Monday, 23 February 2009

Rebuilding the financial services industry

Lloyd Blankfein, CEO of Goldman Sachs - one of only a handful of profitable financial institutions at the moment -outlined a number of important principles for policymakers and regulators to consider in fixing the broken financial system:

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report to is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts on the trading desks: if there is a question about the value of a position or a disagreement about a risk limit, the risk manager’s view should always prevail.

Compensation continues to generate a lot of anger and controversy. We recognise that having troubled asset relief programme money creates an important context for compensation. More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.
For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.
All pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.
After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.
Most of the past century was defined by markets and instruments that fund innovation, reward entrepreneurial risk-taking and act as an important catalyst for economic growth. History has shown that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy.
Lloyd Blankfein, 2009. “Do not destroy the essential catalyst of risk”, Financial Times,, February 8.

Financial Risk Management 101

What lessons can the financial services industry learn from the 2008 global financial crisis. Lloyd Blankfein, CEO of Goldman Sachs gave his views in a recent article published in the Financial Times. Hopefully the industry will take Blankfein's advice seriously; they are (were) after all the custodians of our hard-earned savings!

  1. Risk management should not be entirely based on historical data and reliance on statistical distributions. The events of 2008 have been dubbed “multiple standard deviation events”, yet if an event, for example, were calculated to occur once in 20 years but in fact occurred much more regularly, it is clear the statistical distribution assumption does not reflect accurately the actual outcome. Hence, the industry must do much more to enhance and improve scenario analysis and stress testing.
  2. Too many financial institutions and investors outsourced their risk management. Rather than doing their own analysis, they relied on the rating agencies to do the risk analysis for them. At the same time rating agencies diluted the significance of the triple A rating. In January 2008, there were only 12 triple A-rated companies in the world, but there were 64,000 structured finance instruments, rated triple A!
    In hindsight it is easy and appropriate to blame the rating agencies for their poor credit judgment. Yet, every institution that participated and acted on the credit ratings has to accept its share of the responsibility.
  3. Size matters. Whether an institution owned $5bn or $50bn of (supposedly) low-risk debt in structured finance instruments, the likelihood of losses was proportionally the same. But the consequences of a miscalculation were obviously much bigger if you had a $50bn exposure.
  4. Many risk models incorrectly assumed that positions could be fully hedged. While a host of new products such as various basket indices and credit default swaps were created to help offset a number of risks, the industry did not consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.
  5. Risk models failed to capture the risk inherent in off-balance sheet activities, such as structured investment vehicles. It seems clear now that managers of companies with large off-balance sheet exposure did not appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business.
  6. Complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.
  7. Financial institutions did not account for asset values accurately enough. Lately, arguments were made that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. Blankfein, however, see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

Lloyd Blankfein, 2009. “Do not destroy the essential catalyst of risk”, Financial Times,, February 8.

Thursday, 19 February 2009

The Wisdom of Adam Smith

What would Adam Smith, the father of modern economics and famed author of The Wealth of Nations (1776), had to say about the current global financial crisis:

Peter O'Rourke, author of On The Wealth of Nations, Books that Changed the World (2007), wrote in a recent article it is ironical that people always want to know what Adam Smith would say whenever the free market principle seems to be expired or dead; something that probably happened 10 times already in the past century!

Well, Smith identified the exact course of our current economic misery when he wrote The Wealth of Nations:

“A dwelling-house, as such, contributes nothing to the revenue of its inhabitant. If it is lett [sic] to a tenant for rent, as the house itself can produce nothing, the tenant must always pay the rent out of some other revenue.” Therefore Smith concluded that, although a house can make money for its owner if it is rented, “the revenue of the whole body of the people can never be in the smallest degree increased by it”.

Smith was familiar with rampant speculation, or “overtrading” as he called it.
In 1772, while Smith was writing The Wealth of Nations, a bank run occurred in Scotland. Only three of Edinburgh’s 30 private banks survived. The reaction to the ensuing credit freeze from the Scottish overtraders sounds familiar, “The banks, they seem to have thought,” Smith said, “were in honour bound to supply the deficiency, and to provide them with all the capital which they wanted to trade with.”

The phenomenon of speculative excess has less to do with free markets than with high profits. “When the profits of trade happen to be greater than ordinary,” Smith said, “overtrading becomes a general error.” And rate of profit, Smith claimed, “is always highest in the countries that are going fastest to ruin”.

One simple idea allows an over-trading folly to turn into a speculative disaster – whether it involves ocean commerce, land in Louisiana, stocks, bonds, tulip bulbs or home mortgages. The idea is that unlimited prosperity can be created by the unlimited expansion of credit.

How then would Adam Smith fix the present mess? Sorry, but it is fixed already. The answer to a decline in the value of speculative assets is to pay less for them. Job done.

We could pump the banks full of our national treasure. But Smith said: “To attempt to increase the wealth of any country, either by introducing or by detaining in it an unnecessary quantity of gold and silver, is as absurd as it would be to attempt to increase the good cheer of private families, by obliging them to keep an unnecessary number of kitchen utensils.”

Quoted from: "Adam Smith gets the last laugh" by P.J. O'Rourke,, February 10, 2009

The smart guys have lost the plot

Risk, a magazine for the alternative investment industry, recently reported on the following story:

2008 was the worst year for hedge fund performance since data on alternative investment pools began to be tracked, with average returns of -17.08% across asset classes for the past year, a new report has revealed.

In the report, Hedge Fund Performance in 2008, the France-based Edhec Business School highlighted how widespread poor performance was across asset classes last year, with only two strategies posting positive returns.

Particularly hard hit were emerging markets and convertible arbitrage strategies, which saw their returns performance sink to -30.3% and -26.48% respectively. Fund of funds returns, which the report notes is "sometimes taken to give an aggregate view of the industry's performance" were down at -17.08%, the worst returns since Edhec first began to collate data in 1997. In contrast, fund of funds returns in 2006 and 2007 were 11.25% and 10.07% respectively.

Amid the carnage, however, short-sellers experienced their best year since 2002 - despite the Securities and Exchange Commission banning the practice in September and October 2008 - with returns of 24.72%.

Though losses were concentrated in September and October - a period of heightened volatility that followed the collapse of Lehman Brothers - six strategies actually posted negative returns for as many as nine months in 2008, including convertible arbitrage, distressed securities, emerging markets, event driven, fixed income arbitrage, and funds of funds strategies.

A 180 degree turnaround...

Mr Alan Greenspan, former Federal Reserve chairman and once regarded as the strongest advocate for laisser-faire capitalism, made recently an astonishing "change of mind" on his views how the US government should fix the broken financial system:

"The US government may have to nationalise some banks on a temporary basis to fix the financial system and restore the flow of credit. Nationalisation could be the least bad option left for policymakers. It may be necessary to temporarily nationalise some banks in order to facilitate a swift and orderly restructuring. I understand that once in a hundred years this is what you do.”

"In some cases, the least bad solution is for the government to take temporary control of troubled banks either through the Federal Deposit Insurance Corporation or some other mechanism. Temporary government ownership would allow the government to transfer toxic assets to a bad bank without the problem of how to price them.”

He cautioned, however, that holders of senior debt – bonds that would be paid off before other claims – might have to be protected even in the event of nationalisation.

”You would have to be very careful about imposing any loss on senior creditors of any bank taken under government control because it could impact the senior debt of all other banks. This is a credit crisis and it is essential to preserve an anchor for the financing of the system. That anchor is the senior debt.”

Quoted from Financial Times, February 18, 2009

Tuesday, 10 February 2009

Where are the real engineers?

Bankers were used to lucrative bonuses, but now everything has changed. Or did it? Old habits die hard.

Philip Stephens wrote the following excellent piece of how bankers should behave in a new financial order, published at

"No, Britain’s bankers should not pay themselves extravagant bonuses. Not this year, not next, nor the years (plural) after that. That some of these erstwhile titans believe otherwise is depressing evidence of how remote they have become from the world that lies beyond the deflated bubble of the country’s financial services industry.

The rules have changed. Those who fondly imagine that success in banking can remain an uninterrupted path to untold riches should think again. The best and the brightest from the nation’s universities would be well advised to look elsewhere.

To quote George Osborne, the Conservative shadow chancellor, the days have gone when bankers could routinely pay themselves 20 times more than heart surgeons. Or as Lord Mandelson, the Labour business secretary, has put it, Britain has had its fill of financial engineering. The economy now would benefit from some real engineering.

What sort of banks do we want to emerge from the wreckage of the financial system?
The bankers, I suspect, think they can hang on to the casinos that, before last year’s crash, paid for their yachts and private jets. A little bit more regulation here, a tighter capital ratio or two there and the banks should be allowed to get back to business, and bonuses, as usual. Memories are short in markets.
Just about everyone else believes that banks should in future be, well, banks: the reliable, responsible and financially sound institutions needed to make the capitalist system work. Some even harbour the hope that they might start to rebuild decent relationships with their customers.
This is not a vision of the industry, I suspect, that appeals to the leading lights of British banking. To my mind, most of them have still to grasp the depth of the public rage, shared pretty much by politicians of all parties, at the misery inflicted on businesses and individuals by the financial crisis.
Bank executives too often sound as if they have convinced themselves that they too are victims – innocent bystanders at the scene of someone else’s crime. To help them escape this denial, it is worth spending a moment setting out how things look to those outside the steel and glass towers.
The directors of banks have destroyed, to a greater or lesser degree, the value of their institutions. All the while, they have been paying themselves bonuses beyond the imagination of the most senior executives in most other industries.
It would have been bad enough had the damage stopped there. But the consequence of the banks’ attempts to turn lead into gold by repackaging dodgy loans as triple A rated securities has been the freezing up of international credit markets and a slide into global economic recession.
Little wonder people are angry when they read of the tens of billions of pounds of their money that is being poured into these failed institutions. It is less surprising still that the anger turns to outrage at the thought that some of the very same bankers will soon pick up handsome bonuses.
It is tempting to dismiss all this as the politics of envy. That would be a mistake. It is true that some of the banks have contractual obligations to individuals. They should meet them. Most people will see nothing wrong either in the payment of modest incentives for employees lower down the income scale.

What will not do is the self-serving cant that says banks must be allowed to continue to pay out huge bonuses to retain and attract so-called “talent”: the traders and mathematicians who can generate “easy” profits. We have had enough of that sort of banking – of the seven-figure bonuses that rewarded the risk-taking that brought the financial system to its knees.
There is a place for gambling in financial markets; but if we have learnt anything it is that the banks are not that place. What Britain needs is a sober, efficient and transparent banking system – run by the sort of people who think that remuneration of, say, £500,000 a year is a very fair, not to say generous, reward."
"It is time for banks to behave like banks" by Philip Stephens, 9 February 2009

Friday, 6 February 2009

The folly of securitised credit markets

The global financial system is in a mess because we were misled by a few smart investment bankers and analysts to believe that packaged credit instruments are worth much more than the sum of their individual values. Eventually, investors overpaid for these instruments, hence our troubled financial industry.

John Kay, columnist for, wrote the following:

Abraham Lincoln posed the question: “How many legs does a dog have if you call a tail a leg?” Honest Abe’s answer was four. A tail is still a tail even if you call it a leg.

The world of finance is a bit more complicated, but not much. How can a package of loans be worth more than the sum of their individual values? The amount borrowers pay is just the same even if you call the loans an asset-backed security or a collateralised debt obligation.

Securitisation in lending may add value by allowing the risk characteristics of the new instrument to be precisely tailored to the risk characteristics sought by the buyer. There is something in that argument. But could there be tens of billions of dollars a year of profit in it?
Could the advantages of slightly more elaborate differentiation of an already wide range of fixed-interest products really be so large? If differences in risk appetite determined the market, you would not expect the list of institutions that bought securitised products to be so similar to the list that sold them.

Another account is favoured by economists less convinced of market efficiency and more impressed by information asymmetries. No one is sure what complex packages of loans and securities are worth. You need models to value them, and only fools derive certainties from models. You might expect that undervaluation would be as common as overvaluation, and in general you would be right. But there is a twist. It is not people who undervalue securities who buy them, but people who overvalue them. The errors of market participants affect prices in one direction only.
This mechanism – a variant of the notorious “winner’s curse” – explains why packaging can be rewarding for the issuer. But the apparent value added is illusory. The buyer loses what the seller gains. It may, however, be some time before the buyer catches on.
To think that today’s market conditions are exceptional, and that yesterday’s euphoria represented a normal state of affairs, is a fundamental misconception. On the contrary: in market equilibrium, opaque products sell with difficulty and at a discount. A barrel of apples whose quantity and quality can only be guessed at should sell for less than the combined value of the apples, and does. There was never an economic rationale for structured products on the scale on which the financial services industry created them. They were the result of a frenetic search for commissions and bonuses.

Nor should we be impressed by the argument that since a large fraction of mortgages was turned into mortgage-backed securities, an adequate supply of mortgages depends on securitisation. That argument confuses the mechanism of supply with the source of supply. You might as well suggest that since 25 per cent of groceries are bought on Friday, closing stores on Friday would reduce our food consumption by 25 per cent.

The objective should not be to revive the originate and distribute model of banking, which has demonstrably failed, but to secure its orderly winding down. Banks should retire to the traditional and profitable business of taking deposits to make loans: the business we want them to do and the business they really understand.
Quoted from: John Kay, 2009. "Wind down the market in five-legged dogs"., Financial Times, January 20 2009

Tuesday, 3 February 2009

In search of honest beta...

In recent months we have seen how miserable markets can perform. Most of us know we do not know enough to manage our own investments, hence we appoint professional money managers to do just that; i.e. to protect and grow your investment. Yet, the reality is startling, we do pay them professional fees alright, but the chances are very good that the expected professional performance may be missing...

Lex wrote the following in his daily column on

Faith in the genius of stock-pickers is at an undeniably low ebb. Institutions are now paying heed to the evidence of a series of Standard & Poor’s studies which suggest that the best way for investors to guarantee their fair share of market returns is to throw the net as wide as possible while keeping fees to a minimum.

Over the five years ending in June 2008, almost 70 per cent of actively managed large-cap funds failed to beat the S&P 500. Measured against mid-cap and small-cap benchmarks, active funds did even worse.

By buying an index fund investors won’t get the best performer, nor the worst. But they don’t have to worry about whether the star fund manager will chuck it in to grow grapes in the Napa Valley, or whether the team as a whole will be subject to some unforeseen, value-destroying behavioural bias. For that peace of mind they’ll pay about a third of the fees charged by the typical active manager.
The influx into passive funds will not last. When bear markets fade, investors tend to start believing in their own ability to find individuals who’ll consistently beat the benchmark. But for the time being at least, they’ll take cheap, honest beta over illusory alpha.