Big finance has failed and its rottenness has not yet been purged
ECONOMICS:EXACTLY FIVE years ago, the developed world’s financial system began to fail. Its wide-ranging failure went on to cause the worst recession in living memory. Despite this, far too little has changed in finance.
The failings, the rottenness and the fragilities of the system have been underscored yet again in recent days: by the massive additional losses revealed in Quinn Insurance; by the charging of Standard Chartered Bank with breaches of an international sanctions regime designed to prevent the proliferation of nuclear weapons; and by the $440 million losses Knight Capital incurred when its computers went haywire.
As the administrators of Quinn Insurance (very, very slowly) peel the onion of that institution, each layer appears more rotten than the last. Their latest worst-case estimate for losses is €1,650 million. That is equivalent to more than 1 per cent of Ireland’s annual gross domestic product, or similar to the bailout received by US insurer AIG in 2008 (as a percentage of US GDP).
The difference is that AIG was one of the largest insurers in the world. Quinn Insurance was a small, humdrum firm operating in just two markets. That such a firm could run up losses of this magnitude beggars belief.
Was management grossly incompetent, or worse? What sort of actuarial calculations were premiums based on? How did the regulator not spot that Quinn’s undercutting of the competition could not have been based on a sustainable business model?
If it took a newly appointed regulator (Matthew Elderfield in early 2010) just weeks to see that the company had to be placed in administration, what was his predecessor doing before he came on board?
Just as Seán Quinn likes to portray himself as an all-round decent skin, Standard Chartered Bank has long trumpeted its virtuousness. Among its peer group of global investment banks, it was least affected by the international financial crisis because it stuck to providing services to clients and eschewed its rivals’ casino-type products and practices. But if proved guilty of charges made against it this week while serving those clients, it has been anything but virtuous.
One of the US’s many dozens of financial services regulators has accused the bank of a staggering 60,000 breaches of the Iran sanctions regime, with the value of these transactions reaching $250 billion. The bank responded by saying 99.9 per cent of these transactions were sanctions-compliant. If it is proven that Standard Chartered undermined efforts to prevent an unstable theocratic state acquiring a nuclear weapons capability on even 0.1 per cent of the 60,000 alleged instances, then the withdrawal of its banking licence – as the US regulatory agency is seeking – is entirely proportionate.
If the Quinn and Standard Chartered cases show how incentive structures facing individuals and institutions in the industry favour excessive risk-taking, the Knight case demonstrates how finance is so out control that it cannot control itself.
The financial services industry has exploited greater computing power to conduct automated, high speed and high-frequency trading. It uses computers to identify tiny price differentials and then have the same computers buy securities in massive quantities in very short periods of time. A lot of money can be made. A lot of money can be lost too – and very quickly.
Knight’s computers malfunctioned last week and went on an uncontrolled buying spree, acquiring $7 billion worth of stocks over a 45-minute period. Apart from running the firm into the ground, this destabilised the entire market. This case is not a one-off – in 2010, the New York exchange suffered a “flash crash” owing to computers running amok. If – or perhaps when – such a glitch occurs in a systemically important institution, there could well be another Lehman moment.
Finance is inherently unstable. The last thing anyone needs is for its wheels to whirr faster. Throwing lots of sand in those wheels to slow them down is exactly what is needed, by, for instance, slapping transactions taxes on trades. But such taxes are still some way off and many governments, including the Irish Government, oppose them.
All of this comes on top of other developments in recent weeks which add yet more evidence to the case against the financial services industry. These include a decision (finally) that those who blew up Anglo Irish are to face criminal charges, Barclays’ rigging of Libor and the fining of HSBC for laundering the money of Mexican drug cartels which are tearing that country apart.
The financial services industry is too big, too complex, too fragile and too arrogant. As it is currently structured, it is a serious threat to economic prosperity and stability. How to make it smaller, simpler, stronger and humbler is among the greatest public policy challenges of the 21st century.