PART 3 – WHO WAS TO BLAME FOR THE GLOBAL FINANCIAL CRISIS
13/11
Bankers
Who were these bankers
Smart people. Financial innovation such as the developments in the securitisation market
was the result of highly structured, statistical and intellectual thoughts developed by sharp
minds.
Was there a cost to society given the intellectual efforts diverted into banking?
“I suspect we are throwing more and more resources, including the cream of our youth, into
financial activities that generate high private rewards disproportionate to their social
productivity.” – Tobin, Nobel prize winner
Stiglitz agrees – the financial crisis led to the misallocation of our scarcest resources, our
human talent. I saw too many of our best students going into finance. They could not resist
the megabucks. When I was an undergraduate, the best students went into science,
teaching the humanities, or medicine, they wanted to change the world…
Survey of graduating classes at Harvard BS in 2007 – from the business school 58% went into
banking.
Stiglitz – “Too many came to believe in the theory that pay reflected social contributions,
and they concluded that those that received such high pay must have been making the most
important social contributions.” – this build overconfidence
Too many came to value what the market was valuing. The high pay of bankers said that
bankers were important.
Stiglitz – “No matter how you look at it, our banks and our bankers, both before and during
the crisis, did not live up to the moral standards that we should hope for, especially in their
exploitation of ordinary borrowers”
Although there is some merit in the argument of a breakdown in ethical standards it is
perhaps more “Bankers are not the horned, greedy villains the public now sees them to be.
In classes I have taught over the years, the future bankers were as eager, friendly, and ready
to share as the other students in class ….”
“But because their business typically offers few pillars to which they can anchor morality,
their principle compass becomes how much money they can make.”
“The picture of bankers slavering after bonuses soon after they had been rescued by
government bailouts was not only outrageous but also pitiable – pitiable because they were
clamouring for their primary measure of self-worth and status to be restored.” Your whole
net worth is captured in how much money you earn.
,What were my experiences with bank bonuses – I handed out bonuses. Bonus day was the
worst of the year, the bonus is what you’re worth, you never see the finish line, your whole
life is about that moment.
Is it fair?
Key take-aways
On Iceland, we completed the story which focuses on the unregulated banking sector
fuelled by wholesale and cheap internet sourced retail funding. 2 interesting issues around
Iceland
1. is that is highlights a larger problem in the lead up to the crisis, the lack of diversity in key
decision making groups. As I highlighted in class diversity is a complex issue, and gender
diversity does not always result in true cognitive diversity but is often a good proxy for this.
Further diversity in groups is not always a positive, and that too much diversity can result in
too much conflict and an inability to make any decisions. Further, one has to look at the
context in which groups are operating. More procedural, menial task homogenous more
cohesive groups can be advantageous but for more complex and difficult talks where
solutions are not as obvious then diversity is seen as being most beneficial.
2. Iceland's inability to bail its banks out caused significant short term pain but perhaps
longer term less of an issue compared to say Ireland. Ireland being part of the EU was under
pressure not to let its banks fail.
On bankers, the main points I wanted to get across were
1. An understanding of who these bankers were. There are a lot of popular misconceptions.
2. To understand that the job is unique in that it has no other measure of net worth or
success other than money. This is important when we look at ethics in that one of the points
I will stress is situational factors, and with bankers, as Rajun notes, there are no pillars in
which they can anchor morality.
19/11
What was Fuld’s response when he was asked if his remunerations were fair given the
whole bank system collapsed?
He argued that most of his stock was left in the company, high levels of employee stock
ownership and that his compensation was set by a committee
So far we know
- Who the “bankers” are
- That there was a real opportunity cost of channelling human resources into finance
- That situationally it is a field where ones entire self-worth is measured through the pursuit
of profits.
- Is fairness of remuneration a public concern or it a matter between shareholders and
management?
Financial Incentives and Banker Bonuses
“Economics, when you strip away the guff and the mathematical sophistry, is largely about
incentives.”
, “When the (crisis) occurred countless commentators claimed that Wall Street’s unbridled
lust for money had wrecked the financial system. That assumed that the financiers of 2007
were greedier than the Gordon Gekkos of a generation ago.
In fact what made the difference was not the magnitude of the greed but the new
structures of incentives and compensations that channelled greed in new and dangerous
directions.”
In other words it was not greed that was new but rather a shift in the way that greed was
channelled.
One of the big changes in the way banks where structured after deregulation was bonuses
were tied to short term profits instead of long term, these banks started channeling all their
profits short term, all competing with each other, and as you make loads of money there are
expectations to make even more
Rational Irrationality: the desire to bet on tail risk – Cassidy
Assume a project which has the following RISK profile:
Likelihood of success 99% 100 million gain
Likelihood of failure 1% 1 billion loss
Should the bank invest? Does it make financial sense to pursue this deal?
The returns risk adjusted are lower than the losses risk adjusted so it wouldn’t make sense
to pursue this deal.
What if you are a banker before the crisis and you get 10% of any profits on a deal? Would
you be pushing for this deal to happen?
Of course! The worst case scenario you might get fired, but the loss of 1 billion has got
nothing to do with your money. Loads of upside, little downside.
In 2 trades with positive MVP, which trade do you chose given scarce resources, the one
that gives you the most gain even if the risk of loss is higher. Why not place my bets on red.
If I am right, I make a bundle. If I am wrong then the firm loses and I simply move on. Heads
I win, tails you lose.
Firms seeking Alpha
In competitive markets firms were also looking to make “Alpha” (returns consistently above
benchmark) and in doing so many took risks which they never thought would materialise
(tail risk). Remember this is an environment of high levels of confidence and strong historic
performance.
“Consider a trader who inadvertently develops an investment strategy with high probability
gains but improbable but large losses. Like a firm that has sold earthquake insurance, the
strategy may produce a long string of impressive returns before one year of huge losses will
wipe out many years of profits.”
If so during the good years the trader will be celebrated for his or her brilliance, rewarded
with large bonuses, and given more resources to manage.
13/11
Bankers
Who were these bankers
Smart people. Financial innovation such as the developments in the securitisation market
was the result of highly structured, statistical and intellectual thoughts developed by sharp
minds.
Was there a cost to society given the intellectual efforts diverted into banking?
“I suspect we are throwing more and more resources, including the cream of our youth, into
financial activities that generate high private rewards disproportionate to their social
productivity.” – Tobin, Nobel prize winner
Stiglitz agrees – the financial crisis led to the misallocation of our scarcest resources, our
human talent. I saw too many of our best students going into finance. They could not resist
the megabucks. When I was an undergraduate, the best students went into science,
teaching the humanities, or medicine, they wanted to change the world…
Survey of graduating classes at Harvard BS in 2007 – from the business school 58% went into
banking.
Stiglitz – “Too many came to believe in the theory that pay reflected social contributions,
and they concluded that those that received such high pay must have been making the most
important social contributions.” – this build overconfidence
Too many came to value what the market was valuing. The high pay of bankers said that
bankers were important.
Stiglitz – “No matter how you look at it, our banks and our bankers, both before and during
the crisis, did not live up to the moral standards that we should hope for, especially in their
exploitation of ordinary borrowers”
Although there is some merit in the argument of a breakdown in ethical standards it is
perhaps more “Bankers are not the horned, greedy villains the public now sees them to be.
In classes I have taught over the years, the future bankers were as eager, friendly, and ready
to share as the other students in class ….”
“But because their business typically offers few pillars to which they can anchor morality,
their principle compass becomes how much money they can make.”
“The picture of bankers slavering after bonuses soon after they had been rescued by
government bailouts was not only outrageous but also pitiable – pitiable because they were
clamouring for their primary measure of self-worth and status to be restored.” Your whole
net worth is captured in how much money you earn.
,What were my experiences with bank bonuses – I handed out bonuses. Bonus day was the
worst of the year, the bonus is what you’re worth, you never see the finish line, your whole
life is about that moment.
Is it fair?
Key take-aways
On Iceland, we completed the story which focuses on the unregulated banking sector
fuelled by wholesale and cheap internet sourced retail funding. 2 interesting issues around
Iceland
1. is that is highlights a larger problem in the lead up to the crisis, the lack of diversity in key
decision making groups. As I highlighted in class diversity is a complex issue, and gender
diversity does not always result in true cognitive diversity but is often a good proxy for this.
Further diversity in groups is not always a positive, and that too much diversity can result in
too much conflict and an inability to make any decisions. Further, one has to look at the
context in which groups are operating. More procedural, menial task homogenous more
cohesive groups can be advantageous but for more complex and difficult talks where
solutions are not as obvious then diversity is seen as being most beneficial.
2. Iceland's inability to bail its banks out caused significant short term pain but perhaps
longer term less of an issue compared to say Ireland. Ireland being part of the EU was under
pressure not to let its banks fail.
On bankers, the main points I wanted to get across were
1. An understanding of who these bankers were. There are a lot of popular misconceptions.
2. To understand that the job is unique in that it has no other measure of net worth or
success other than money. This is important when we look at ethics in that one of the points
I will stress is situational factors, and with bankers, as Rajun notes, there are no pillars in
which they can anchor morality.
19/11
What was Fuld’s response when he was asked if his remunerations were fair given the
whole bank system collapsed?
He argued that most of his stock was left in the company, high levels of employee stock
ownership and that his compensation was set by a committee
So far we know
- Who the “bankers” are
- That there was a real opportunity cost of channelling human resources into finance
- That situationally it is a field where ones entire self-worth is measured through the pursuit
of profits.
- Is fairness of remuneration a public concern or it a matter between shareholders and
management?
Financial Incentives and Banker Bonuses
“Economics, when you strip away the guff and the mathematical sophistry, is largely about
incentives.”
, “When the (crisis) occurred countless commentators claimed that Wall Street’s unbridled
lust for money had wrecked the financial system. That assumed that the financiers of 2007
were greedier than the Gordon Gekkos of a generation ago.
In fact what made the difference was not the magnitude of the greed but the new
structures of incentives and compensations that channelled greed in new and dangerous
directions.”
In other words it was not greed that was new but rather a shift in the way that greed was
channelled.
One of the big changes in the way banks where structured after deregulation was bonuses
were tied to short term profits instead of long term, these banks started channeling all their
profits short term, all competing with each other, and as you make loads of money there are
expectations to make even more
Rational Irrationality: the desire to bet on tail risk – Cassidy
Assume a project which has the following RISK profile:
Likelihood of success 99% 100 million gain
Likelihood of failure 1% 1 billion loss
Should the bank invest? Does it make financial sense to pursue this deal?
The returns risk adjusted are lower than the losses risk adjusted so it wouldn’t make sense
to pursue this deal.
What if you are a banker before the crisis and you get 10% of any profits on a deal? Would
you be pushing for this deal to happen?
Of course! The worst case scenario you might get fired, but the loss of 1 billion has got
nothing to do with your money. Loads of upside, little downside.
In 2 trades with positive MVP, which trade do you chose given scarce resources, the one
that gives you the most gain even if the risk of loss is higher. Why not place my bets on red.
If I am right, I make a bundle. If I am wrong then the firm loses and I simply move on. Heads
I win, tails you lose.
Firms seeking Alpha
In competitive markets firms were also looking to make “Alpha” (returns consistently above
benchmark) and in doing so many took risks which they never thought would materialise
(tail risk). Remember this is an environment of high levels of confidence and strong historic
performance.
“Consider a trader who inadvertently develops an investment strategy with high probability
gains but improbable but large losses. Like a firm that has sold earthquake insurance, the
strategy may produce a long string of impressive returns before one year of huge losses will
wipe out many years of profits.”
If so during the good years the trader will be celebrated for his or her brilliance, rewarded
with large bonuses, and given more resources to manage.
