Clearing The Bull on the Financial Crisis – Part II

This is the second in a three-part series of articles on the financial crisis. Part I can be found at this link.

The Real Reason for the Subprime Crisis and Bank Failures

The subprime crisis was not really about management, risks, controls and regulations—these were all after the fact. The crisis was a direct result of human failings which stemmed from a poor system of values. In order to understand this we have to look at and examine the crisis within the context of the industry’s human ecosystem. The following analysis does precisely that.

Mission and Values – Poor strategic thinking including an obsession with organizational size as a barometer of success led to unwieldy, unfocused, and unstable organizations.

Individual Employees – Perverse incentives for traders and salespersons meant that they prioritized profits and bonuses over longer-term business sustainability.

Employees – Poor integration of employees in risk and control functions plus rigid governance structures was inadequate for managing such complex and dynamic environments.

Management – Big egos and megalomania driven strategies backfired. Management also placed too much faith in complex mathematical models and this too proved fatal.

Organization, IT, and Systems – An overly complex product and operating environment diminished the effectiveness of employees which in turn diminished the effectiveness of governance and controls. The absence of a values-based approach to managing risk.

Managing The External EnvironmentBecause missions and values were poorly defined, as with previous crises e.g. junk bonds, banks were easily seduced by the echo chamber of the prevailing financial orthodoxy.

SuppliersThe entire supplier value chain, from unlicensed brokers to small banks and rating agencies, was corrupted by a combination of greed and perverse incentives.

Customers – The industry failed to act in the best interest of its customers. Retail customers were sold fraudulent mortgages and were later foreclosed on those mortgages. Wholesale customers suffered tremendous losses from investing in poor quality securitized loans.

The Community – CSR programs were inconsistent with the recklessness with which banks pursued their strategies and the fallout from that recklessness continues to threaten the sustainability of the industry.

It is fair to say that organizations failed to recognize that values are more important than valuations. The mathematical models used to value securitized subprime loans were inadequate because the supplier “value” chain—unlicensed brokers, small banks and rating agencies—all failed the smell test. Just as there are certain things that you cannot shine, there is no mathematical model advanced enough to turn ninja loans into worthwhile investments.

Plato put it another way: “a good decision is based on knowledge and not on numbers”.

The problem with the current prescriptions for the subprime crisis is that they have given priority to product, risk and financial analysis over the human behaviors and values that gave rise to product, risk and financial outcomes of the subprime crisis.

This brings us to a very important observation. Where values are absent then failure is always just around the corner. This is why we have periodic financial crises. Predatory lending and subprime mortgages were just the latest in a long line of “crisis opportunities”—as were LDC debt and junk bonds in their day.

Thus by implication we can begin to make the connection between values and controls—the former are and will always be more important in reducing business risk.

This brings us full circle to the idea that piling more legislation, more regulations, more governance and more controls—in order to manage the fallout from a particular crisis—cannot be the long term answer. Such a response is reactionary as it only treats the product-driven symptoms of that particular crisis, while leaving the door open to another crisis stemming from the use or misuse of another product.

Thus, in order to create an economically and competitively sustainable banking industry we must treat the underlying cause of the problems and not the product symptoms. This means taking the analysis of the human ecosystem above and changing the changing values in every part of it.

A human problem demands a human solution. Without understanding this all we are doing now is waiting for the next crisis.

In Part III we will see how we can use this analysis of the human ecosystem to create a more economically and competitively sustainable banking industry. In the interim you can share your opinion on banks, values and the financial crisis by doing the Clearing The Bull survey using this link.


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