but he had a point. Who needs credit default swaps on collateralized debt obligations, and other such concoctions?
7. Standardize Derivatives and Trade Them on Exchanges
Derivatives acquired a bad name in the crisis. But if they are straightforward, transparent, well collateralized, traded in liquid markets by well-capitalized counterparties and sensibly regulated, derivatives can help investors hedge risks. It is the customized, opaque, “over the counter” derivatives that are the most dangerous — and the ones more likely to serve the interests of the dealers than their customers. Dodd-Frank pushed some derivatives toward greater standardization and transparent trading on exchanges, but not enough. The industry is pushing to keep more derivatives trading out of the sunshine.
8. Keep Things on the Balance Sheet
Before the crisis, some banks took important financial activities off their balance sheets to hide how much leverage they had. But the joke was on them. The crisis revealed that some chief executives were only dimly aware of the off-balance-sheet entities their banks held. These “masters of the universe” hadn’t mastered their own books. Dodd-Frank specifies that “capital requirements shall take into account any off-balance-sheet activities of the company.” That’s a welcome step toward making off-balance-sheet entities safe and rare. Now regulators must make the rule work.
9. Fix Perverse Compensation
Offering traders monumental rewards for success, but a mere slap on the wrist for failure, encourages them to take excessive risks. Chief executives and corporate directors should “claw back” pay when putative gains turn into losses. If they don’t, we may need the heavy hand of government to do it.
10. Watch Out for Consumers
The meek won’t inherit their fair share of the earth if they are constantly being fleeced. What we learned in the crisis is that failure to protect unsophisticated consumers from financial predators can undermine the whole economy. That surprising lesson mustn’t be forgotten. The Consumer Financial Protection Bureau should institutionalize it.
Mark Twain is said to have quipped that while history doesn’t repeat itself, it does rhyme. There will be financial crises in the future, and the next one won’t be a carbon copy of the last. Neither, however, will it be so different that these commandments won’t apply. Financial history does rhyme, but we’re already forgetting the meter.