Predictable and Avoidable

Repairing Economic Dislocation and Preventing the Recurrence of Crisis

Ivo Pezzuto

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781409454458
• eBook ISBN: 9781317076261
• Topic: Business
• Subtopic: Business General
• Index: Business

Much has been said and written about the 'financial tsunami' and subsequent economic dislocation that occurred in the opening decade of the 21st Century. Professor Ivo Pezzuto is described by business scholars as an expert on the global financial crisis. He has lectured about it at conferences and seminars; written some of the most read and quoted papers; contributed to what is considered the most authoritative book on the subject; and to one of the best known US-based blogs dealing with it. In Predictable and Avoidable, Dr Pezzuto offers business school students; academics; and industry experts in the fields of finance, risk management, audit, corporate governance, economics, and regulation, a truly independent and unbiased analysis of the financial crises starting in 2007 and one of the first fully considered expositions of the financial, governance and regulatory reforms needed for the future. Augmented with personal interviews involving selected global thought leaders and industry experts, the author's narrative focuses on the technical issues that led to the global crisis, but also addresses the human, cultural, and ethical aspects of the events from both sociological and managerial perspectives. The book exposes the root causes and contributes significantly to the debate about the change needed in the banking and finance industries and to supervisory frameworks and regulatory mechanisms. This analysis enables readers to understand that the crisis we have seen was predictable and should have been avoidable, and that a recurrence can be avoided, if lessons are learned and the right action taken.

CHAPTER 1

Introduction

The dramatic events that generated the US subprime meltdown in 2008, and the following liquidity conflagration, as well as the systemic financial and economic crises which have reverberated throughout the global markets, have led to Wall Street’s biggest crisis since the Great Depression. In the last quarter of 2008, the US banking system and those of other major economies were on the brink of collapse and systemic failure.

Central banks and governments in the US and in other countries have, since 2008, orchestrated strong actions and an unprecedented set of policies aimed at restoring some degree of trust, stability, and liquidity in the financial markets through an unusual level of liquidity injection, aggressive monetary policies, massive bail-outs, banks’ and de facto corporate nationalizations, rescue plans, and other governmental interventions and fiscal policies. The point of these initiatives, of course, was to avoid the potential implosion of the overall banking and financial markets and the likely consequent long-term global economic recession and probable depression. Some prominent authors, such as Nobel Laureate in Economics, Paul Krugman, argues that the crisis we are currently experiencing is not just a prolonged and deep recession but rather a true depression. In fact, he states that what we are experiencing these days is essentially the same kind of situation that John Maynard Keynes described in the 1930s: “A chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse” (Krugman, 2012, p. x).

Instead, according to Luigi Zingales, the US has finally recovered from the 2008 financial crisis, reaching the pre-crisis gross domestic product (GDP) growth rate. This slow economic recovery trend, according to Zingales, is quite typical of severe financial crises. Thus, according to him, the current major threat to the US economy growth is represented by two other major crises. One is the Eurozone crisis and the other is the difficult-to-sustain welfare system in most Western economies. The welfare crisis might be solved in the years to come but it will require radical structural reforms (that is, to the welfare system), greater labor market mobility in Europe, and some painful social costs for the citizens as a result of the loss of entitlements and adjustments in entry salaries. In Europe, the Eurozone crisis may be resolved in the years to come, according to Zingales, but it will require the strengthening of solidarity mechanisms on a pan-European scale (Zingales, 2012).

Regardless of the fact that one might have a preference for Krugman, Zingales, or other scholars’ perspectives of the current economic situation and scenario analysis, one thing is quite clear to many observers. Both in the US and in Europe, five years since the start of the financial crisis, only limited effective reforms to prevent new future crises and to fix the distortions that led to the 2007–2009 financial crisis have been introduced.

If political and economic leaders had opted for a no bail-out policy in 2008, the potentially devastating impact of a crisis of this magnitude would have been unimaginable, particularly given our current highly complex and interconnected global economy. Certainly, the bail-outs, rescue plans, and the unprecedented fiscal and monetary policies undertaken since the beginning of the crisis have placed a significant burden on current and future generations in terms of high social costs for taxpayers, higher unemployment rates, higher bankruptcy rates, higher levels of volatility in the markets, and higher governments’ sovereign debt levels and solvency risks.

According to Rutgers Professor Cliff Zukin and Michael Greenstone, who was Chief Economist at the White House Council of Economic Advisers in 2009 and 2010, a shift to a downwardly mobile society may be lasting. This terrible recession is threatening to unravel the American dream for Generation Y professionals, making it very difficult, if not impossible, for them to do better than their previous generation (Blair-Smith, 2012).

Today there is a general consensus among political leaders, industry experts, academic scholars, investors, and ordinary people that the governments’ and central banks’ massive, unprecedented, non-conventional interventions to rescue the global banks were indeed quite prudent and timely decisions. At the peak of the crisis in 2008, under the pressure of a potentially systemic risk implosion, there was probably little more that policy makers could have done to immediately and effectively mitigate that emergency situation. The potential domino effect of the default of a number of so-called too-big-to-fail global banks forced governments and central banks to use any possible means to restore a degree of trust, stability, and liquidity in the financial markets. Some may argue, however, that the timing, cost, allocation, and impact of the policy decisions and interventions that were taken might not have been optimal. Nevertheless, in those troubled days the pressure was so great, the markets were panicking, and the fear of replicating the tragedy of 1929 was overwhelming, thus there was a need for an immediate intervention to shore up banks and other financial institutions from the subprime meltdown, and the perceived liquidity and solvency crisis. There is no doubt, however, that given the dramatic and extremely risky situation, policy makers have demonstrated a good degree of flexibility, pragmatism, and unconventional wisdom, in addressing the most immediate and difficult phase of the crisis. Some argue, supported by sound evidences, however, that since the Bear Stearns crisis, a high level of uncertainty surrounding the US Government’s rescue plans for financial institutions have significantly increased risk spreads thus worsening the dramatic situation (Taylor, 2009, pp. 25–26).

Regarding the bank reforms in the US, EU, and in other markets, the timeliness and effectiveness of the new proposed reforms might be a bit more questionable since, once the crisis had passed its worst stage, the coordinated emergency approach reached by the political and economic leaders of the G8/G20 countries in the peak critical days of the crisis turned into a new one with a stronger focus on the national and local economic and political interests. I recall that in that new phase (2009) I reported in an interview to the Brazilian news agency, Agência Estado, the following statement: “Banking and Finance these days are global whereas politics is still mainly local” (Pezzuto, 2009a).

Starting from the most dramatic days of the financial crisis in the last quarter of 2008, a massive number of books, articles, and publications have been written on this topic, offering to the general reader and to researchers a rich, detailed, and highly specialized and diversified perspective on the topic. I have also contributed to shed light on what I believe are the real causes and possible consequences of the financial crisis since October 2008, through the publication of a number of papers, articles, and a book chapter by the title “Miraculous Financial Engineering or Legacy Assets” (Pezzuto, 2010a, pp. 119–123), published in Robert W. Kolb’s 2010 book titled Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future. Robert W. Kolb is Professor of Finance and Frank W. Considine Chair of Applied Ethics School of Business Loyola University Chicago. In my first paper on the topic dated October 7, 2008 I reported analyses and claims that were, by and large, confirmed three years later by the Final Report of the US Financial Crisis Inquiry Commission (FCIC) issued in January 2011. In that paper I also raised attention to the potential risk of a sovereign debt crisis in the Eurozone, and in particular in those countries (peripheral economies) with slower GDP growth rates, high level of sovereign debt and/or budget deficits, structural economic problems, and current account imbalances. The underlying assumption being that these weaker economies (as a result of slow or negative GDP growth and high debt) would certainly have a harder time coping with banks’ bail-outs, local economic shocks, and prolonged interventions of automatic stabilizers than other more solid nations, following the global economic slowdown in the international trade and consumptions, the credit crunch, the progressive deleveraging process of financial firms, and the worsening imbalances (surplus versus deficits countries) among Eurozone nations. These mature economies also lost significant competitive advantages in global trade versus the more dynamic emerging markets, in particular when the globalization phenomenon reached a turning point in the year 2000 with the progressive decline of barriers to the free flow of goods, services, and capital (China entered the World Trade Organization – WTO – in December 2001) (Pezzuto, 2008; Hill, 2012). The lack of a real European labor market with effective mobility, of a European Central Bank (ECB) with a lender of last resort mandate, of symmetric economic shocks, and of a fiscal mechanism of solidarity among the Eurozone economies made it difficult for political and economic leaders to handle the impact of the 2007–2009 financial crisis and its aftermath (Zingales, 2012; Pezzuto, 2012).

In spite of the large amount of existing publications on the topic of the financial crisis, the majority of them seem to focus mainly on the causes of the crisis or on the responsibility (who was to blame) and only indirectly and more recently (mainly since 2009) on whether it was preventable and avoidable. Some have reported, soon after the most acute phase of the crisis in 2008 – 2009, that it was just the result of unpredictable and uncontrollable property prices and mortgage lending bubbles, bad luck, system instability, imbalances, or the so-called “black swans” (tail-risk or extremely low probability events). These assumptions, although partially true, are now largely questioned by the most prominent and influential scholars, regulators, and industry experts such as, Richard Posner, Phil Angelides, Brooksley Born, Robert J. Shiller, Luis Gaircano, Dean Baker, Simon Johnson, Nouriel Roubini, Paul Krugman, Luigi Zingales, Peter Schiff, Raghuram Rajan, Nassim Nicholas Taleb, Anat Admati, Frank Partnoy, Robert W. Kolb, Jeffrey Friedman, Amar Bhidé, Steven Gjerstad and Vernon L. Smith, Joseph E. Stiglitz, John B. Taylor, Perter J. Wallinson, Viral V. Acharya and Matthew Richardson, Juliusz Jablecki and Mateusz Machaj, Lawrence J. White, Yulia Demyanyk, Otto Van Hemert, William W. Lang, Peter J. Wallinson, Daron Acemoglu, David Colander, Michael Goldberg, Armin Haas, Mike Stathis, Katarina Juselius, Alan Kirman, Thomas Lux, and Brigette Sloth. These authors have clearly addressed and thoroughly explained that the global financial crisis was not just a normal business cycle downturn, a normal asset bubble, the result of bad luck, or just an unpredictable black swan (Friedman et al. 2011). It was, instead, as clearly stated also in the final report of the FCIC, “the result of human action and inaction, not of Mother Nature or computer models gone haywire” (FCIC, 2011, p. xvii).

The reader today will find easily available an overabundance of publications on the topic. Some of the most scholarly ones are indeed very insightful and intriguing and their precious contributions have been a hallmark for the preparation of this work. They generally provide the following assumptions as root causes of the financial crisis: the responsibility of bank executives’ excessive risk-taking and short-term compensation goals (greed); inadequate or missing regulations in the financial industry; the faulty monetary policy of the Federal Reserve Bank; the governments’ inadequate response to the crisis or its intrusion in the banking and financial markets; others also blame bad luck, the so-called black swans, faulty risk models, the rating agencies, or the irresponsible and illiterate mortgage borrowers. Perhaps the true story will never be fully disclosed to the general public, given its complexity, although reading some of the most fascinating, fact-based, and educated available analyses, it is probably possible to get closer to the big picture of what really happened.

This book aims to provide a series of fact-based evidences on the topic from the most prominent scholarly publications that, combined with a comprehensive perspective of the interconnected events related to the crisis and the precious contributions of a restricted number of interviews I have undertaken in 2012 with selected thought leaders and industry experts, will allow the reader to realize that the 2007–2009 financial crisis was predictable and avoidable. Of course, I am not the first author to state this hypothesis (although I first wrote of it in 2008) nor certainly the most distinguished one, but I hope that my little contribution might add some additional value to the study of this topic. The book also intends to explain what I believe are the combined triggering factors that have contributed to create such a devastating event. Finally, it aims to explore some possible enhancement in regulatory, corporate governance, and corporate cultural changes hoping to prevent other similar crises in future.

A few authors report that this crisis could probably have been managed sooner and better; that it could have been significantly mitigated, and perhaps even avoided, if authorities had played a more proactive and effectively coordinated role in reducing financial firms’ excessive risk-taking in the shadow banking market and the astonishing expansion of the property and lending bubbles. As is well known today, a number of brilliant scholars and industry experts actually reported early warnings on the topic even before 2007 in their articles, papers, presentations, and interviews, but unfortunately they did not receive adequate attention or support from political leaders, policy makers, and regulators.

According to Gerald Epstein and Jessica Carrick-Hagenbarth’s working paper of the UMASS Political Economy Research Institute (2010), titled “Financial Economists, Financial Interests, and Dark Corners of the Meltdown: It’s Time to Set Ethical Standards for the Economic Profession,” conflicts of interest might have prevented a number of economists from timely and effectively reporting to policy makers and regulators early warning messages on the potential financial meltdown or on new and effective financial reforms to stabilize the global financial markets and economy. They revealed that there are potential conflicts of interest among academic economists who have contracts with the institutions in question in writing about the financial crisis and financial reform for a general audience. Focusing on the Squam Lake Working Group on Financial Regulation (2010) and the Pew Economic Policy Group’s Financial Reform Project (2010), they found that a majority of the economists involved had affiliations with private financial institutions, yet few of them disclosed those affiliations even in academic publications, preferring to identify themselves by their university affiliations (Epstein, Carrick-Hagenbarth, 2010, p. 28).

Everybody knows that financial institutions, as well as multinational corporations, have always given very generous grants to universities, business schools, and financed scholarships, fellowships, professorships, research projects, and advisory services. Thus, although their financial support represents an essential contribution for innovation and development in the field of banking and finance, in particular extreme circumstances it may also represent a potential constraint to independent research. The 2007–2009 crisis might have been one of these situations, at least immediately after the crisis occurred. But today there is such an excess of information available from online and offline sources, whistleblowers, prosecutors, and financial service authorities that it is practically impossible to protect undisclosed information for a long time. And in fact, after a while, the true story of what caused the global financial crisis begins to be in the public domain.

Powerful banking lobbies have spent billions of dollars since the beginning of the global financial crisis in an attempt to mitigate, through their activities, stricter financial reforms, regulatory oversight, and reputational damages, or to comply with the new rules and to settle law suits and fraud cases.

Nepotism and cronyism (cartels, lobbies, and sects of all kind), with their asymmetric power, indifference for inequality, and arrogant oligarchy, are the enemies of free-market economy, and ultimately, of a true capitalist democracy.

Since 2008, the financial crisis has quickly spread all kinds of risks on a global scale as a result of the globalization of markets and the high interconnectedness of institutions and stakeholders, but at the same time it also owes to the globalization of information sharing (internet, social networks, online publications, and so on) the identification of its complex root causes, in spite of any potential attempt of the organizations involved in the crisis to limit their disclosure.

In addition to the generous financial contributions of banks and financial institutions to universities and research centers, the financial sector is also a significant contributor to political campaigns, through its powerful and rich lobbying activity; it also has an influence in the placement (that is, primary dealers) and trading of sovereign bonds. Furthermore, financial institutions directly or indirectly control or influence most companies’ decisions and strategies, and even households, through lending, funding, and investment advice (that is, consumer, retail, commercial, and corporate banking, investment banking, venture capital, private equity funds, hedge funds, asset management firms, and so on).

Thus, it is possible, as some authors say, that a number of financial economists might have preferred not to report to policy makers and regulators early warning messages on the incumbent financial meltdown simply because (1) they were not interested in the topic (that is, crises are not “cool”); or (2) because their economic ideologies, expectations on asset prices, and risk model assumptions (that is, scenario analyses and stress testing) were inherently faulty and inaccurate. Furthermore, regarding the use of wrong risk models, financial economists most likely have used models for predicting the probability of defaults based on unfit historical data sets which did not correctly reflect the boom-bust scenario of the period 2003–2006. Many of them apparently also did not pay enough attention to the explosive growth of the uncontrolled and poorly capitalized shadow banking system and on the impact of the systemic risk (banking panic) this complex, opaque, and highly leveraged sector could have on the overall financial industry stability. Finally, (3) even assuming that financial economists might not have had direct conflicts of interest with financial institutions, they might have perceived anyway a psychological pressure and threat going against the mainstream ideologies and theories of the leading international academic community (a contrarian view). So this psychological conditioning might have discouraged them from expressing a truly independent and unbiased opinion on the topic. They just did not want to jeopardize their academic reputation, prestige, and career opportunities (that is, to become a black sheep).

In summary, the power and influence of the financial sector as a whole on politics, on the real economy, and on society has always been significant but in the last decades this influence has rapidly escalated to what we now call the “too-big-to-fail” phenomenon. Even some multinational corporations have, in recent years, reached a similar excessive power and dominance in politics, leading in some cases to dramatic corporate governance failures, fraud scandals, and perverse conflicts of interest between the corporate world and politics. This concept has also been confirmed by Luigi Zingales in his book A Capitalism for the People: Recapturing the Lost Genius of American Prosperity (Zingales, 2012).

Probably, after the publication of the final report of the FCIC in 2011 (issued by the US ...

Table of contents

• Cover Page
• Dedication
• Title Page
• Copyright Page
• Contents
• List of Figures and Tables
• About the Author
• Acknowledgements
• List of Abbreviation
• 1 Introduction
• 2 The Factors that have Led to the Global Financial Crisis
• 3 The Financial Crisis Was Predictable and Avoidable
• 4 The Need for Improved Risk Governance
• 5 The Need for Cultural Change in Organizations and Society
• 6 Experts’ Insights for Improved Governance
• 7 Conclusion
• References
• Index