‘Financial weapons of mass destruction still primed to detonate’ – Professor Prem Sikka UK

21 March 2011

www.tribunemagazine.co.uk/2011/03/11437/

Financial weapons of mass destruction still primed to detonate

The current uncorrected political course means another banking crisis is inevitable, cautions Prem Sikka

by Prem Sikka

Friday, March 18th, 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