Other People’s Money

The following is an excellent excerpt from the book “THE BANKERS’ NEW CLOTHES: What’s Wrong with Banking and What to Do About It” by Anat Admati and Martin Hellwig from Chapter Thirteen titled “Other People’s Money” on page 208 and I quote: “I am disappointed because many of these behaviours happened on my watch. It is my responsibility to make sure that it cannot happen again. . . We did not have appropriate controls in place. Frankly, we misjudged the risk associated. . . . We know that a small minority have let us down. We also know that we need to rebuild bonds of trust with the society we serve.” –Bob Diamond, Barclays CEO, July 2, 2012
The above quote is taken from a letter to the employees of Barclays, the giant U.K. Bank. The letter concerns Barclays’ involvement in a scheme whereby traders of several large banks allegedly conspired to manipulate reporting for LIBOR (London interbank offered rate), a key index for interest rates, whose value affects trillions of contracts around the globe. A few days earlier, Barclays had agreed to pay more than $450 million to U.S. and U.K. authorities to settle allegations that Barclays had manipulated LIBOR. The chairman of the board of Barclays had just resigned, and Mr. Diamond was forced out as CEO the next day.
In his letter Mr. Diamond is remarkably vague about the “behaviours” he is referring to. He talks about insufficiently controlled “risk” but does not mention any violation of the law. Nor does he let on that manipulating reports for personal gain might raise concerns about criminal behavior such as fraud. Mr. Diamond attributes the manipulation to a small group of people whom the bank had not sufficiently controlled. Yet the manipulation had gone on for years, and even outsiders had had suspicions about it. Why did the bank fail to control the people in question? If senior management knew that they might misbehave, why did it put them in positions in which misbehavior might matter? If management did not know, why not?
According to many accounts, greed has come to dominate the culture of major banking institutions over the past two or three decades. With ever larger speculative positions, the banks’ traders have taken ever larger risks. If their bets succeed, the traders can earn large bonuses, and many of them have become extraordinarily rich. This behavior sets an example for others to emulate; they strive either to become as rich or to prove that they are just as daring as their role models. Large rewards and a sense that “everyone is doing it” have eroded behavior codes focusing on clients’ trust.
Convenient Narratives – Mr. Diamond asserts that the LIBOR scandal had nothing to do with the culture of the bank. Despite recognizing that “our culture, and that of the industry overall, needs to evolve,” he insists that “a small minority have let us down.”
A major theme of this book has been that people often use convenient narratives, stories they tell to explain what happened or what is going on, hoping that others will not ask too many vexing questions. In the case of bankers and banking experts, most of these narratives are examples of the flawed claims we refer to as the bankers’ new clothes. Mr. Diamond’s letter fits this pattern perfectly. By insisting that the LIBOR scandal was due to the misbehavior of a few individuals, Mr. Diamond tries to deflect any demands for wider investigation or reform.
Downplaying problems has also been a standard response to the financial crisis of 2007-2009. For example, many politicians and regulators downplay the costs of the crisis. The U.S Treasury and the Federal Reserve proudly announce that they made a profit on the assets they acquired to relieve banks, but they leave out important parts of the intervention, such as the support using taxpayers’ money that was given to Fannie Mae and Freddie Mac. Most importantly, in discussing the costs of the intervention, politicians and regulators, like bankers, frequently ignore the enormous costs of the crisis to the broader economy—the loss of output in the recession, job losses, and hardships associated with foreclosures. By minimizing the costs of the crisis, this narrative aims at silencing calls for more reform.
A related narrative often advanced by bankers, regulators, and economists is that the financial crisis of 2007-2009 was primarily a “liquidity crisis.” According to this interpretation, investors lost confidence, first in mortgage-related securities and then in banks. The runs that followed caused extensive damage, with strong contagion effects on other banks and markets.
If it had not been for these runs, so the narrative goes, losses would have been much smaller. The runs are compared to depositors’ bank runs before the introduction of deposit insurance, except that the recent runs were driven by companies rather than individuals, and the focus was on short-term lending to banks and investments in money market funds.
In the liquidity narrative, the financial system is sometimes compared to the plumbing of a house, invisible but essential. The metaphor is intriguing, but it is not clear what it is meant to tell us, and unclear metaphors are bad guides for policy. Seeing the words plumbing and liquidity next to each other, one might suspect that the message concerns the need to make sure that fresh water—or money—is available where and when we need it. (Or does the metaphor refer to the part of the plumbing that is used to flush waste down the drain?) The analog of a liquidity problem in a financial system would then presumably be a lack of water coming from the tap, and the central bank’s pumping money into the system would be like getting an additional water supply to fill the pipes.
But why is no water coming from the tap? Is it because of leakage through rusty pipes or because of a drought that has forced the water company to limit the water supply? If the pipes are rusty and have holes, more water will hardly help; if there is a drought, even the government might not be able to provide more water.
Plumbing must be seen in the context of the structure it serves. A highly indebted bank is like an unstable, shoddily constructed building. When such a building is exposed to a strong storm or an earthquake, the walls many not be able to withstand the pressure, and their shaking may damage the plumbing. This will cause a “liquidity problem” at the water tap, but we should be most worried about the instability of the walls. Just as the lack of water flow is really due to the building’s being badly built, so the lack of liquidity is often due to a bank’s being highly indebted.
In the liquidity narrative, the main problem for policy is to prevent runs and liquidity problems for occurring and provide liquidity when they occur. If this is actually the key issue, one might conclude that policy should focus on extending the government safety net, that is, on providing government guarantees to strengthen investors’ confidence and liquidity support by the central bank to help banks in need. This focus on the safety net is inappropriate, however, if liquidity problems and runs are just symptoms of deeper difficulties of banks.
The liquidity narrative benefits from people’s fascination with runs and panics, which contributes to the success of movies such as It’s a Wonderful Life and Mary Poppins. Scholars, analysts, journalists, and the public are intrigued by how a small spark of mistrust, even one that is based on a misunderstanding, can kindle a panic that destroys a bank. The fascination with runs and panics makes the liquidity narrative attractive, but that does not mean that this narrative attractive, but that does not mean that this narrative is true.
Throughout this book we have emphasized the critical importance of solvency for banks and other financial institutions. If these institutions are highly indebted, it does not take much of a shock for solvency concerns to arise. Such concerns can lead creditors to withdraw their money as soon as they can, causing liquidity problems for the banks. As we discussed in Chapters 3-5, runs and other liquidity problems rarely appear out of the blue but usually start when a bank’s solvency is in doubt. Even during crises, investors tend to distinguish between institutions according to their strength. A run can sometimes even be the mechanism for discovering a hidden insolvency and triggering corrective action.
In explaining the crisis of 2007-2009, solvency concerns must be taken very seriously. Banks faced substantial losses from mortgage lending due to homeowners’ defaulting on their debts. These losses would have caused serious problems even if there had been no liquidity problems. Many banks were so highly indebted that they did not have enough equity to absorb the losses. Even those that did not become insolvent found that their equity was much impaired, and this forced them to reduce their activities or sell assets. The resulting credit crunch for the real economy was a result of banks’ financial distress caused by excessive borrowing.
Describing the financial crisis as a liquidity crisis without much concern for the underlying solvency issues is convenient for many, but it is inappropriate for this crisis, just as it is foremost—virtually all—recent financial crises. This narrative diverts attention away from much more important underlying questions, such as why low-quality mortgage lending had expanded so much, why so many banks were so vulnerable to losses, and why regulators and supervisors had looked on passively as the risks were building up.
The liquidity narrative diverts attention away from the question of responsibility for the vulnerability of the banks and of the system. It therefore masks the numerous failures of governance and of regulation, in the financial sector and among supervisors, which contributed greatly to the buildup of risks in the run-up to the crisis. Bankers took many risks and hid them from investors. Regulators were poorly designed and counterproductive. Supervisors allowed banks to get away with practices that bent or broke the rules and that proved to be very harmful in 2007 and 2008.
The crisis was not due to pure liquidity problems. It was driven by serious and legitimate solvency concerns about a number of banks and other institutions. The liquidity narrative distracts audiences from trying to understand why the solvency problems arose.
Many politicians, regulators, bankers, and others want us to believe that banks and the financial system are in much better shape now than they were before the crisis, that dangerous activities have been much reduced, and that many new rules have made the system safer. But some improvements for which regulators take credit cannot really be attributed to them. For example, banks can appear profitable by taking advantage of cheap interest rates to borrow. At the same time they can delay the refinancing of mortgages so their borrowers cannot benefit from the low rates. These actions make banks look better, but they do not reflect any real improvement in the system.
The new reforms that are being put into place are far from satisfactory. Banks may be more robust today than they were in 2008, but this statement does not say much about where they really are and where they should be. As discussed in Chapter 11, bankers and bank regulators prefer to deny the banks’ weaknesses rather than deal with them properly. This attitude has meant that concerns about hidden insolvencies have still not been addressed, and the financial system remains vulnerable to problems inherited from the past. As of this writing, in October 2012, this system does not appear to be better equipped than it was in 2000-2006 to limit the buildup of risks or than it was in 2007-2009 to bear losses.”

(PADDING THE BOOKS IS NEVER A GOOD IDEA AND ONLY BENEFITS THE INVESTMENT BANKS, WHO ARE REALLY MAKING THE PROBLEM WORSE THROUGH THEIR HUGE BONUSES AND POOR TRACK RECORDS OF CONSTANTLY GETTING FINED AND NEVER ADMITTING GUILT, SO YOU KNOW THEY’RE NOT GOING TO CHANGE BECAUSE THEIR METHOD OF SHADOW BANKING UP TO NOW, HAS BEEN SUCCESSFUL IN COVERING UP THE PROBLEM BUT THE PROBLEM OF SECRECY IS MAKING THE WHOLE BANKING PROBLEM WORSE. AND NOTHING WORSE THAN AIG ACCORDING TO NEIL BAROFSKY, IN THE ARTICLE TITLED “FORMER TARP WATCHDOG: ‘WE’RE HEADED TOWARD ANOTHER FINANCIAL CRISIS’” ON “HERE AND NOW OVER WBUR ON SEPTEMBER 9, 2013. EVEN THOUGH THIS EXCERPT IS MAINLY ABOUT THE LIBOR (LONDON INTERBANK OFFERED RATE) ISSUE, SHADOW BANKING IS TALKED ABOUT LATER IN THIS CHAPTER, THERE’S A FOOTNOTE THAT DEFINES IT AND I QUOTE FROM FOOTNOTE NUMBER 53 ON PAGE 335 AND I QUOTE:
“53. For an overview of the shadow banking system, which includes hedge funds, special-purpose vehicles, and other entities, see Poszar et al. (2010), Acharya et al. (2010, Part III), and FDIC (2011, Chapter 2), and FSB (2012). As discussed in Chapter 4 (see note 27) and Chapter 10 (see note 46), money market mutual funds were developed in the 1970s in order to get around the regulation of commercial banks and savings banks. These funds are regulated by the SEC, which means that they are very lightly regulated relative to banks and operate with few restrictions. The concern with shadow banking and so-called regulatory arbitrage can be traced to the establishment of money market funds. Since that time, regulators have feared that regulating banks might lead to displacement of regulated banks with new unregulated institutions. The problem of enforcement is particularly challenging in the United States because the regulatory system is highly fragmented. Under the Dodd-Frank Act, the Financial Stability Oversight Council is authorized to provide “comprehensive monitoring to ensure the stability” of the U.S. financial system, with the idea of closing regulatory gaps (see http://www.treasury.gov/initiatives/fsoc/Pages/default/aspx, accessed October 22, 2012).”

LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members

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About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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