Germany's President Horst Koehler has described the world’s banking system as “a monster that must be tamed”. This is not political hand wringing that politicians so often do after the event. Koehler knows what he is talking about because he is himself a former banker. In an interview yesterday, he condemned in no uncertain terms the failure of a large part of the international banking system for taking on highly risky investments without making adequate provision in their balance sheets for their going sour. We thus now see the procession of some of the greatest names in world banking, going cap in hand to their shareholders, to raise huge amounts of fresh capital to try and plug gaping holes in their accounts, thanks to speculation in high risk assets, including US subprime mortgage-backed securities.
Germany’s president has called for far-reaching structural reforms in the finance industry to ensure that this latest banking debacle does not occur again. However, the problem extends far beyond properly monitored and enforced rules in key areas like capital adequacy. There is a moral issue here, underpinned by the idea that profits can be conjured from nowhere by cleverly structured deals, dreamed up by an elite of investment bankers who individually were often paid millions of dollars a year in salary and bonuses.
The emergence of widespread asset securitization some 30 years ago lies at the heart of the problem. At its simplest, it seemed a good idea for a bank that had lent money, to then sell that loan to other investors, at a slight discount. It had earned its arrangement fees and it now had the original capital back to be lent again. Tension emerged, however, as a growing body of institutional investors, mainly pension funds but also more speculative entities like hedge funds, demanded ever more investment product. Old-fashioned prudential banking of the kind the German president knew when he was a savings banker, flew out the window as investment bankers scrambled to conjure up new securities backed by ever more complex, variegated and inevitably dubious securities. And what has been so significant about this financial disaster is that many banks started buying these products from each other. Although banks have failed in the past and caused panic, this time a large proportion of the banking system has been prepared to assume almost criminal levels of risk and in doing so has abandoned the basic banking principle that liabilities must always be matched by adequate provisions.
The prevalent delusion that the financial world could itself speculate in junk investments was what allowed super-high-earning investment bankers to style themselves as “masters of the universe.” A few of these individuals are being fired to live on their assembled millions. Most top bankers are staying on. They should reflect with shame that their greed and stupidity have plunged ordinary hard-working families worldwide into financial distress.
