Posted by: gautithor | 10. February, 2009

Unpreventable crisis?

It is interesting to read this story about the executive warning of excess risk in the UK banking industry. In short, he was fired and gagged.

Professor Lo discussed this in class last fall (and in his testimony for the House oversight committee, see here) and pointed out that even if you were working in one of these banks and you saw what was happening, you could not have stopped it:

Lo said: 

Consider, for example, the case of a Chief Risk Officer (CRO) of a major investment bank XYZ, a firm actively engaged in issuing and trading collateralized debt obligations (CDO’s) in 2004.  Suppose this CRO was convinced that U.S. residential real estate was a bubble that was about to burst, and based on a simple scenario analysis, realized there would be devastating consequences for his firm.  What possible actions could he have taken to protect his shareholders?  He might ask the firm to exit the CDO business, to which his superiors would respond that the CDO business was one of the most profitable over the past decade with considerable growth potential, other competitors are getting into the business, not leaving, and the historical data suggest that real-estate values are unlikely to fall by more than 1 or 2 percent per year, so why should XYZ consider exiting and giving up its precious market share?  Unable to convince senior management of the likelihood of a real-estate downturn, the CRO suggests a compromise— reduce the firm’s CDO exposure by half.  Senior management’s likely response would be that such a reduction in XYZ’s CDO business will decrease the group’s profits by half, causing the most talented members of the group to leave the firm, either to join XYZ’s competitors or to start their own hedge fund.  Given the cost of assembling and training these professionals, and the fact that they have generated sizable profits over the recent past, scaling down their business is also difficult to justify.  Finally, suppose the CRO takes matters into his own hands and implements a hedging strategy using OTC derivatives to bet against the CDO market.4  From 2004 to 2006, such a hedging strategy would likely have yielded significant losses, and the reduction in XYZ’s earnings due to this hedge, coupled with the strong performance of the CDO business for XYZ and its competitors, would be sufficient grounds for dismissing the CRO. 

In this simple thought experiment, all parties are acting in good faith and, from their individual perspectives, acting in the best interests of the shareholders.  Yet the most likely outcome is the current financial crisis.  This suggests that the ultimate origin of the crisis may be human behavior—the profit motive, the intoxicating and anesthetic effects of success, and the panic sell-off that inevitably brings that success to an end. 


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