Change we can believe in?
There was a heck of a lot of talk in the intimidate aftermath of the credit crunch regarding regulatory changes that would be made, but what if anything has actually been done?
Sure there are some capital ratios that have been tweaked, but what about wider, more pervasive changes?
My argument is that the credit crunch happened due to flaws in human psychology – well duh! you might say.
But if this is such an obvious explanation, why are all the proposed changes still ignoring well known and well researched biases from the world of behavioral economics?
In the years leading up to the bust, banks were run with a testosterone fueled target driven culture. Want your bonus? hit your targets! This comes from the top down. Your boss is screaming at you to make the numbers because his bonus depends on it, you in turn scream at your underlings and so on.
Somewhere in this process corners are cut. Risk factors were ignored.
Picture the broker in this situation. He knows he has to turnover X amount to make his bonus.
He could play it safe or deal with the new fangled CDOs. He might question,
"Is this CDO really worth £X million, should it really be AAA rated?"
He gets that feeling of doubt in his stomach. It doesn't feel 100%, but he knows he's got to make his numbers. Anyway everyone else is dealing in them and if they go kablooey in 2 years, he'll still get his bonus.
Maybe it's not his own greed that's driving this. Maybe its the desire to not let the team down, keep his boss happy. Maybe it's not the money per say but his station amongst his peers. Come bonus time, they'll be buying another flat in Chelsea, how will he feel if he can't even take his wife on that holiday?
Now, I'm not for a minute saying all bankers were or are bending the rules like this. I have some good friends working in the banking industry who are fine upstanding fellows. What I'm trying to demonstrate is how easy it is for someone to start cutting corners and trading in assets they wouldn't otherwise touch with a barge pole.
There are two behavioral traits at work here.
- As explained here, if your peers are bending the rules you are more likely to as well.
- No-one starts out believing or thinking they will bend or break their own moral boundaries, but breaking/ bending the rules one bit at a time can lead to a point that you would have thought unthinkable at the outset. When they interviewed the people involved in the Watergate scandal, they asked certain people how they let themselves get to that point. The answer was simple, they did it one small rule break at a time.
Where does that leave us now?
There's nothing wrong with an aggressive bonus/ target driven culture per se. Many business use this model. It works fine most of the time. However, all too often, aggressive targets can encourage some bending of the rules. This might be selling something to someone you know isn't appropriate for them. Most of the time, this will result in a loss of business. If you sell faulty goods, it usually won't take much time for the client to realise they've been duped and complain, then look for someone else to provide the service.
But what if the payback period is over years not months. What if you could sell something to someone that might have hidden risks, but those risks won't become apparent until next year, or maybe 2 years down the line. What if the risks aren't clear? The seller might be able to justify to themselves that they have no way of knowing how the future will work out and the buyer should be sophisticated enough to know this anyway. You might then be temped to sell something you wouldn't want to put your own money in.
You can see that the financial markets could be highly prone to mis-selling in these circumstances.
The last few major financial bubbles demonstrate this well.
We've had a junk bond frenzy, tech stock bubble, Asian stock bubble and of course mortgage bond mania.
We can't say we weren't warned, plenty of well placed people have shared their experiences of working inside an investment bank or written about the reasons for past explosions.
Richard Thomson's Apocalypse Roulette from 1999, and Phillip Augar's Merchants of Greed (2006) provided some clear examples of the culture running within investment banks and how they gave rise to the current crisis.
Because unless there are real changes, there will be a next time. China? Oil?
So what is the answer?
Gordon Brown's call for a tax on banking won't work, or at least as
well as he hopes. You're dealing with 'the smartest guys in the room'
who will no doubt find a way to minimize the impact by driving revenue
offshore or using over the counter products. No doubt it will be the
retail investors who end up bearing the cost without the added
protection it is supposed to be bringing.
Brown is right on one level though, any changes need to be applied across the globe.
Ideally, bonuses from the very top down would be tied to long term results. For example, 10 year stock options with tiered payouts that rover the years reward long term performance. This is in an ideal world though and may be hard to implement.
Perhaps the best option as proposed by the likes of Talleb, and ex Fed chairman Volcker etc is to make banks smaller and to split investment banks from retail banks. The speculative operators can therefore gamble away and fail without bringing down the whole system. The trouble with this argument is that the financial system is now so tightly interlinked that a supposedly small independent operator could cause a ripple effect.
There's probably no single solution and mandatory training on previous collapses and insights into human psychology for new employees would probably help too.
Banks do provide training on the dangers of insider trading and brokers have achieve various qualifications before being let loose with client funds. Adding a compulsory module on behavioral economics and lessons from the past sure won't hurt.