Friday, 4 February 2011

Out with the Tiger, in with the Rabbit


As the Year of the Tiger fades, it has been a year of drama and change. The last Year of the Tiger was 1998, an unforgettable year for the Asian financial crisis. As the Tiger year fades, there has been regime change in Tunisia and big demonstrations for change in Egypt. The Year of the Wood Rabbit in a metal year means that some of the Tiger volatility might remain. Surprisingly, from the perspective of investors, 2010 was quite a year of recovery, thanks to Uncle Ben and his printing machine.

I will not try to predict the future, but will use the Chinese New Year to reflect on an important publication that reviews the lessons of the last three years of crisis. We need to study the past to understand the future.

On Jan 27, 2011, after 18 months of hard work, the US Financial Crisis Inquiry Commission (FCIC) report was finally published, a 633-page document with more appendices to be published soon. This is an important historical document, because it was based on comprehensive evidence called by the commission on almost all the major players in the crisis. Mark my words, the facts are more astonishing than fiction.

The majority view of the report listed the usual suspects: the crisis was due to human faults, with widespread failures in financial regulation and supervision; failures of corporate governance and risk management at systemically important financial institutions; excessive borrowing, risky investments, lack of transparency put system at risk; the government was ill-prepared to manage crisis and systemic breakdown in accountability and ethics. The trigger to the crisis was bad mortgage-lending standards and securitisation; and contributors were over-the-counter derivatives and rating agency failures.

This official document is elegantly written, richly filled with quotes from the insightful to the four-letter direct utterances. It rightly seeks to “expose the facts, identify responsibility, unravel myths, and help us understand how the crisis could have been avoided.”

Despite some who tried to argue that no one could have foreseen or prevented the crisis, the report argued that “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.”

Even though the report commended the principal actors in doing their best to manage an incredibly complex crisis, the report did “not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it. To give just three examples: the Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup's excesses in the run-up to the crisis. They did not. Policymakers and regulators could have stopped the runaway mortgage securitisation train. They did not.”

Why did these regulators not act? “Too often, they lacked the political will in a political and ideological environment that constrained it as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee.”

Unfortunately, the report was split along partisan lines. The three dissenting Republican Party FCIC Commission members considered the report as too broad and rejected as too simplistic a view that too little regulation caused the crisis.

On the contrary, they took the view that too much regulation might have been a cause. They pointed out that the report ignored the global nature of the current financial crisis and argued that the causes should look beyond the housing to the credit and other bubbles.

Another lone dissenter, Peter Wallison of the American Enterprise Institute, identified US government housing policies as the major contributor to the financial crisis.

The complexity of the current financial crisis and its causes will give rise to more debates in the years to come. The majority view of the report was correct in identifying that the crisis was avoidable. However, the dissenters were also correct in identifying that the majority view was partial, by not putting the crisis in its global context.

Indeed, I feel that a serious omission of the report was not to point out that mainstream economic theory failed to provide a holistic and systemic-wide view of the financial system and its vulnerability to crisis, instead inculcating policymakers and regulators to focus on partial analysis and silo-based views that inevitably missed the big picture and the relevant details.

In the 2010 and 2011 Annual Meetings of the American Economic Association, the economics profession is finally beginning to address its own deficiencies and also its own ethics.

Former Obama presidential economic adviser Larry Summer had the most graphic quote on the causes and trigger of the crisis. He likened the financial crisis to a forest fire and the mortgage meltdown to a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest?

The real question is who was supposed to look after the forest in the first place?

Now that we know who is responsible for the financial crisis, how is it that no one seems to be accountable for what went wrong?

The Tiger has roared. Now we want to see if the response is that of a Rabbit. Kung Hei Fat Choy to all readers.

>Andrew Sheng is the author of From Asian to Global Financial Crisis.

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