How the Financial Crisis of 2007-2009 has made the financial system more unstable and how a return to market segmentation in the industry can restore credibility to our present form of Capitalism
by
Thomas Schinkel
October, 2009
A central theme in the financial crisis of 2007-2009 is that many people in high places in the financial services industry assumed they were effective managers of risk. Ever more complex and impressive looking mathematical formulas assisted them in their quest to allocate and re-distribute the many risks associated with their actions. But those “post-modern methods of risk management” backfired and a taxpayer-financed bailout was required to prevent the entire system from certain collapse.
Two Remedies
To remedy the situation, two major ideas have come to the surface. One would place a cap on bankers’ bonuses. The other would prescribe strict limits on how much a bank can borrow against its own equity capital. The first idea is inspired by hopes that caps on bonuses will discourage bankers from taking exorbitant risks in the first place. This is pretty much a European idea, heralded by politicians from France and Germany, but also from the UK and elsewhere. The other main idea, with American roots, is to adopt strict rules on leverage. Leverage of course defines the amount of dollars or Euros banks borrow against their “at risk” capital. Such caps are interesting because several banks, such as Lehman, that got themselves in trouble had built up borrowings at 30 times and more of their own capital. And we are not even talking about the shadow bankers, the hedge funds and the like that saw leverage ratios even much higher than that. Going forward into the Fall of 2009, let’s assume that the Global Community actually can agree on some sort of a consensus and that it will embrace a little bit of both. Would that solve the problem of risk management and would that return the financial services community to a condition of health and stability?
Risk Management
Intuition and common sense seem to dictate that risk must be taken cautiously and the best way to guard against systemic failure would be to spread risk among as many parties as possible. What has entirely fallen off the table is the notion that with all the restructuring and the bailouts that we have witnessed, risk in the financial services community has not become less concentrated; it has become more concentrated! According to the Dallas Federal Reserve, before the crisis, the SIX largest financial conglomerates in the U.S. controlled approximately 50% of all financial assets in the country. With the consolidation that was set in motion since the crisis erupted that number today has dwindled to FOUR.