On the 5th anniversary of the great meltdown of 2008, it’s not a bad time to re-read a 2012 article by Noël Amenc (Professor of Finance, EDHEC Business School and Director, EDHEC-Risk Institute), wherein he made the interesting argument that hedge funds, speculators, et al. really were not to blame for the financial crisis of 2008.

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In his view, the regulators and politicians both set up and exacerbated the recession by (a) not understanding how financial markets work and (b) not allowing even more derivative evolution/activity in response to market risk.

As Amenc notes:

Ultimately, the error in diagnosis of the causes of the degradation of the subprime market, and the financial markets globally, led to a failure to take the measure of the importance of the crisis and inability to implement, when it was still possible, the firewall required to avoid the financial debacle of the end of 2008. The regulators and decision-makers organised the crisis of 2008. Firstly, by stigmatising the role of speculation instead of understanding that it was the whole of the risk management system at financial institutions that was to blame. Secondly, by focusing on the leverage effect at hedge funds instead of the lack of genuine integration of the leverage effect of banks by the Value at Risk. Thirdly, by preferring to look at the increase in the volume of transactions relating to hedge funds on the financial markets rather than the major risk represented by the failure of the strategy to diminish systemic risk. The latter occurred through the dissemination of risks, notably through securitisation, which instead of reducing risk increased it by setting up structured products based on low-cost debt.

It was the banks, he notes earlier, supposedly constrained by leverage ratios and Basel 2 regulations, and not the hedge funds who had the problem:

The problem was that banks, not hedge funds, had been affected by excessive investment in asset-backed securities and in structured credit products that turned out to be illiquid and those banks thus appeared insolvent to their counterparties in the money market. So it was the most heavily regulated institutions in the world–institutions whose new capital rules (Basel 2) had been presented three years previously as the result of reflection on the lessons learned from the financial crises of the previous two decades, especially with respect to credit risk—that required the intervention of central banks on a massive scale. It was, in any case, hard to imagine central banks coming to the rescue of “speculators” and running the risk of increased moral hazard.

To say that Amenc’s position would strike the average reader as contrarian is a serious understatement, yet there is a lot of merit in his argument, even if some of his positions seem over-simplifications. First of all, what he gets right: no financial instrument, (CDO, swap, etc) in and of itself destroyed anything. There were human begins behind every trade where risk was assumed intelligently or ignorantly. To blame an individual market or product is asinine, and it would be like blaming Pearl Harbor on a Japanese airplane. The failure was not in regulating instruments or markets but in regulating the people who work in them. Think of it this way: on any given day, millions of cars, two-ton missiles hurtling through space at high speed with the power to kill many,  take to the road, and yet it is rare to see one used deliberately to kill. We have managed to create a social and regulatory framework of privileges and penalties that allows dangerous instruments to be used safely by millions every day.  We have not done that in financial markets. As Amenc further notes:

In fact, the euro zone crisis is not the result of financial speculation, but rather the result of concurrent design, management and communication errors. It is the result of a design error because, in forbidding monetary parity adjustments between countries that do not have the same factors of competitiveness, the euro zone provides troubled countries with no hope of economic recovery, thus forcing their leaders to impose budgetary restraint, which solves nothing in the long-term. It is the result of a management error because the European Central Bank (ECB) is being made to play a very different role to that specified in the treaties, and as it is being transformed into a constant lender of last resort, the ECB is losing all credibility in its ability to prevent sovereign and financial debt crises. Its capacity to stabilise prices in the long-term is also brought into question. Finally, the crisis is the result of a communication error because, by linking the fate of the euro to that of its debtors, European leaders are implying a degree of financial solidarity that does not and cannot exist, due to a lack of common economic and fiscal governance.

What is needed to prevent another crisis, and has been completely absent from the reactions since 2008, is a new way of constraining not markets or instruments but the people who use them and the regulators who define the rules by which they operate, who often react not to future risks but to past events. In this Amec is wholly correct to attack silly ideas like a transaction tax or ill-conceived transaction barriers:

There is a substantial body of empirical work studying the effect of a financial transaction, or Tobin, tax, on the volatility of the prices of financial securities. Most of these studies find that a transaction tax either fails to reduce return volatility or leads to an increase in volatility. Moreover, the imposition of a transaction tax leads to a reduction in the demand for that financial security, and thus, a drop in its price. This drawback could go against the wishes of euro zone leaders to facilitate the distribution of their debt in stable conditions and to decrease the cost of debt for the zone’s most fragile economies.

Where Amec is wrong, I think, is where he seems to suggest that things were fine the way they were, except for those stupid politicians and regulators, and that the only thing we need are to increase the cushions bank keep around for rainy days:

Prudential regulations must impose the use of truly loss-absorbing buffers, i.e., regulators must oblige institutions to develop internal policies to hold some buffers above the strict regulatory minimum, to a level aligned with their own assessment of the degree of stress they are facing: high during periods of above-average profitability, medium when business is as usual, and low when a crisis occurs. Naturally, a low buffer—available capital close to the regulatory minimum—requires the institution to have a recovery plan that allows it to restore its buffer over the medium term.

This is wishful thinking at best, since it either ignores the irresponsible and/or fraudulent behavior of many financial sector actors in the latest crisis.  Bigger cushions are a good idea, but they do not address the cause of the 20008 crisis, just some of its effects.  And while Amec has a good point to make about political and regulatory failures post-crisis, his argument would be stronger if he would be equally serious in his attacks of the incompetent and often criminal aspects of the system he eloquently defends.

That said, his paper is worth a thorough read by anyone interested in looking beyond the political headlines and cursory analyses. Surprisingly for such a devastating event, the crisis of 2008 has spawned insufficient thinking about what really went wrong and how to fix it. This paper’s positions deserve to be taken seriously, because from what I can tell another financial crisis is simply a matter of when and not it.

Read more:

http://www.edhec-risk.com/latest_news/featured_analysis/RISKArticle.2012-05-22.1143

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Posted by Carlos Alvarenga

Carlos Alvarenga is the Executive Director of World 50 ThinkLabs and an Adjunct Professor at the University of Maryland's Smith School of Business.

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