We need a balance between arrogant marketing fundamentalism and social good.
The media has been describing what is happening in the western banking system as “private gains, public losses”: the takeover of Northern Rock in the UK and Bear Stearns in the US, the poor quality of assets being bought by central banks to provide liquidity, and, most importantly, the rescue package for homeowners and for Fannie Mae and Freddie Mac signed by President Bush last week. About 4,00,000 homeowners are expected to benefit by their costly loans being re-financed by cheaper money from a federal agency, to the extent of $300 billion. Brokers and banks who sold unserviceable loans to sub-prime borrowers have walked away after pocketing their fees.
Fannie Mae and Freddie Mac are privately-owned, government sponsored enterprises which play a major role in providing housing finance and guarantees for housing loans in the US — their aggregate direct and guarantee exposure to the sector is of the order of $5.2 trillion (40 per cent of the GDP) and they are counterparties to interest rate derivatives with an aggregate notional principal of $ 2.3 trillion. On mark-to-market basis, the giants are bankrupt but still carry very strong ratings because of the implicit federal guarantee for their debt: this became more explicit with last week’s enactment. No doubt their defaults would have posed a systemic risk not only to the US market but even globally — $1 trillion of the bonds are owned outside the US. The principle, or at least the practice, of private owners gaining as long as the going was good and the government having to take over the losses when things turn bad, has had a long innings even in economies swearing by market fundamentalism.
Where did the problem start? I am currently reading a history of Citibank and in one place it quotes Arthur Burns, the then Chairman of the US Federal Reserve, telling Walter Wriston, Citibank chairman: “Walter, you are absolutely wrong to have an earnings target for a bank. It is not seemly.” In those days, banking was a quasi-public utility and not a “business” aimed at maximising earnings of share-holders, traders and top management. Under Wriston’s leadership, Citi lost the “milk of human kindness”, as an unnamed person is quoted in the book. If Citi was, and perhaps is, the most aggressive pursuer of profits, many other banks quickly followed suit, and compensations came to be built around the profit objective. These banks and the financial markets they created came to be called “mature”, not only by western commentators, but accepted as such by us as well.
After seeing what has happened in the US banking industry since the sub-prime credit crisis, one is tempted to exclaim: “Mature? Heck, NO! Just greedy and incompetent!”
To me, what is truly amazing is how “the best and the brightest”, and the highest paid, in the US banking industry believed that housing prices will keep rising indefinitely. Why did they take so much time to realise the extent of losses arising from the sub-prime debt market? Bank after bank is reporting losses in the second quarter as well. (Have markets and instruments become too complex for risk management even by the best?) As a risk management consultant, it has also amazed me how investment portfolios of many banks were being valued by traders themselves: it is an elementary principle of internal controls that valuations are done by the mid/risk/back office, completely independently of the front office.
One other point: as if banks were not enough hedge fund-like in their trading operations, several of them started their own in-house hedge funds. (Several banks have invested in Citi’s hedge funds and are now losing a packet.) Citi even bought a hedge fund promoted and run by Vikram Pandit for almost a billion dollars — to get him on its payroll! Ironically, he is now the chairman and chief executive when the fund is being liquidated.
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If overemphasis on profits led to a lot of excesses, does it mean that virtue lies in bankers sitting behind their desks, disdainful of any marketing or innovation or risk-taking, content to offer their services as a “favour” to the client?
I do not think so. There does, however, seem to be a need for a better balance between private gains and public duties, between excessive hard-sell (which we have witnessed in currency derivatives market in India as well) and bureaucratic inertia. Aristotle surely had the last word on the subject a couple of millennia back, arguing that extremism is the only vice and moderation the only virtue. In a broader perspective, we need some balance between arrogant market fundamentalism and social good.