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Opinion

Editorial: Failure on an epic scale

Many banks will become less-levered, more conservative, far duller institutions promising much lower and more utility-like returns to investors

A generation of Britons, now middle-aged, learnt to read with the Ladybird picture books, which are enjoying something of a revival, having acquired a sheen of vintage chic. "Some men work in a circus," one Ladybird book tells us. "It is work they like, but there is danger and some get hurt. Here is one man at work in a circus." The accompanying picture shows a gaudily clad trapeze artist plunging headlong towards a distant and none too sturdy-looking safety net.

The Institute of International Finance has just produced its own version of the Ladybird book especially for bankers. But the IIF needs to work on its titles. Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations is not the snappiest. But the text is a pure joy and rivals Ladybird prose. "Senior management should be involved in the risk-control process and both the Board and the management should regard risk management and control as essential aspects of the business," it tells us. And "effective development of a ‘risk culture’ throughout the firm is perhaps the most fundamental tool for effective risk management".

It might as well add that some men work in a bank. It is work they like, but there is danger and some get hurt.

Maybe bankers deserve a report like this. Euromoney believes that the banking industry is populated by some of the best-educated and cleverest people in the world. Unfortunately, such people are always capable of doing the stupidest things. And at the institutional level, while plenty of individuals inside banks saw the crash coming and tried to raise the alarm, those clamouring for greater earnings and higher returns drowned their voices out. This is institutional failure on an epic scale that demands even the most accomplished bankers be seen to go back and relearn the basics.

Talk to chief executives of the world’s largest banks today and they will all tell you that they and their chief risk officers are poring over the IIF report, examining their own banks’ shortcoming against its best-practice recommendations and moving to close the gaps.

It is a little worrying and surprising to discover just how basic many of its recommendations are. Banks need to define a risk appetite that should be the basis on which to establish risk limits and "the firm’s risk appetite should be connected to its overall business strategy and capital plan". Well, yes, but didn’t bankers learn all this on day one at banking primary school?

Apparently, they did not.

So it is worth asking how banks will operate in future, if they implement all the IIF’s best-practice recommendations and those from other equally well-meaning reports now cascading out of various committees set up to study what went wrong and how to prevent a crisis on this scale from ever happening again.

We can only conclude that if, having previously paid attention only to earnings and not the risks from which they were derived, bankers now invest equally in monitoring and managing the downside, many of their banks will become less-levered, more conservative, far duller institutions promising much lower and more utility-like returns to investors.

Is that a bad thing?

Not if you go back to the picture in the Ladybird book and look closely at the straining circus workers holding the edges of the safety net. Some people pay taxes. It is not something they like and there is danger.

A country’s large banks are a contingent liability of the sovereign, a lesson learnt and relearnt many times over just the past 15 years by taxpayers from Japan and Korea to Scandinavia, continental Europe, the UK and to the US. If taxpayers provide the safety net, it is insupportable that the trapeze artists should take excessive risks in the pursuit of huge bonuses during the good times.

If specialist financial institutions wish to pursue high profits from taking high risks, confident in their ability to monitor and manage them, then they should be capitalized by investors on the understanding that no sovereign bailout will rescue them. These activities should take place in institutions outside the remit of policymakers to rescue. These institutions could be called hedge funds, perhaps merchant banks, or even investment banks.

Will the global economy and national societies suffer if banks’ newfound conservatism reduces the supply of funding to motors of growth. Perhaps so. But not if those motors turn out to be hugely overleveraged corporate Ponzi schemes or grotesquely overvalued assets such as tech companies, office blocks or homes.

The best way of avoiding the damage from the bursting of an asset bubble is to ensure it is not inflated in the first place.


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