13 jan

Working, praying and sleeping, that’s what monks did, or were supposed to do according to the Rule of St Benedict. They spent eight hours on each of these things. No eating then? Of course not. I guess it was sometimes called working, sometimes praying and sometimes sleeping.
The division into three categories has the great benefit of simplification. I am working on a scheme for ‘my book’ in which I use the same division. There will be eight chapters about the current state of the finance industry, eight chapters about the twelfth century and eight chapters about my own way to Santiago. In a way I would like these three times eight chapters to be clustered into eight separate themes: the eight sins; greed, anger, jealousy, etc. It takes quite a bit of stretching and molding at the same time, but it has kept my mind busy, not to say frantic in the past week.
I spent today in the stimulating company of Adair Turner, the former UK McKinsey director who headed the FSA in the years I was in London. I interviewed him once, which was one of the most stimulating experiences of my time there. He coined the phrase ‘social useless innovation’, which I still think is a very crucial description of what went wrong in the financial industry.
It is not easy to grab though. In theory one could say that anything that someone wants to pay for has value. With regulation a government can influence the price of a product, and by doing that, it influences the ‘value’ towards society of a certain product. A regulator can also straight out forbid some products, like it is doing with illegal drugs.
Financial regulation before the crisis had become lax. The Greenspan-doctrine was that one should focus on inflation. If there was a problem somewhere, one should isolate it, analyze it and fix it, preferably combined with lower interest rates to smoothen the pain.
It worked well as long as it worked. When it stopped working it caused catastrophe.
Back to Turner. In the beginning of the last decennium banks became engines of growth, not the dull transmission machines that they had been in the past. The banking engine worked on oil which was called ‘financial innovation’. Derivatives were invented. Financial instruments that ‘derive’ their value from a different financial asset. Like options derive their value from the underlying stock. Beautiful things, they are, derivatives. They are a real innovation. They make it possible for companies to protect themselves against all kind of unexpected things, like changes in interest rates, bad weather, currency valuation changes and what more.
The derivatives that caused most damage in the financial crisis were mortgage backed securities. Again, beautiful products in which the risk of default of a group of combined mortgages are categorized, bundled and sold through.
Socially valuable too, because it is a way to access available money (and risk) to different customers (and investors).
So far so good. This is part of the work i did when working a Commercial Federal, a small bank in Omaha, in the beginning of the nineties.
It went wrong because the demand for the higher risk parts of these mortgage backed securities became so valuable that there was a stimulus to sell mortgages to people who could hardly (and gradually plainly not) afford them.
It became a disaster when these derivatives where used as the basis for some new financial products. The relation to reality had become completely blurred. But it was still possible to sell these products, to generate fees and to generate profits. The social usefulness of these profits, was questionable and pretty soon proved to be disastrous.
What Turner really was saying is that the crisis was caused by lax regulation. To blame bankers for the fact that they follow the rules, and focus on making profits, is neglecting the fact that the rules should have prevented social useless activities in the first place.
Following this thought, not the bankers should be blamed for the crisis, but the regulators. The regulators are part of the government, and the government is us, in a represented form. We chose the governments that chose the regulators.That’s why we are ourselves to blame for the financial crisis. And that’s why we, as taxpayers, have paid up for it.
It is exactly as it should be, following Turner’s logic. Change the regulators and change the regulations. That’s what has been done and should have been done. If it is enough. Most certainly not, but the again, the changes are probably good enough for a generation or two.