« Five years on from the financial crisis, what has changed? »

« Five years after the collapse of Lehman Brothers, the Forum:Blog will be publishing a number of personal views by key figures on the event and its implications. The views expressed are those of the author, not necessarily the World Economic Forum.

A great deal of pain was inflicted on ordinary, innocent people by the financial crisis, a crisis that was neither an act of God nor a perfect storm but a totally preventable, greed-fuelled tragedy.

The simmering crisis erupted on September 15th 2008 at 1h15 AM when lawyers for investment bank Lehman Brothers petitioned the U.S. court for protection under Chapter 11 of the bankruptcy code. With liabilities of over $600 billion, it was the largest bankruptcy in U.S. history.

The Lehman bankruptcy triggered a lethal spiral. As liquidity and trust evaporated from the system and as the linkages among financial institutions became glaringly obvious, the whole financial system was revealed to be vulnerable and tottering. A wind of panic blew hard and cold. Politicians had no other choice but to throw public money at the banks and other financial firms to prevent a total meltdown of the international financial system.

The storm passed. In amazement and disbelief, the world looked at the extent of the devastation and the price that governments had to pay to contain the crisis. Then the real economies of almost all the developed countries went into a recessionary tailspin. Some governments introduced ill-advised austerity programs to repay some of the debts and further deepened their economic woes. Popular anger was and still is palpable and flammable.

Regulation post-crisis

Committees, commissions and books that have looked into the crisis have largely concurred on its causes: the massive deregulation of the financial system; the size and form of executive compensation; the use of poorly understood, esoteric financial “products”; rating agencies’ uncritical approach to those products; poor risk assessment methods; and accounting principles which turned out to be lethal in a crisis situation.

Proposals for new laws, regulatory frameworks and preventive measures gushed out from the G20, the European Union, Basel and Washington. In July 2010 the American Congress passed the Dodd-Frank Act, 800 pages of legislation aimed at giving additional powers to regulators.

After enduring a purgatory of vilification by lawmakers, pundits and lay people, the financial industry began to push back. A different twist was given to the causes of the crisis, a twist that emphasized the reckless behaviour of people with little means wanting to live beyond their financial capability.

Wall Street quickly realized that not much had changed in how the American political process operated. The implementation of the Dodd-Frank Act has been slowed down by political manoeuvring and court challenges. Key parts of the Act remain in limbo, and reformist enthusiasm in Congress is gradually subsiding.

Five years on from Lehman and more than three years after the enactment of Dodd-Frank:

• Derivative products are but partly regulated;
• Other than an advisory say-on-pay vote by shareholders and the eventual publication of the ratio of CEO compensation to the employee median compensation, executive pay levels and practices remain practically unchanged;
• The “Volker rule”, to prohibit banks from trading in the markets on their own account and restrict their activities involving private equity and hedge funds, remains inoperative;
• The rating agencies have retained most of their prerogatives;
• Systemically important financial institutions have been identified and will eventually be subjected to capital-adequacy rules and other measures to limit the risk they represent for the financial system as a whole;
• The limitations of corporate governance in large complex organizations – the asymmetry of information, expertise and knowledge between the board and management – remain unaddressed.

Slow-paced, stumbling, diluted, yet a financial system reform is taking shape and will eventually reduce the risk of a crisis with the same dynamics as the last one; it may be the equivalent of building the Maginot Line after WWI ! But the character of the international financial system is fundamentally unchanged; the motivations that drive the system remain as they were before the crisis. That may be a harbinger of crises to come.

What should be done?

Space here does not allow for an extensive consideration of measures that may go to the root of the causes; but here’s a sketchy set of proposals:

• It must be noted, and it is not a coincidence, that all firms involved in the financial crisis were widely-held, stock-market traded corporations; a particular nexus of risk-rewarding compensation systems, soaring complexity and weak board governance has come to characterize this form of ownership; but for the last twenty years, all investment banks were organized as partnerships; would partners have taken the risks that Bear Stearns, Lehman, Morgan Stanley and Goldman Sachs eventually took on as publicly traded companies? Publicly traded firms should not be allowed to take on more complexity than a competent board can govern effectively.
• Corporations must take on a broader role than delivering ever growing quarterly earnings per share; yet, the whole framework of impatient and transient shareholding, proxy advisory firms, and activist hedge funds make it very difficult to pursue any objective other than the satisfaction of the financial markets; it would be productive to adopt measures to motivate longer term holding of shares (different vote structure, enhanced dividend after a period of years, et,) as well as alternative forms of ownership, like dual class of shares, cooperative undertaking, private ownership. In this way, companies might be insulated somewhat from short-term pressures and again plan and manage for the long term, which implies due consideration to all stakeholder that give legitimacy to a business firm.
• The legal framework for corporation should make clear that the board must act and decide in the long-term interest of the corporation, which must include consideration of all stakeholders of the company.
• Finally, let’s review the whole system for setting executive compensation; it is a broken system that needs retooling. »