I was reading a very long and interesting piece by the Atlantic, which talked about how almost everybody has lost faith in the banking system. The article, as good as it is, admits that even the Atlantic doesn’t have a clear idea about what’s going on in American banks.
Why have people lost faith in the financial system over the last four years? Because rather rapidly, our view of the risks facing banks has changed from, “Yes, I understand them” to “I can understand them if I invest time and energy” to “I don’t think I can ever understand them”. Banking, an activity which serves best when it is boring (borrow at x% and lend at x+y%), has been modified into an arbitrage-chasing system that no outsider really understands.
Our parents grew up associating banks with the following words: lending, borrowing, credit-worthy, hedging. We now have to grow up with these added terms: mortgage-backed securities, credit-default obligations, credit-default swap, sub-prime, proprietary trading, and with each passing day, phrases such as ‘rate-fixing’ (in light of the LIBOR scandal) and ‘money-whitewashing’ (in light of HSBC being accused of facilitating drug money laundering).
Bankers have lost the public’s trust by going for the short-term kill over long-term sustainability. One example: Originators of loans have an information advantage, while buyers of loans have an information disadvantage. While previously, banks were too ‘dull’ and not permitted by regulation to try to exploit these disparities, the twin factors of decreasing regulation and increasing demand for loans from the sub-prime category of borrowers allowed banks to exploit informational disparities by originating questionable, or even doomed-to-default loans, and selling them for a small profit to other financial institutions, and ultimately to individual holders who have no idea that the asset that they hold is actually a time-bomb. Worse, some banks went a step further in buying financial products that effectively ‘bet’ that the very asset they sold will go bad! If in the future, the same banks even swear on the Bible that the asset they are packaging and selling is reliable, the public will find it hard to trust them. Bankers were traditionally a respected community because of their contribution to the progress of the society, for giving those without ready access to capital an opportunity to grow in wealth, and most importantly, for using their intelligence and better judgment for the sole benefit of customers. We can effectively write an obituary now for that view of bankers.
In the pursuit of profits, our bankers have become extremely good at constructing complex models to hide or at least disguise risk so that they can more easily meet ‘capital adequacy requirements’, which refers to the amount of shareholders’ funds that have to be held for each dollar of risky assets that a bank holds. We were captivated by the finance boom without fully understanding how it was happening. And we are now regretting how complex, less trustworthy, and thereby ineffective, finance has become.
So, in this situation, maybe we should look to reform our education system to build future regulators, who will be extremely good not at ‘constructing’ models, but at ‘deconstructing’ them. Someone who doesn’t “leave it up to the banks to decide the risk weights”, but who would assign a reasonable asset weight for all assets of a similar category. Someone who relies heavily on heuristics rather than complex rules. Someone who can replace lengthy ‘to-do’ and ‘to-not-do’ lists with a small list of principles like, “The bank cannot gain at the cost of its customers.” Someone more ethical and less intelligent than Wall Street. In short, a closer representative of the common man, the customer.
Our focus should be simplicity and comprehensibility, not complexity. My favourite rule-book in history is the Hammurabi Law Code (which also happens to be the first law-code ever written), because it keeps things simple – if your actions cause a fellow to lose an arm, you too will lose an arm. There is no ambiguity, no qualifiers of circumstances in which it does not apply, no complexity that can be used by the intelligent to create loopholes. As a result, subjects will be extra-cautious about causing ANY harm to anyone, which results in a safer society.
While Hammurabi Law Code may be too blunt and primitive, we should strive to move our finance rule books in this direction, not the other way. So let us not look for innovation, creativity, and an alarmingly high IQ in our regulators. Let us look for strong ethics, the will power to make tough decisions, and a definite ability to deconstruct what’s complex to make it accessible to the average citizen. Most importantly, let us learn two important lessons from the past four years:
- If they do not trust us, we will not survive for long
- If they do not understand us, they will not trust us.
(The author is an investment analyst at the International Finance Corporation)