Lehman Anniversary Musings and Wish Lists
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20 September 2013Cubillas Ding
There are a multitude of Lehman Brothers anniversary stories going around, and perspectives can get lost. Hence, I decided to let a week pass before I commented on the fifth anniversary of the infamous collapse of Lehman. I promise to make these points short (and hopefully sweet). What have we really learned from Lehman and the last crisis? Apparently the financial industry is unable to regulate itself, so is it really a surprise that it now needs to be externally regulated? We have opened Pandora’s Box. Virtually every sector within financial services is facing heavy regulations. But the problem I have is that the current paradigm of external regulation is expensive for everyone (expect perhaps regulators, lawyers, and consultants), compared to a scenario where the industry can learn to govern itself appropriately. So, what can we take from five years ago? Many lessons have been identified around short-term funding concentrations, leverage, mispricing of risk, misaligned incentives, lack of governance at both board and industry levels, complexities in the valuation of “hard to value” assets, and the potentially fatal interplay of various risks. Will we have another crisis? Despite the changes the industry has made, one gets a sense that the consequences — the unpalatable prospect of capital and liquidity shortages, negative impact to the cost of funding for banks, corporates, and small businesses; and the ongoing threat of counterparty failures — all linger in various guises today. By that token, you could say that we have treated the symptoms but not the causes. The "virus" of inappropriate culture, failing to govern (e.g., treating risk management as a formality), and not using the right information to make risk-adjusted business decisions are still in the blood of the industry. A new crisis may emerge before we know it. Some observations: In the last year, corporate earnings have failed to track recent market rises. Yet US equities are up 30% over the past 18 months, while earnings have only risen 6%. Has the investment community become trigger-happy to trade while ignoring fundamentals? How soon did significant operational risk failures and conduct incidences happen after the firms, regulators, and governments supposedly “learnt the lessons” of 2007/2008? Unfortunately, not long after. We are still seeing market trading failures (Knight, Nasdaq), whale trading losses, LIBOR rigging, and product mis-selling. We have observed (and here, regulators and policymakers are not exempt) how L/ZIRP (low or zero interest rate policy) created a bubble in commodities (which has burst). It created a bubble in emerging markets (which has deflated), and it is creating a bubble in bond markets — all of which may pose a major risk in the event of rise in rates or aggressive QE tapering. The boom and bust dynamic seems to be rearing its ugly head again. Old habits die hard. What does the Holy Grail of risk management look like? I will answer in terms of outcomes I would like to see, rather than how the mechanics of risk management need to look like. I will know that the Holy Grail has been found when: 1. Regulators and firms embrace the right rules and the right tools to spot future financial bubbles. 2. Frontline personnel that pursue risks (and rewards) within organizations are directly compensated (based on both soft and hard incentives) according to the risks they are taking. 3. We have resolved the “too big to fail” problem, and taxpayers no longer need to bail out firms they are not responsible for. For me, the longer-term questions are: Has the industry taken the right medicine? We know that there were bitter pills prescribed, but were they the right ones? Are we still taking the medication, or have we forgotten? We need to follow through; if the lessons of the last crisis do not improve our ways to anticipate, prevent, or manage the next crisis, then what have we really achieved? Undeniably, stringent capital, collateral and liquidity requirements are some mechanisms that can preserve stability and mitigate risks during crisis scenarios, but these are not necessarily preventive in nature. In the end, perhaps cultural astuteness about risk-taking within financial firms and a better understanding of the collective behavior of capital markets globally are the most effective medicines to avert systemic failures. For now, my advice would still be: Buyer beware!