The Financial Crisis - are the Bankers to blame or was it the rules they were playing by?

The post financial crisis debate and theories as to how it happened and whether it can be prevented from happening again are moving away from media hype and gaining academic and regulatory credibility.

At the 2010 ICAEW “PD Leake” lecture, Professor Greg Waymire posed the question of what can we learn from history and through robust financial reporting to prevent future crises. The first interesting point raised was the definition of “Financial Crisis”, or rather the lack of one. There is no precise definition, just a loose phrase of “lots of bad things happening to several firms/individuals at the same time”.

There is not a lack of historical examples; financial crises it would appear are not rare events. Reinhart and Rogoff suggest that some financial crises are fuelled by excessive debt and poor risk management. Accounting procedures are secondary and it is profitability that encourages excessive risk taking and fuels a potential financial crisis. They have identified seven types of financial crises; two critical ones link problems with overvalued assets and “bubbles bursting”.

Post mortems will identify markets “pre-crisis” and will look to ask whether poor accounting caused the bubble. Then, in the midst of the crisis, poor accounting was evident in the crash. Finally arriving at post crisis - can a “reform” prevent future crisis. The 2007 Financial crisis was driven by overvalued assets - the US housing market. Potentially inadequate risk management polices were evident because “profits” could be easily realised. Due to the now interdependent Global Markets, the crisis was not localised and the ripple effect took hold. So, was this a crisis borne of poor financial reporting or behavioural factors driven by individuals/ corporations and poor decision making?

A quick look back through history would seem to back this up –

The South Sea Bubble (1720) In return for a loan of £7m to finance the war against France, the House of Lords passed the South Sea Bill, allowing the South Sea Company a monopoly in trade with South America. The company underwrote the English National Debt, on a promise of 5% interest from the Government. Shares immediately rose to 10 times their value, as speculation ran wild about all the weird and wonderful opportunities that arose from far away shores. Some were plausible, others optimistic, with some plain fraudulent! English people got investment fever and stocks increased in all these and other 'dodgy' schemes with fortunes being made….until the truth was found out and the bubble burst.

The Great Crash (1929) The roaring twenties, a decade of decadence, huge wealth and excess. A speculative boom had taken hold in the late 1920s, hundreds of thousands of Americans began investing heavily in the stock market. To allow “ordinary people” the opportunity of investing in shares, brokers would lend small investors often more than two thirds of the face value of the stocks they were buying. On October 24, 1929, with the Dow Jones just past its peak, the market finally turned ….and panic selling started.

October Crash (1987) Whilst there was no significant underlying event that precluded this stock market crash, there was a prolonged period of rising stock prices and excessive economic optimism, in a market where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants. The prospect of realising profits continued with no thought of risk. Then the “bubble” burst.

The "Dot-com bubble" (2000) This was a speculative bubble starting in 1995 which saw stock markets in industrialised nations experience rapid growth in equity value, specifically in the internet sector and related fields. Companies were seeing their stock prices shoot up if they simply added an "e-" prefix to their name and/or a ".com" to the end, which led to a term called "prefix investing”. In 1999 and early 2000, the U.S. Federal Reserve increased interest rates six times, and the economy began to lose speed. The dot-com bubble burst.

The underlying theme of the financial crises listed above revolves around behaviour – both individually as in American citizens borrowing to invest in the 1920’s (and being encouraged to borrow again by the US Government in the 2000’s) to corporates name changing to encourage investment in the 1990’s. In Professor Waymire’s conclusion – we don’t know enough about financial crises and their relationship to accounting. More research is required to allow greater knowledge of how the combination of effects of political and social policies and legislative accounting polices interact.

Humans evaluate the acceptability of behaviour using social norms and regulate behaviour by means of social control. This is the bedrock of “culture”, but with shifting social patterns and changes in acceptability, can you police culture or is it self-regulating?

The whole premise of the FSA was built on self-regulation. Over the last two years the FSA has significantly overhauled it’s supervisory philosophy and it’s ability to deliver it. Hector Sants, CEO of the FSA, has made several key note speeches throughout 2010, specifically referring to the Financial Services Culture and how he believes this helped fuel the financial crisis and what needs to be done to prevent it happening again in the future. Sants strongly believes that some of the causes of the crisis were deeply rooted in behavioural or cultural issues resulting in actions or decisions that, in hindsight, were not right. There are examples of actions and decisions by some senior management teams that can be directly linked to their demise.

Taking Financial Services as a sub-set of society, the wider community expects certain institutions to behave appropriately and to be able to make “good decisions” based on having the right culture in place. Not only to ensure that the decisions are correct for the organisation, but also for the sub-set and the community as a whole. But how do you ensure these measures are in place? The FSA’s existing policy and supervisory framework recognises the importance of culture in regulatory outcomes, so tools are available. It’s all about introducing them to a wider audience with specific emphasis on ensuring that the people who are responsible [Boards] regularly review and actively follow their “values”. The role which regulators play is to help ensure the correct frameworks are in place and are workable and being adhered to. A regulator cannot enforce the “right culture” but it can intervene when it identifies the “wrong one”.

So, were the bankers to blame or was it the rules that they were playing by? History does suggest that irrespective of rules, basic human nature will drive events. The prospect of a profit can influence behaviour. Whilst no rules were actually broken in the Great Crash in 1929, the October Crash of 1987, the Dot-com boom or the encouragement towards home ownership by the US Federal Government in the early 2000s; it was in fact culture, engendered by some of society’s sub groups that took advantage and now we must ensure that lessons are learnt and measures are in place to minimise the effects of the next financial crisis.