We often hear that those who do not learn from history are doomed to repeat it. Does anybody in the audience contest those words of wisdom?
Why do you think I hear from many former colleagues and other Wall Street insiders that we are very likely going to experience another economic crisis—or perhaps merely a prolonging of our current crisis—and accompanying significant market decline?
My ‘sense on cents’ indicates to me that we will have more economic and market turmoil for the very simple reason that our financial titans, our political leaders, and our nation as a whole have not embraced nor learned from the lessons of the past.
I do not believe this ‘financial amnesia’ is an involuntary development but very much a result of misguided and misdirected plans and policies which have benefited a small minority at the expense of our nation as a whole.
What are the lessons we have failed to learn? In what reads like a Sense on Cents encyclical, these lessons were recently highlighted by the CFA Society of the UK.
Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are:
Lesson 1: “Innovation”, the illusion of safety and “this time it’s different”: “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version” (Galbraith).The expansion of credit plays a key role in fuelling “innovation” while the creation of an illusion of safety results in a “this time it’s different” approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.
Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.
Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure.
The drive to introduce a new framework via the Financial Services Bill is another example of a failure to address root causes by focussing solely on symptoms.
Effective regulation involves the design of policies, rules and laws that are effectively monitored and supported by the credible threat of enforcement. The new framework is focused on new architecture rather than making the existing one work more effectively. The tripartite system failed because insufficient emphasis was placed on supervision and enforcement. In our opinion, the risks of regulatory failure have not been reduced.
CFA UK believes that effective regulation is essential for the laws of demand and supply to function appropriately. History has demonstrated that market discipline cannot be reliably imposed by all regulated financial firms. The high risk of market failure makes the regulator the last line of defence for maintaining market integrity and thereby trust and confidence.
Sadly, the evidence demonstrates that the regulator is also prone to failure. CFA UK calls upon regulators to learn from financial and corporate history and to make material changes in their regulatory approach to deliver the following outcomes:
1) Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.
2) Enhance financial capability so that consumers become a more robust source of market discipline on firms.
3) Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets. Rather than facing a binary choice of market mechanism or command and control, the philosophy should embrace asymmetric paternalism. This would create an environment of market command with robust control mechanisms and make it possible for firms to fail without endangering the system or imposing major costs on the rest of society.
Just like regulated firms, senior regulators should also be held to account. However, along with the senior managers at financial firms that had engaged in inappropriate activity, very few senior regulators have been held to account following the crisis.
As La Porta et al2 suggest “these laws and the quality of their enforcement by regulators and courts are essential elements of corporate governance and finance… in contrast, when the legal system does not protect outside investors, corporate governance and external finance do not work well.”
On occasion it may be more beneficial to enforce existing laws and regulations than devise new policies, or as La Porta et al state: “the strategy for reform is not to create an ideal set of rules and then see how well they can be enforced, but rather to enact the rules that can be enforced within the existing structure.”
By improving the quality of the regulatory environment, the level of trust and confidence can be raised. The onus will be on each generation of regulators to learn from the mistakes of their predecessors.
By fulfilling the essential role they play in enhancing the quality of market integrity, regulators will be able to further strengthen the UK’s position as a leading global financial centre.
While this commentary is written in regard to developments in the UK, who would question that the very same piece could and should be written in regard to the United States. Who has confidence that Dodd-Frank will be effective in creating the framework necessary for a healthy financial regulatory system? Not me.
What are we missing? Why do my many former colleagues and current friends believe we are doomed to repeat the past?
Our lack of real political will. Our lack of meaningful corporate integrity. A populace which is easily led astray and hoodwinked by those on Wall Street and in Washington who harbor and protect information for their own self-benefit.
To give credit where it is due, the Financial Times highlighted the CFA Society’s work this morning in writing Financial History Lessons Urged to Help Prevent Future Bubbles.
For the overachievers in the crowd who would like to read the entire CFA piece, I am happy to link to the CFA Society of the UK’s Response to the Joint Committee on the Draft Financial Services Bill.
Navigate accordingly with the full knowledge that those who fail to learn from history are most definitely doomed to repeat it.