Saturday February 21, 2009
This is a network crisis of trust
THINK ASIAN BY ANDREW SHENG
THE current crisis can be seen as four excesses – excess liquidity, excess credit, excess leverage and excess greed.
Of course, there is a fashionable school of thought in Western academia that the current crisis is all due to the savings glut in Asia. I find this argument fallacious, because it is like a banker blaming his excess liquidity on his depositors! Something is very wrong in our values when the saver is being blamed for excess consumption.
This is why the naïve version of capitalism that says that greed of individuals adds up to a public good is logically and morally wrong. This crisis is fundamentally a balance sheet crisis, basically meaning that for every asset, there is a liability. For every saver, there must be a borrower.
And there are two types of borrowers – those who pay back and those who do not pay back. Economists like to use big words to explain simple things.
Markets have two fundamental issues – the information asymmetry problem and the principal-agent problem. Both issues boil down to one word – trust, on which all markets, indeed all human relationships, are based. If there is no trust, there is no market. This crisis was a fundamental breakdown of trust in global wholesale banking. What is a bubble but a false promise of unending prosperity? The bubble should not have happened, but the whole world wanted a party – something for nothing.
This is where leverage comes in. The bubble can only be created through the willingness of banks to extend credit. And why were the banks willing to extend credit? Because the incentive structure is such that the more the banks lend or create new products, the more profits and the higher the bonus for the financial engineers. Millions of savers have put their trust in bankers who have fundamentally betrayed their trust by gambling away their savings, forcing governments to bail out the banks in order to protect savings.
I call this crisis a network crisis of trust, because financial markets are networks. Under universal banking, commercial banks began to network with securities business, insurance and even hedge funds, because under Metcalfe’s Law, the value of the network increases with the number of users. Hence, business geography merged to become market space – enabling banks to become financial Walmarts providing the whole range of financial services.
What top bankers did not realise was that networks are linked both ways – benefits come with risks. The more the networks expanded, the higher the risks of contagion. In a sense, the network is only as safe as its weakest link and if one part of the network is taking higher and higher leverage to increase its profitability, it is doing so at the expense of the rest of the network.
There are five basic elements of trust in the financial network.
First, trust has to be earned. The most basic trust is between two persons, but trust is never completely mutual. One party has to offer more to earn the trust of the other. In business, this is the entrepreneur who is willing to put his own capital at risk before everyone else. A bank is trusted because it puts its capital before the losses of the depositor.
Second, trust has to be learned. Trust is mutual. One side can offer confidence and trust, the other side has to learn how to trust or not trust. As legalist philosopher Han Feizi said, big trust is accumulated from small trust. Trust is about repeated games in which trust and confidence is reinforced through practice. This is why investor education is so important in the market place and why the relationship between a bank and its customers is not just a fiduciary issue, but also an educational one. When one party treats the other as an uneducated sucker, there can be no trust.
Third, trust has to be enforced. For trust to be valuable, there must be a high cost to mistrust. As the saying goes, fool me once, shame on you. Fool me twice, shame on me. The investor trusted the bankers, the rating agencies, their auditors, the independent directors and the regulators, and each line of defence failed to verify that what the CDOs promised was not right. If Mr Greenspan also trusted too much the bankers who were supposed to look after other peoples’ money, what chance do small investors have?
Fourth, trust needs transparency. Trust needs open communication between those in fiduciary duty to explain what the rights and responsibilities are. The basis of a market economy is caveat emptor or buyer beware, but the seller must also have responsibility to be transparent to the buyer. In some of the fancy accumulator products that I have seen, the bankers did not explain to the buyer that at certain price levels, the amount of collateral that the buyer would have to provide would exceed his net worth.
Fifth, trust begins bilaterally, but ultimately becomes multilateral. The over-the-counter market, which is largely unregulated, is essentially a market between professionals and comprise bilateral relationship between the bank and the investor. Everyone thought that the present system of collateral margin would be sufficient to cover the counterparty risks. Unfortunately, when the market is exceedingly large and complex, such as the CDS or CDO market, then failure of one counterparty or the weakness of one product can create huge contagion risks throughout the network.
When the relationship breaks down at the bilateral level, in a period of confusion and uncertainty, the whole network breaks down. This was what happened to the core of the wholesale banking network. We must have centralised clearing and settlement of these complex transactions so as to control the level of system leverage and the counterparty risks.
In other words, we cannot allow the breakdown of small trusts to create big chaos. Trust goes slowly up the stairs and crashes down the elevator.
Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served as adviser and chief economist to Bank Negara, deputy chief executive of the Hong Kong Monetary Authority and chairman of the Hong Kong Securities and Futures Commission
This is a network crisis of trust
THINK ASIAN BY ANDREW SHENG
THE current crisis can be seen as four excesses – excess liquidity, excess credit, excess leverage and excess greed.
Of course, there is a fashionable school of thought in Western academia that the current crisis is all due to the savings glut in Asia. I find this argument fallacious, because it is like a banker blaming his excess liquidity on his depositors! Something is very wrong in our values when the saver is being blamed for excess consumption.
This is why the naïve version of capitalism that says that greed of individuals adds up to a public good is logically and morally wrong. This crisis is fundamentally a balance sheet crisis, basically meaning that for every asset, there is a liability. For every saver, there must be a borrower.
And there are two types of borrowers – those who pay back and those who do not pay back. Economists like to use big words to explain simple things.
Markets have two fundamental issues – the information asymmetry problem and the principal-agent problem. Both issues boil down to one word – trust, on which all markets, indeed all human relationships, are based. If there is no trust, there is no market. This crisis was a fundamental breakdown of trust in global wholesale banking. What is a bubble but a false promise of unending prosperity? The bubble should not have happened, but the whole world wanted a party – something for nothing.
This is where leverage comes in. The bubble can only be created through the willingness of banks to extend credit. And why were the banks willing to extend credit? Because the incentive structure is such that the more the banks lend or create new products, the more profits and the higher the bonus for the financial engineers. Millions of savers have put their trust in bankers who have fundamentally betrayed their trust by gambling away their savings, forcing governments to bail out the banks in order to protect savings.
I call this crisis a network crisis of trust, because financial markets are networks. Under universal banking, commercial banks began to network with securities business, insurance and even hedge funds, because under Metcalfe’s Law, the value of the network increases with the number of users. Hence, business geography merged to become market space – enabling banks to become financial Walmarts providing the whole range of financial services.
What top bankers did not realise was that networks are linked both ways – benefits come with risks. The more the networks expanded, the higher the risks of contagion. In a sense, the network is only as safe as its weakest link and if one part of the network is taking higher and higher leverage to increase its profitability, it is doing so at the expense of the rest of the network.
There are five basic elements of trust in the financial network.
First, trust has to be earned. The most basic trust is between two persons, but trust is never completely mutual. One party has to offer more to earn the trust of the other. In business, this is the entrepreneur who is willing to put his own capital at risk before everyone else. A bank is trusted because it puts its capital before the losses of the depositor.
Second, trust has to be learned. Trust is mutual. One side can offer confidence and trust, the other side has to learn how to trust or not trust. As legalist philosopher Han Feizi said, big trust is accumulated from small trust. Trust is about repeated games in which trust and confidence is reinforced through practice. This is why investor education is so important in the market place and why the relationship between a bank and its customers is not just a fiduciary issue, but also an educational one. When one party treats the other as an uneducated sucker, there can be no trust.
Third, trust has to be enforced. For trust to be valuable, there must be a high cost to mistrust. As the saying goes, fool me once, shame on you. Fool me twice, shame on me. The investor trusted the bankers, the rating agencies, their auditors, the independent directors and the regulators, and each line of defence failed to verify that what the CDOs promised was not right. If Mr Greenspan also trusted too much the bankers who were supposed to look after other peoples’ money, what chance do small investors have?
Fourth, trust needs transparency. Trust needs open communication between those in fiduciary duty to explain what the rights and responsibilities are. The basis of a market economy is caveat emptor or buyer beware, but the seller must also have responsibility to be transparent to the buyer. In some of the fancy accumulator products that I have seen, the bankers did not explain to the buyer that at certain price levels, the amount of collateral that the buyer would have to provide would exceed his net worth.
Fifth, trust begins bilaterally, but ultimately becomes multilateral. The over-the-counter market, which is largely unregulated, is essentially a market between professionals and comprise bilateral relationship between the bank and the investor. Everyone thought that the present system of collateral margin would be sufficient to cover the counterparty risks. Unfortunately, when the market is exceedingly large and complex, such as the CDS or CDO market, then failure of one counterparty or the weakness of one product can create huge contagion risks throughout the network.
When the relationship breaks down at the bilateral level, in a period of confusion and uncertainty, the whole network breaks down. This was what happened to the core of the wholesale banking network. We must have centralised clearing and settlement of these complex transactions so as to control the level of system leverage and the counterparty risks.
In other words, we cannot allow the breakdown of small trusts to create big chaos. Trust goes slowly up the stairs and crashes down the elevator.
Datuk Seri Panglima Andrew Sheng is adjunct professor at Universiti Malaya, Kuala Lumpur, and Tsinghua University, Beijing. He has served as adviser and chief economist to Bank Negara, deputy chief executive of the Hong Kong Monetary Authority and chairman of the Hong Kong Securities and Futures Commission