“La chose la plus importante à toute la vie est le choix du metier: le hazard en dispose. La coutume fait les maçons, soldats, couvreurs.” (1)
In my public life, stubborn pursuit of personal inclinations has alas never been my forte. Already at age 18 I cowardly succumbed to utilitarian propriety (2) : the then raging economic crisis and my parents’ insistence made me duly discard a penchant for Classical Languages & Philosophy to enrol instead at the Faculty of Business Economics.
My Brush with the Foundations of Modern Finance
At this utilitarian, and thus eminently boring (3) faculty my academic career had its ups and downs, as periods of diligent if reluctant studying alternated with brief, rebellious assertions of more innate urges. But 4 years later I nonetheless had been suitably imbued with the business and financial wisdom of that age:
- free competition and profit maximisation ensure that scarce resources are put to their best use ;
- financial markets are efficient and should be left well alone to do their blessed job of optimally allocating capital ;
- whether a company is financed with debt or with own equity does not matter (Nobelprize winning Miller& Modigliani ) ;
- deregulation in finance is the way to go (e.g. abolishment of the separation between investment banks and deposit banks; Big Deregulatory Bang in the City) ;
- risks can be adequately hedged and transferred via derivatives that can be correctly priced via mathematical models (Black & Nobel Prize winning Merton and Scholes ) ;
- the interest rate paid by (western) governments on their bonds is the risk-free rate that serves as reference point for all other risky investments ;
Not that I fully grasped the import of all of these maxims (some of them being pretty counter-intuitive), let alone that I could critically assess them, but then, well, I didn’t have a Nobel Prize winning intellect either and at exams I did manage to reproduce enough of it to earn my degree.
Having earned this business degree, I did not in fact have a particular career path in mind, except perhaps for a keen sense of having to earn my own living and to do “something useful”. So I sent out my CV to a random list of companies and promptly accepted the first serious job-offer I got.
Thus I started my working life at a small cooperative bank, which had just launched up a new department for “portfolio management” . A team of 3 people managed about 60 portfolios of wealthy clients, totalling 1 billion Belgian francs. I was mightily impressed by that whopping “1 billion francs” figure (though less than 25 million Euros ...) as well as by the Datastream-terminal on which stock-prices flashed by. It was only a few months after the October 1987 stock market crash (-20% on one day), so every day at 4 PM my colleagues would nervously watch the Wall Street opening.
(They needn’t have worried, not then, not yet at any rate ...., since the US monetary authorities in the following 2 decades would promptly come to the rescue at each sign of financial markets distress ... . By always promptly lowering short term interest rates, they thus put a floor under the markets, while on the other hand failing to raise rates to check any rise in asset prices, however exuberant ... Don’t mess with markets efficiently pricing assets, was the creed. But I digress, all of that of course was still to come..., and could obviously not be foreseen back then in 1988, or could it?)
My tasks at first were very humble – inputting transactions, updating prices, answering client queries - before being entrusted with the actual management of a dozen small client portfolios . As a budding portfolio manager I treaded very cautiously, diversifying broadly, preferring bonds to stocks, panicking at each possible risk. But my senior colleague soon initiated me in the secret of successful investing: Japanese warrants (equity derivatives)!
Buy ‘m today – sell’m next week with profit! As the Japanese markets soared from one peak to the next, these warrants indeed seemed a sure way to make the most of only a small initial money outlay. Japanese brokers called all the time with new and juicy warrant offerings. As these brokers themselves made so much money in the heady markets, they also could afford to invite all their clients over for a Tokyo-visit. Even as a lowly junior portfolio manager at a tiny cooperative Belgian bank I thus got invited for 2 weeks of company visits in Tokyo (4).
(The Japanese asset price bubble duly burst in 1991 and arguably the Japanese financial markets and banks have even now not yet fully recovered as the Japanese debt/GDP ratio remains huge . The 80s Japanese bubble was a matter of financial hubris & irrationality as well as excessive private debt. And also a matter of a declining active population. So Europe and the US could have drawn lessons from the Japanese debacle to avoid their own later excesses – but they didn’t of course. Drawing humbling parallels is not something the financial sector is good at. )
But back to my career: soon it had become clear that, being a born risk-averse person, I was not really made for a swaggering front office equity manager function.
So I went on to specialise in the (then) humbler bond and money market management . In due course I also tortured my brain with the maths involved in pricing hybrid fixed income instruments, including the now infamous Mortgage Backed Obligations and other interest rate based derivatives. These MBO’s& CDO’s etc were fixed income’s bid for financial glamour & sophistication.
And they played a disastrous role in the recent Great Financial Crisis – (but that, of course, nobody could have foreseen back in the 90s).
However, also in fixed income management my risk-aversion kept me from chasing the highest returns and, tellingly, my boss once copied and urged me to read a Financial Analyst study “Bond managers need to take more risk”.
Macro-economic analysis was also part of my job then and I did love to understand and describe how and why economic evolutions unfolded as they did . But obviously, “understanding and describing” is not what asset management is about, one should try to anticipate and outwit the markets with immediate profitable effect. Thus, after having read a macro-economic article of mine, my boss shook his head and sighed “well, this is all very nice and erudite – but it is not going to make us a lot of money, is it?”. And right he was, I did indeed seem to lack the “making money instinct” , so essential for an asset manager.
A Cog in a Booming and then Busting Business
So I wisely moved on to more pedestrian support functions in the company – where neither risk taking nor instant money making forecasting skills were required.
From those posts I went on to obediently serve the system and to observe the ebbs and flows in the financial markets. Thus I witnessed the dotcom bubble when everyone thought the technology and internet productivity miracle justified stellar valuations for each and any internet start up.
I also remember a very smart economic analysis made by an unassuming but brilliant macro-economist working at our company – he explained how consumer price deflation in fact was normal in case of a positive productivity shock and that it should not be countered by an overly lax monetary policy because that would only lead to asset price inflation. How right he later proved to be!
But he left our company, not being considered a good economist, since for months and months his pessimistic forecasts were ridiculed by euphorically rising markets – until also that bubble duly burst again.
In the meanwhile my work context had profoundly changed too. The modest cooperative bank I had joined had felt obliged to do a takeover of another bank in order to play in a bigger league (Bigger Banks was what we needed, small banks could not survive – or so the whole financial and political establishment declared at that time).
The asset management activity was spun off in a separate company with now about a hundred staff (barely 10 years after I had joined the tiny department with its 3 staff-members). But this was not yet the end of it.
Four years later we were taken over again, by a big Franco-Belgian bank, itself the result of an ambitious cross border merger .(5) And while over the next 5 years we became an European asset manager with over 500 staff, our mother company pursued its breathtaking growth – becoming a world leader in public finance and one of the world’s most solid banks with superior credit ratings! (AA-rating).
And this is the same banking group that in October 2008 was as good as bankrupt and had to be saved by the Belgian and French governments. And the same banking group that had to declare forfeit in October 2011, turning to the Belgian and French governments again for help, parts being nationalised, other parts (including asset management) being put up for sale to raise money for the ailing mother company.
What Went Wrong? Whose Fault Is It?
What on earth went wrong? With a bank that still had a AA –rating back in 2007? It is embarrassingly simple what went wrong. So simple .... (6)
This bank was not content to take client deposits and make loans in turn, no, in order to become a world leader they wanted to make even more loans (beyond their own client deposits funding capacity) and didn’t hesitate to go borrowing themselves in the short term interbanking market.
And then – to boost profits even more, they also saw fit to build up a huge financial portfolio (nothing to do with the core business) of long dated financial assets again partly financed by short term lending. (7)
The problem of this financial portfolio was not even mainly one of toxic insolvent investments (though there were some) but rather one of a maturity mismatch (short term funding of long maturity bonds) (8) leading to acute liquidity problems once the markets turned sour. (Try to borrow each day more than 100 bn Euros when people no longer trust you ....).
So there we are, this is what went wrong: irresponsible leverage and hubris. But so, how come nobody saw it coming?
A non-financially savvy person might naively wonder how a bank could have been allowed to blow up its balance sheet to 630 bn Euros while having only an own capital of 16 bn Euros? (9) Why did no-one shout out? No regulator? No asset manager? No financial analyst?
So whose fault is it? There’s of course an individual responsibility of individual CEO’s blinded by easy success in an almost virtual money-world (10) .
There may also be a collective responsibility of academics, regulators, banks, financial analysts , asset managers for all having contributed to the miscomprehension and therefore mis-pricing of risk and for all having failed to critically check against reality the prevailing financial dogma’s .
In the real world of enterprise risk-loving certainly can turn awry too but for every 10 failures or so it can at least produce one success with (hopefully) true added value for society – they are “the bubbles of speculation on a steady stream enterprise” as Keynes called it (and it gave us the railways and the amazon.coms of this world).
But while finance ideally is meant to ensure that all over the world savings flow to the investments and entrepreneurial ideas with the best potential (by efficiently pricing risk and allocating capital), there’s no denying that finance these past decades has more often than not merely amplified irrational hypes and has promoted glaring in-efficiency.
The Charges are: Greed, Stupidity , Hubris and Vanity
So is there something particularly rotten in finance? Could it be that money-lenders and money-managers are more prone to greed, stupidity , hubris and vanity than other professionals? (11) Well, yes, perhaps they are, perhaps in finance it is indeed easier to succumb to fundamental errors and illusions of human nature:
- the “skill or luck” question: financial markets traders and money managers can too easily mistake simple luck for skill (which a bricklayer or a virtuoso violinist cannot) and think themselves geniuses after a couple of lucky trades.
- the “agency” problem: traders and money managers make “bets” with other peoples’ money and get rewarded when things go well, but they do not necessarily suffer enough themselves when things go wrong. While an entrepreneur having put his own money & energy on the line cannot escape from the consequences of his failure. (12)
- the” illusion of quantifiable rationality” in economics and financial markets: not withstanding strands of economic thought such as behavioural finance, finance has more and more put faith in sophisticated quantitative techniques which seemed to allow a perfect mastery of risk. But the models could not adequately capture real life quirks or ‘fat tail events’ and the quants didn’t ever question the received dogma’s (see 1st part of this post..) . Thus common sense made way for a sophistication that kept at bay the non-initiated who might have asked critical questions.
- The “amorality of money” : thinking of money boosts selfishness: this indeed is shown by a number of psychological experiments ...
In any case, over the past decade , finance has failed, judged even on its own terms of efficient-free-markets-capitalism (13).
What to do then – perhaps finance should just go back to basics: let bankers and mainstream asset managers again become humble and slightly boring clerks in a tightly regulated industry, and let risk-loving and entrepreneurial financial types run their own small venture capital outfits and hedge funds, with their own capital at stake (and obviously without state guarantee).
And as to myself – instead of doing “something useful” (which was why I choose business economics in the first place) it now turns out that for over 20 years I have been a diligent cog in a dubious system. So what can I say? Cogs in support functions of course don’t personally initiate any actions of great impact – but they do facilitate what’s happening all around them .
And while I definitely plead “not guilty” to the charges of greed, hubris and vanity – I must admit I do feel rather stupid. (14)
An Inflation of Notes
(1) Pascal – Pensées “The most important thing in life is the choice of career: it is arranged for by chance. Mere custom makes bricklayers, soldiers, roofers”
(2) A dubious waiving of personal responsibility perhaps – after all, also this succumbing to ‘utility’ is obviously a character trait or personal inclination ... (though by no means a cherished one)
(3) the imminently subjective verdict of a 18-year old
(4) what I mainly remember from that Tokyo-trip, were the rare occasions we would meet with a female financial analyst or company official (who would have escaped from the ranks of the so-called office ladies), how condescendingly they still were treated by their male colleagues, how brave they were ( a braveness against despairing odds) and how they seemed relieved and a tad triumphant when they saw women amongst the foreign visitors.
(5) Belgian readers will now sigh and will be barely able to suppress their disgust - they know the story is not going to end well.
(6) Just turn to page 7 with the Financial Highlights in the 2007 annual report of this bank . You’ll see a nice operating result but what you need to look at is the balance sheet. Look and weep. Here’s a bank that between 1999 and 2007 pumped up its balance sheet from EUR 246bn to EUR 604bn (the entire Belgian GDP is around EUR 300bn) and this with an own capital of only EUR 16.1 bn. Then turn to pages 114 and 115 for a closer look at assets and liabilities. End of 2007 you’ll see loans to clients for 243 bn and a huge financial portfolio worth no less than 258 bn! And how was this financed? By client deposits for 127bn, by issued debt securities for 204bn, and by a staggering 179bn of short term lending (“due to banks”).
(7) For the (cynical) fun of it, read also the auto-congratulating messages of the chairmen in the 2007 annual report, on pages 10-13. While the bubble was already bursting the erstwhile CEO still proudly boasts the further growth in loans and assets...
(8) Since most of the time short term rates are below long term rates, funding a portfolio of long term bonds with short term lending (esp. if you’re a well rated bank who can borrow cheaply) looked like a magical profit formula: pay, say, 2.5 % in the market and get 4% or so on the bonds you have bought with the borrowed money , and this on hundreds of billions ...
(9) Oh but that’s a simplistic reasoning, financial experts and regulators could have said back in 2006 – you have to look at the risk adjusted ratios, you have to look at the “risk weighted capital adequacy ratio” which is excellent at 9.6%! The ratio could be so excellent because most western government bonds got a zero risk weighting so banks didn’t even had to put capital aside when they invested in them... Excellent, because it neither adequately captured the risks of a liquidity gap.
(10) Modern computer driven finance has made it deceptively simple to build up a bond portfolio of 100 billions of Euros in just a couple of years.
(11) No wonder so many religions fundamentally distrust money-lenders, condemning the sins of usury and avarice ...
(12) Which is a variant of moral hazard
(13) Lets’ not even think about the failure of “Finance” judged on “other terms” .... i.e. what about the venerated free markets and the needs of future generations (once the last barrel of oil will have been pumped up)? what about price-less goods such as silence, clean air, beauty, relative permanence, goodness, ...
(14) I did not ever really read the annual report of the shareholder-bank of the asset management company I work for, but if I had, I’m sure I would not have questioned the bloated balance sheet, I would have been fooled by its high capital adequacy ratio just like everybody else. But I do faithfully read The Economist every week, and so I could have seen graphs showing an excessive growth in debt, showing the unrealistically outsized proportions the financial sector was taking. And no, I did not ever particularly like or adore the “efficient free markets ruled by self-interest” but I too had come to think that, though unappealing, these free markets did do a good job in creating and spreading wealth all over the world (after all, hadn’t the critics of the free markets been proven wrong in ’89? )