How did finance lose its way?

In recent years, especially since the advent of the 2008 financial crisis, the worst one of the century, bankers have seen a spectacular nosedive in public approval. Many see them as the orchestrators of this crisis, and although they were not wholly responsible, it is true that banking, and more broadly the finance industry as a whole, has had systemic problems that are not even close to being solved to this day. Tales of plunging share prices and financial woe have been what today’s generation have grown up with; almost everything they have known has been financial negativity. It’s almost redundant to say at this point that a field which was created in order to benefit the public should really not be hoodwinking and failing them in the way which it has. However, for some people, it’s difficult to pinpoint how exactly the finance industry started to degenerate. That’s exactly what I plan to do in this article; single out the places in which the finance industry has turned in the wrong direction, in the hope that they can correct their wrongs and flourish as they once did. Maybe then, it will be known for more than just some of its exorbitant salaries.

Those exorbitant salaries had to come from somewhere though, right? This somewhere is gains made due to leverage. This is when one uses borrowed capital when investing, as they hope for the profits accrued to be greater than the interest payable. This is a direct consequence of the risk appetites of top financial officials going into overdrive, and having no concern for what could potentially happen if their assets suddenly start depreciating in value. Obviously, a small sub section of them got their comeuppance, when Lehman Brothers, who had leverage of 30.7, or $30.70 for every dollar invested, went bankrupt. Despite this, key global financial institutions seem not to have learned from this and finance still has the “casino” reputation that it did before. It’s ludicrous to think that the direction of something so sensitive and integral to the global economy as finance is now almost being reduced to gambling. If finance wants to regain its once stellar public image, then it needs to cool down its risk appetite and make sure that its investment decisions are based on solid reason, rather than instinct. Otherwise, well, the finance industry will continue to degenerate both in name and in actuality, and the fine line which separates financial investment from gambling will continue to get finer and finer. Who knows, maybe we’ll even see a couple more Lehmans.

It’s not just the banks with all the problems, though. It’s the institutions which let them wreak havoc on the global financial system in the first place. These, of course, are the credit ratings agencies Moody’s Investors Service, Standard and Poor’s, and Fitch Ratings. Without them, the banks would not have free reign to kickstart the financial crisis under the guise of collateralised debt obligations. This is because throughout the whole of 2007, they gave the highest “triple A” credit rating to over three trillion dollars worth of loans to homebuyers with shabby credit histories. This sheer incompetence led to over half a trillion dollars worth of losses by 2010, with the US government itself having to buy $700 billion worth of bad debt. These agencies aren’t stupid. They knew that some, at least, of what they were doing had dire potential consequences. When asked about the job that these credit agencies did, Richard Michalek, a senior credit advisor at Moody’s, proclaimed “Oh God, are you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of the time. . . . It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P.” The only way in which we can stop this happening again is through the democratisation of finance; there needs to be more transparency regarding how and why these agencies give the credit ratings they do. By now, it may have already been too late; a second crisis could be lying in wait.

One of the most important components of the success of any corporation, let alone any financial institution is the threat of failure. Unfortunately, some banks have become so big than they have been bestowed with the term “too big to fail”. This term, as defined by the former chairman of the Federal Reserve, Ben Bernanke, is a firm whose “size, complexity, interconnectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the financial system and the economy would face severe adverse consequences.” This is risky chiefly because it creates a dependency culture in the largest banks; if something adverse happens to them, they know that they will be bailed out. This is a massive problem with the financial industry as a whole even today; they can take as much risk as they want without fear of any consequences, meaning that, in essence, they can use their money how they want. Again, the only way in which this can be stopped is through further regulation of the financial system. Although significant strides have been made towards these means in recent history, still more needs to be done to ensure that the financial industry does not step out of line once more. Regardless, enough damage may have already been done till now to sink the global economic system once more. The optimist in me, however, thinks that we still have time, time to regulate finance, time to make sure that it cannot cause as much harm to the economy, and time to restore it to previous heights which we all know it can attain.

Shrey Srivastava, 15

16 Comments Add yours

  1. Tim says:

    I’ve always wanted to work in the finance industry, this is a great post showing where it could do better.

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  2. rdquinn says:

    Do you disagree that the root cause was gov’t policy promoting sub prime home ownership and pressure for sub prime lending, plus individuals knowingly borrowing above their ability to sustain payment?

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    1. moslerfan says:

      I can’t speak for Shrey, obviously, but that’s at best a quarter truth. Congress did indeed lower standards for loans acceptable to Fanny and Freddy, but they did it at the urging of bank, mortgage company, and real estate lobbyists. These companies stood to make huge profits from subprime loans, and did. Their plan was to take the origination fees and upfront profits while passing the loans (and downstream risks) to pension funds and, well, taxpayers. Lehman unfortunately got caught holding too much of the bag when the bubble burst.

      As far as culpability for “individuals knowingly borrowing above their ability to sustain payment,” this is why we have underwriting standards. Banks can operate in two ways, not mutually exclusive. One is to lend against projected future profits that will be generated by investment. The other is to lend against collateral. The first approach benefits society by increasing economic output. The second approach increases asset prices (creates bubbles).

      A loan that is extended to a borrower who cannot repay is fraudulent. Any bank that lends against collateral without regard for ability to repay is probably engaging in fraudulent and/or predatory behavior.

      A lot of people believe that banksters should go to jail for fraudulent behavior. As it happens, criminal fraud is particularly hard to prove in a court of law because it involves proving the perpetrators knowledge and intentions, which must be proved “beyond reasonable doubt.” A simpler solution would be to just require mortgage originators to hold the loans they make. That would put the responsibility for “individuals knowingly borrowing above their ability to sustain payment” where it belongs — on the banks.

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      1. rdquinn says:

        The policy of pushing him ownership goes back before the crisis and was clearly Democratic policy which resulted in strong arming lenders. Even the current housing secretary started out by saying he was pushing home ownership and today you can still get a mortgage with 5% down. Ridicules.

        Don’t let borrowers off the hook. Any marginally intelligent person will not take a loan based on what somebody else tells them they can afford.

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      2. moslerfan says:

        rdquinn, how do you propose to hold these irresponsible borrowers accountable, presumably in some way that gets the loan repaid? And how exactly does one go about strongarming lenders?

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      3. conrad seitz says:

        To rdquinn: blaming the “pushing [home] ownership” on Democrats exclusively is just plain wrong. Bush II was heavily responsible for this “pushing” as well. Obviously it didn’t work.
        Extreme pressure from international money wanting something, anything to invest in was (and is) partially responsible for the inflation in home loans. Now they just buy the US property outright.
        The only way “individuals knowingly borrowing above their ability” would work is if the underwriting standards were loosened inappropriately– you can’t borrow unless they let you– and “liar loans” were heavily responsible for the bubble and crash. But the underwriting firms had to cooperate to give people these loans.
        Then there were the loaners who knowingly gave people (more blacks) inappropriately complicated home loans when they qualified for perfectly simple traditional loans. They made more money up front originating these loans so they cheated people with good credit (mostly black) by giving them balloon loans instead of traditional loans. This happened a lot because of the profit motive (see Shrey’s most recent post.)
        Don’t blame everything on Democrats or the little people who supposedly cheated. You can’t cheat a home loan unless the loan officer cooperates.

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  3. Hi Shrey

    Interesting and nice blog! Several good points here.

    Are you familiar with the discussion on Knightian /genuine uncertainty? As some argue, if no one really knows the future, it’s not certain that we will avoid instability, even if everyone has to bear their own risks. Hyman Minsky, FIH etc.

    / Erik

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  4. ratishagoyal says:

    I agree with you, Shrey! The Credit ratings are potent enough to tear down any country let alone individual business! Still such voracious weapon lies in unaccountable hands and what methods they resort to script the fate is known to them and God! I don’t understand why the developing and underdeveloped world is still letting the World financial institutions like IMF, WTO to be controlled by the rich nations?? Dirty politics everywhere disgusts me!!

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  5. Reblogged this on newsociety21stcentury and commented:
    A very interesting and thought provoking piece.

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  6. There are some definite flaws within the financial industry, and unsurprisingly I believe it all stems from personal greed. It is much easier to gamble when it’s someone else’s money that you may lose without an effect on you, but you have much to gain if you succeed!
    Great topic.
    Tori
    http://www.themamanurse.com

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  7. Shannon says:

    greed+Fraud=disaster

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  8. Car says:

    Once the Glass–Steagall act was removed it gave the financial institutions a free pass to ultimate greed and other people’s money.

    Liked by 1 person

  9. Yes, I am all for a more regulated financial system worldwide. However, I think financial education is also necessary for everyone. Being cultured in finance is not only practical, but also it protects unknowing victims from being preyed upon by opportunists just like what happened in Spain (See: https://euobserver.com/economic/119809).

    Like

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