Report from the bunker

Some disclosure: my real-world avatar is a boring banking lawyer deeply embedded in the belly of the beast.  I can therefore confidently explain what has happened to make all the major financial institutions of the world look like a fleet of Titantics ploughing dead ahead into various icebergs. 

While it may be true, as everyone seems to have concluded, that most bankers are indeed minions of beelzebub, Satan alone should not be blamed for the current mess. Unless we want to make greed a capital offence it's pretty pointless to get all uppity about avaricious bankers. After all, we were the ones who gave them the rope to hang us all with. 

It is important to keep in mind that in the parlance of our times, thanks to Reagan revolution, it has been long accepted conventional wisdom that all government is bad, and regulators are particularly bad, which I think often explained the quality of regulators I myself have come into contact with. This is not always true: some have been astute and very good – but for a long time they have been radically underpaid and maligned to the point of irrelevance. 

So why should anyone be surprised when the end result is massive and comprehensive regulatory failure? 

The financial system, though complex, can work if risks are correctly assessed. The problem is that under conditions of large liquidity, which we had when credit was cheap, the quest for “returns” encourages excessive risk taking and exposes the system’s vulnerabilities: 

Market participants that work for fees (mortgage brokers, payments receivers) don’t have incentives to monitor the quality of loans, only to increase the quantity of loans. 


The same thing happens with the credit rating agencies which supply “ratings” for the structured products and do not face any financial responsibility to cover losses from their mistakes. 


Regulatory Arbitrage: different financial institutions undertaking similar activities face different regulations (especially capital requirements). 


Principal-Agent Problem: huge disparity in traders’ maximum loss (zero bonus) vs. investors’ losses (the full capital invested). 

The job of regulators is to ensure these risks are correctly assessed and, where they aren't, the financial system is protected. 

Guess that hasn't happened.