Swiss bank UBS AG has recently released a report where it has tried to explain to shareholders what went wrong in the subprime crisis. UBS is one of the worst affected firms and the decisions of its managers needed explanation. The report is an honest admission of various judgemental errors by the management.
Illustration: Jayachandran/ Mint
One wonders how many of UBS’ shareholders understood what was written. It sounds Greek all the way. There is a surfeit of jargon and acronyms. One has to continuously flip back the pages to understand the chain of events.
An example: “Within DRCM, there were Subprime positions in the Reference Linked Notes (“RLN”) program, the Asset Backed Securities Relative Value (“ABS Relative Value”) strategy, ABS Collateralized Debt Obligation Trading (“ABS CDO Trading”) strategy and in the US Short Term Asset Backed Portfolio.”
If other firms release similar analyses of what went wrong, the outcome is likely to be no better. Every business should be explainable to the owners/shareholders. Unfortunately, this is not the case in the financial sector.
The financial sector has come a long way from its early days of relative obscurity. Finance wasn’t even mentioned in the early literature on economic growth and development. The early theories of finance were based on perfect markets and this made economists sceptical of the role of financial firms. This perception changed due to work on information asymmetry (led by Joseph Stiglitz) that showed the usefulness of financial intermediaries in lowering asymmetry. Then there was exhaustive work by Ross Levine, Thorsten Beck and Demirguc -Kunt that showed how a financial system helps lower costs, manage risks and reduce poverty.
Now, an efficient financial system has become as important—if not more—a factor for growth as factors such as human capital, institutions, etc., are. It has become a vital part of the “reforms package.” We keep hearing about how developing countries are trying to reform their financial systems.
But just as roses have thorns, financial systems have crises. So far, the crises were limited to emerging markets. Their policymakers were chided and called reckless by their counterparts in developed markets. Now, the credit crisis is hitting countries whose financial markets were used as benchmarks. This has been perplexing. Many economists have written defending/opposing the role of financial markets and the practices of financial firms. The reality is that financial markets are important and dangerous, too. We can’t escape from both the realities.
The main reason for these developments: The financial sector has moved from being simple to abstract, from serving the public to serving the private interests. The participants call it Modern Finance (what is modern about a system that keeps crashing?) and take pride in creating more and more complex instruments. As investor John Bogle says: “We’re merely trading pieces of paper, swapping stocks and bonds back and forth with one another, and paying our financial croupiers a veritable fortune.”
This makes the problems worse and in times of stress, even the creator of the instrument does not know how to value his instrument. If we add distorted incentives (that reward risk seeking and making fuzzier instruments) to complexity, we know there is serious trouble.
All this poses numerous problems for the policymakers. They have to not only develop their financial systems, but also make them more crisis-resistant. Take the India example. There have been numerous reports on India’s financial sector. All these committees/reports suggest the same —an efficient financial system with more participation of public and encouraging financial innovation. But then, we can’t really ignore the risks from these fancy financial products. The UBS-type shareholder reports might soon be written by Indian firms (I hope not in times of crisis) and the recent derivatives crisis suggests the time will come sooner than later. How many shareholders will actually understand these derivative positions? If they don’t, then the purpose of bringing more public savings into capital markets needs to be questioned.
The subprime crisis has pointed to the need for financial literacy, but understanding what happens in financial markets requires much more than basic financial literacy. Even the best financial brains can’t figure out the developments. Hedge fund Long Term Capital Management (LTCM) failed miserably despite having Nobel-winning economists on board. The subprime crisis is a collective failure of many such minds.
There is an urgent need to tackle the perverse incentives and complexity in the financial system. The regulators alone can’t do the job and the participants will have to become responsible themselves. But then, we are all interested in our yachts, who cares for the customers/shareholders? Financial deepening without creating financial excesses (as said by Hervé Hannoun of the Bank of International Settlements) is the need of the hour. The focus so far has been on the first part. The sooner we move to second, the better it will be.
Amol Agrawal is an economist with IDBI Gilts Ltd. Comment at firstname.lastname@example.org