The Forum was on ‘Financial Amnesia’ If the financial market forgets lessons from history, is effective regulation possible?
We asked: What are the causes and characteristics of Financial Amnesia? How do we identify the best way forward? Have any of the lessons been learned, and how are new Government measures going to produce different results?
Focusing on the recent Financial Amnesia Report by the Chartered Financial Analysts Society of the UK , (CFA UK
“Financial amnesia is when financial market participants forget (or behave as if they have forgotten) the lessons from financial history. Financial amnesia disarms individuals, the market and the regulator”
Sheetal gave an engaging presentation that was ideally pitched for the mixed audience of Parliamentarians, entrepreneurs and business owners, academics and finance professionals.
Sheetal identified the three key lessons that participants appear to forget:
Lesson 1: Innovation; the illusion of safety and ‘this time its different’
Innovation is usually a variation of a theme - “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 the continuation of unsustainable activity and risk taking. For example the ‘end of boom and bust’ was a fallacy. Sadly, it is never different.
Lesson 2: Regulated financial firms are prone to failure
Financial services firms, by acting in their own self-interest and in the interests of their shareholders, are supposed to impose market discipline. History demonstrates they commonly fail to act as expected either because of poor information, poor governance or flawed incentives. The financial sector is supposed to be the ‘brain of the economy’ but needs robust internal governance otherwise these firms are able to impose market discipline effectively and not trigger the moral hazard on the rest of society As even Alan Greenspan recently admitted, the market doesn’t know best!
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. The inability of regulators to supervise and enforce effectively contributes to crisis.
Why do regulators fail? In essence they fail to supervise and monitor the regulations in place to ensure financial firms are behaving appropriately. In regulators also have structural and behavioural barriers that prevent them from being effective.
Much of the cause is human behaviour, as our behavioural traits create a spiral of activity when people follow the herd. It’s also due to cognitive dissonance, the way we see the world - our innate reluctance to change our point of view and keenness to maintain the status quo.
He explained how crises have happened throughout history, although the one in 1929 was pivotal Following the 1929 crash, authorities realised the dangers of unfettered capitalism. However, by the 1970s and 1980s as the painful memories of this event faded, many of these effective regulations imposed following the 1929 crash were repealed; hence contributing in part to the most recent crisis.
Sheetal believes that capitalism didn’t fail but our and other nations’ system of governance did; the laws of demand and supply cannot work properly without an effective rule of law. We need to create an ‘institutional memory’ so we don’t forget the pain of this crisis. We must collectively avoid the ‘its different this time’ attitude – its not!
He asked why after a crisis Government always plans to create a new framework and set of rules. In fact, its vital to get better at enforcing the existing rules as well as create greater independence for regulators. Part of this must be improved internal governance.
Sheetal suggests we ‘create an environment where we have market command with effective control mechanisms’. He said ‘financial amnesia is an embarrassment to our profession’. Sheetal’s solutions are:
Solution 1: Educate investment professionals to maintain and apply their financial memory
Solution 2: Consider the development of an ‘index’ to monitor credit growth and financial innovation
Solution 3: Encourage Boards of financial institutions to undertake an annual amnesia check
Solution 4: Encourage the regulator to:
emphasize supervision rather than regulation;
establish and operate supervisory processes that mitigate adverse behaviours;
aim for informed independence from market influence.
Dr John Potter then chaired wide-ranging debate with excellent contributions from Lord Erroll, Chairman of the APPGE, and Dinah Bennett OBE as well as the other senior participants.
John asked whether there was still ‘good’ debt and ‘bad’ debt, which Sheetal felt was a case of ‘good’ lenders and ‘bad’ lenders. It was pointed out not all lenders fell into the trap of lending to those unlikely to repay, but this was based on brave decisions – going against market behaviour, the group-think of the time.
Merlin Erroll commented that after 1929, risky and safe investment was separated, but the Act was later repealed. There are calls today for this to occur again by splitting up retail and investment banks. Perhaps if this had been the case, the riskier investment banks would simply have been allowed to fail?
John Potter summed up our discussion. Everyone had gained far greater understanding of how the financial framework should operate and the practical and achievable steps that Government could – should- take.
It was agreed we should urge policy makers that there are solutions to limit the impact of future crises, we need to ensure this is a collective issue not one just for the financial sector and Government. We need a thorough post mortem.
It was agreed we should urge policy makers that there are solutions to limit the impact of future crises, we need to ensure this is a collective issue not one just for the financial sector and Government. We need a thorough post mortem.
