Financial weapons of mass destruction still primed to detonate

Written By: Prem Sikka
Published: March 18, 2011 Last modified: March 16, 2011

Are you ready for the next financial crisis? With interlocking banks and corporations, it will be more severe than anything that we are experiencing now. The Government’s plan to replace the Financial Services Authority with the Prudential Regulation Authority is akin to rearranging the deckchairs on the Titanic. The PRA is to be guided by a new Financial Policy Committee. Its membership includes Lord Turner and Hector Sants, respectively chairman and chief executive of the FSA, who presided over current failures; Bank of England governor Mervyn King; former Deutsche Bank and Goldman Sachs executive Michael Cohrs; and Sir Richard Lambert, a former chief of the Confederation of British Industry. The current mess is the outcome of the neo-liberal world view embedded in regulatory towers and the same is set to continue. This will be of no comfort to the taxpayers who are still providing £512 billion to support banks.

The Treasury’s consultation paper does not contain any proposals to deal with the underlying causes of the banking crisis. These relate to incessant demand for higher profits, executive rewards and speculative activity. Stock markets expect corporations to produce ever-rising profits. Markets don’t care if that is delivered by squeezing wages or employee pension rights, or through tax dodging. As directors’ remuneration is linked to profits, they have  incentives to charge exorbitant interest rates, pay measly rates on savings, hide liabilities, create toxic debts and take excessive risks. There are no proposals to check the race for higher corporate profits and executive remuneration. Separating the investment and retail arms of banks might help  in managing the risks to the economy. So might higher taxes on executive bonuses. But even these reforms would not change the practices which have plunged economies into crisis.

Gambling, or placing bets on the movement of exchange rates, interest rates, price of wheat, oil, gold, commodities and even rates of death, is ingrained in the world of finance. The trade in derivatives has been described by Warren Buffett, the billionaire American investor, as “financial weapons of mass destruction”. Northern Rock, HBOS, Barclays, HSBC, Goldman Sachs and all other banks trade in derivatives. Derivatives are not dissimilar to placing a bet on a horse, where the outcome could be anything from loss of the wager to a large win.

The logic of derivatives is driven by neo-liberal economic theories embedded in complex mathematical models designed to enable individual traders to hedge their risks. These models contain no space for consideration of social welfare, ethics, or economic collapse caused by reckless gambling. The mathematical techniques were developed by business schools in the United States with  funding from corporate sponsors and cannot be refined to consider social consequences. That would require a complete reinvention of the theories of finance and that is unlikely to happen in the foreseeable future.

The destructive capacity of derivatives and related mathematical models is well documented. In the US, Myron S Scholes and Robert C Merton are credited with developing models for trading in derivatives which offered the possibilities of comparatively low-risk trading through a calculated use of borrowing, lending and short selling. In 1997, the two professors shared the Nobel Prize in Economics “for a new method to determine the value of derivatives”. They made huge profits  through Long-Term Capital Management, a hedge fund. But just seven months after receiving their Nobel Prize, their models were in trouble. At one stage, LTCM had capital of only $4.72 billion, but borrowed $124.5 billion and thus tied numerous other banks to its risky positions. Inevitably, in 1997-98, LTCM misjudged the severity of the East Asian and Russian financial crisis and found itself with $400 million of capital, $100 billion of debts, $4.5 billion of losses and derivatives with a face value of $1 trillion. Rather than letting LTCM swing for its follies, the US government feared the knock-on effects and bailed it out with the help of a consortium of banks.

The destructive practices have continued unabated. Bear Stearns collapsed in 2008. For nearly six years before its demise, almost all of its pre-tax profits came from speculative activities. The bank had shareholder funds of only $11.8 billion, but borrowing of $384 billion. Its derivatives had a face value of $13.4 trillion, not much less than the entire gross domestic product of the US. At Lehman Brothers, speculative activity generated around 80 per cent of pre-tax profits in 2006, up from 32 per cent in 1997. For every $1 of its capital, it borrowed $30.7 to feed its gambling habit. In September 2008, when Lehman Brothers filed for bankruptcy, it had nearly 900,000 derivative contracts with a face value of around $738 billion entangling numerous other entities. At the end of 2007, Northern Rock had derivatives with a face value of £125 billion and was soon bailed out by the British taxpayer.

The mathematical models, frequently written into computer software, may enable individual traders to hedge risks, but they also increase the destructive risk to the economy. In December 2007, when the banking crisis hit the headlines, the face value of derivatives was around $1,148 trillion. Just five banks had derivatives with a face value of some $170 trillion. JP Morgan had $2.251 trillion of assets and $91.339 trillion face value of derivatives. Citibank had $2.050 trillion of assets and $38.186 trillion of derivatives, and Barclays Bank derivatives had a face value of nearly £29 trillion. In March 2010, the face value of all derivatives stood at $1,048 trillion. Even if the actual economic exposure was only 5 per cent, the next derivatives crisis would cause massive economic destruction to the global GDP of around $65 trillion. Yet no one is asking bankers to pay 100 per cent of the bets up front and thus limit the number of gambles that they can make, or place any upper limits on their gambles.

Rather than wringing their hands, policymakers should learn and adapt some lessons from other walks of life . In the world of medicine, for instance, manufacturers cannot launch products without prior testing and specific approval from regulators. Manufacturers can be held liable for the negative effects and forced to withdraw the products. They are rarely bailed out after failures.

The destructive practices of the finance industry have not been adequately scrutinised by the Independent Banking Commission or parliamentary hearings. The finance industry remains free to indulge in unlimited gambling and is not held liable for the resulting social devastation. The taxpayer-funded bailouts hardly provide any incentives for curbing the destructive practices. Even if the retail and investment banking is separated, the bankers will still be gambling with other people’s savings and pensions, and thus fritter away other people’s wealth. If the gambles are successful, they will walk away with large bonuses. If they fail, the taxpayer will pick up the tab.

With rampant stock markets, an unchecked appetite for executive bonuses, reckless gambling and regulatory deference to big corporations, the next financial crisis is inevitable. The chances of developing socially responsible risk management theories and mathematical models in the foreseeable future are remote, especially as universities are hungry for corporate patronage. The only alternatives is meaningful, full-time supervision of the finance industry. Banks should not be allowed to trade in untested products, nor permitted to create systemic risks through unconstrained speculative activity. The impulse for gambling should be checked by ensuring that depositors, borrowers and employees appoint directors and impose their risk averseness on them.

Financial enterprises should be subjected to the freedom of information laws so that we can demand to see the destructive transactions and contracts and thus check the selfish impulses of executives. All this is urgently needed, but goes against the grain of the neo-liberal ideology. Successive governments have been only too keen to appease the finance industry and have done little to check its excesses. They have thus sown the seeds of the next financial crisis.

Prem Sikka is professor of accounting at the University of Essex

About Prem Sikka

Prem Sikka is professor of accounting at Essex University

9 replies to “Financial weapons of mass destruction still primed to detonate

  1. terence patrick hewett says:

    Our political aristocracy have run out of ideas. They are like First World War generals of cavalry, struggling to come to terms with poison gas, aeroplanes and tanks. They are, poor dears, blundering about in a world that they do not understand. When mathematicians within financial institutions came up with financial models using the Black-Scholes formula and the Gaussian copula function, the non-mathematical bankers and politicians did not understand their limitations; these models merely give us a better understanding of random behaviour, they do not predict the future.

    It has to be a function of a political class that is drawn from such a narrow set of experience that they do not understand that an enormous part of our life is now controlled by mathematical algorithms, once set in motion, chunter on until they reach their conclusion. The inability to understand the implications of this is not a failure of the free-market system but a failure of governance and a failure of leadership at the highest level; financial, political and intellectual.

    Prem’s analogy with medicine is a false one: the medical industries have to comply with some 200 standard systems including ISO 13485 and the American Food and Drug Administration (the FDA successfully prevented the use of Thalidomide in the US). These institutions seek to impose traceable logic and quality systems to ensure patient safety; they essentially deal with predicable behaviour and can in the end be boiled down to the controlled application of classical physics.

    Because there are no financial models that proceed from first principles that are unambiguously correct, models are largely driven by parameters (which may or may not be the correct ones) and those parameters are in a constant state of flux so although models are an essential tool in risk management they are very much a blunt instrument.

    Model “quality assurance” now exists in most large financial institutions, although model risk is generally only determined in an incomplete fashion. Model assumptions and procedures are documented. Sensitivities to different parametric assumptions can be examined. Models can be assessed and compared but unlike medicine these assessments can only be subjective.

    Any sort of reform would need to be on a global scale since all our economies are interlinked; it could be augued that reform is impossible since un-stoppable technology is empowering the individual and removing those of the state. No one can predict the future but our failures are human ones and not the fault of those wicked mathematical models.

  2. I totally agree with this article. Spot on and I don’t believe you have to be a professor to see it. Artificailly ramped up house prices are one thing that has come about from lack of regulation. We are being made into drones that just exist to work hard to pay money to banks. However, there is another way…It’s quite simple folks. Change your accounts. Move to mutuals where you get more say over what happens. If we don’t give them the dosh to gamble with they cannot do it. Buy what you can afford to and don’t take out that tempting loan. You wouldn’t go shopping and pay £150 for £100 worth of goods. That’s exactly what you do with a loan. We all need to get back to good old fashioned saving. It might be boring and it might not mean immediate gratification but our current methods mean 3/4 of the world can barely eat while 25% of us act like little kids getting what we want and when we want it. The professor is right. It can’t go on.

  3. Thatcherite nightmare says:

    Brilliant and goes straight to the systemic problems. I can’t see how bankers are going to be weaneed off their addiction to speculation. Neoliberals call it risk management and creating market mechanisms for liquidity. If it was so then how come that we are all sinking in the risks created by these manupulators and even worse many could not even save themselves. Labour should not be so much in awe of these peopel and now have a perfect opportunity to do what this article recommends.

  4. Thatcherite nightmare says:

    Brilliant and goes straight to the systemic problems. I can’t see how bankers are going to be weaneed off their addiction to speculation. Neoliberals call it risk management and creating market mechanisms for liquidity. If it was so then how come that we are all sinking in the risks created by these manupulators and even worse many could not even save themselves. Labour should not be so much in awe of these peopel and now have a perfect opportunity to do what this article recommends.

  5. FreddyZeddy says:

    “The finance industry remains free to indulge in unlimited gambling and is not held liable for the resulting social devastation. The taxpayer-funded bailouts hardly provide any incentives for curbing the destructive practices.”

    Actually, the bailouts provide positive incentives to take even riskier gambles.

  6. melmo says:

    Someone coined the phrase, ” privatise the profits and socialise the debt” could not be more correct. Until the general public wake up to these criminal bankers then I don’t see much hope for the future. When we have a culture of greed, one can only expect the consequences. Until human beings have a change in mind set then it is a continual cycle.

  7. Davinder says:

    It is very interesting that in all the talk about the banking crisis commentators have totally ignored the impact of academic ideas or theories – the silent drivers or what might now be seen to be killers.

    Yuval – the problem is that Goldman Sachs and others will still be using someone’s savings even though they are not directly invested with Goldman. It could be my pension savings and pension managers don’t take any account of my risk averseness in choosing their investments. The figures in the article draw attention to insane leverage ratios and total inadequacy of any capital to back up the doomsday scenario. When the derivatives misfire their impact will still be spread on to everyone else.

  8. Yuval says:

    I agree with the general notion Prem Sikka expresses here: the combination of the high leverage that derivatives allow with over-reliance on mathematical risk model can lead to catastrophic results. That said, regulation can do quite a lot about this. For example, one of the approaches, one that was proposed in the discussions on the Dodd-Frank Act, is to prevent banks from using customer deposits to fund derivative trading. This approach was very promising and it is a shame that it was diluted in later versions of the Act.

  9. Dragon says:

    An extremely useful article and should be read by anyone trying to understand the real causes of the crisis. Finance theories and accounting practices are key factors in the crisis and unless they are totally reinvented they will play havoc again. I don’t remember Lord Turner, Merv King and others even talking about the role of finance theories – the silent killers. Some years ago I studied finance at LSE and we were bombarded with Black-Scholes Option Pricing Model with absolutely no mention that something can go wrong.

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