On May 3, 2013, at the Toronto Board of Trade in the heart of Canada's financial district, Convivium Editor-in-Chief Father Raymond J. de Souza joined Mark Carney, Governor of the Bank of Canada, and Roger Martin, dean of the University of Toronto's Rotman School of Management, for a Convivium forum on the fundamental threats that still beset global capitalism almost five years after the 2008 financial crisis. Each man app roached the issue from his speciality: theology, trust, and education. In the end, all agreed that renewal will rely much more on the transformation of hearts than the imposition of new rules and regulations. Their remarks are printed below.
Six years ago, the collapse of the global financial system triggered the worst global recession since the Great Depression.
Losing savings, jobs and houses has been devastating for many. Something else was lost—trust in major banking systems. This deepened the cost of the crisis and is restraining the pace of the recovery.
The real economy relies on the financial system. And the financial system depends on trust. Indeed, trust is embedded in the language of finance. The word credit is derived from the Latin, credere, which means "to have trust in." Too few banks outside of Canada can claim credit today. Bonds of trust between banks and their depositors, clients, investors and regulators have been shaken by the mismanagement of banks and, on occasion, the malfeasance of their employees.
Over the past year, questions of competence have been supplanted by questions of conduct. Several major foreign banks and their employees have been charged with criminal activity, including the manipulation of financial benchmarks, such as LIBOR, money laundering, unlawful foreclosure and the unauthorized use of client funds. These abuses have raised fundamental doubts about the core values of financial institutions.
The G20's comprehensive financial reforms will go a long way but will not be sufficient. Virtue cannot be regulated. Even the strongest supervision cannot guarantee good conduct. Essential will be the rediscovery of core values, and ultimately this is a question of individual responsibility.
Trust is strained at multiple levels.
Between banks and their shareholders: Most major banks outside Canada are now trading well below their book value, indicating shareholder concerns about a combination of the quality of bank assets and the value of their franchises.
Between banks and their debt holders: Bank credit ratings have been downgraded, and even the revised ratings reflect continued reliance on sovereign backstops.
Between banks and their supervisors: For too many institutions, concerns over competence, conduct and, ultimately, culture have fed supervisory concerns and built the political case for structural measures such as ring-fencing or prohibiting certain activities such as proprietary trading.
Between supervisors in advanced economies: Fearful that support from parent banks cannot be counted upon in times of global stress, some supervisors are moving to ensure that subsidiaries in their jurisdictions are resilient on a stand-alone basis. Measures to [isolate and protect] the capital and liquidity of local entities are being proposed. Left unchecked, these trends could substantially decrease the efficiency of the global financial system. In addition, a more balkanized system that concentrates risk within national borders would reduce systemic resilience globally.
Between emerging and advanced economies: Given that the crisis originated in the advanced economies, the incentives for emerging and developing economies to [isolate and protect] their financial systems are particularly pronounced. This has been, at times, supplemented by more active management of capital inflows, further fragmenting the global system.
Finally, and most fundamentally, there has been a significant loss of trust by the general public in the financial system. There is a growing suspicion of the benefits of financial deregulation and cross-border financial liberalization, a suspicion that could ultimately undermine support for free trade and open markets more generally. The costs are potentially enormous. A global system that is nationally fragmented will lead to less efficient intermediation of savings and a deep misallocation of capital. It could reverse the process of global economic integration that has supported growth and widespread poverty reduction over the last two decades.
Within economies, the hesitancy of firms to invest reflects, in part, low confidence that banks will be there to provide credit through the cycle.
Reduced trust in the financial system has increased the cost and lowered the availability of capital for non-financial firms. The massive response of central banks has provided some offset, but access to credit remains strained.
The G20's comprehensive financial reforms will go a long way to rebuild trust. The good news is that there has been progress, even if it is not yet fully reflected in market valuations or public attitudes. So what to do? A combination of institutional and individual initiatives—the "Five Cs"—is required.
Many people remember the pivotal moment when Lehman Brothers collapsed, but that was only one example of a widespread failure of banking models across the advanced economies.
That same year, major banks in the United States, the United Kingdom, Germany, France, Ireland, Switzerland, the Netherlands and Belgium either failed or were rescued by the State. Gallingly, on the eve of their collapse, every bank boasted of capital levels well in excess of the standards of the time.
So it should be no surprise when building a more resilient system [that] the first priority was to strengthen the bank capital regime. Through higher minimums, surcharges for systemically important banks, counter-cyclical buffers and tougher definitions of capital, the largest banks will have to hold at least seven times as much capital as before the crisis.
Canadian banks are setting the pace. Since withstanding the financial crisis, they have become considerably stronger. Their common equity capital has increased by 81 per cent, or $77 billion, and they already meet the new Basel III capital requirements six full years ahead of schedule.
Greater clarity, the second "C," is critical to wellfunctioning capital markets.
In the run-up to the crisis, financial institutions became increasingly opaque. Their balance sheets were stuffed with mark-to-model assets, massive undisclosed contingent exposures, and debt classified as regulatory capital. Annual reports ran over 400 pages in some cases, leaving investors exhausted but no better informed. One of the most important initiatives to improve clarity is the work of a private sector group, the Enhanced Disclosure Task Force, which was formed at the encouragement of the Financial Stability Board. It has made a series of recommendations to improve annual financial reporting by banks based on seven principles. Disclosures should be clear, comprehensive, relevant, consistent, comparable, and timely. Finally, annual reports should explain how risk is actually managed.
Once adopted, enhanced disclosure will contribute to effective market discipline, better access to funding and, importantly, improved market confidence in banks.
Perhaps the most fatal blow to public trust has been the perception of a heads-I-win-tails-you-lose finance. Bankers made enormous sums in the run-up to the crisis and were often well compensated after it hit. In turn, taxpayers picked up the tab for their failures. Thus, at the heart of financial reform must be measures that restore capitalism to the capitalists.
To that end, the Financial Stability Board (FSB) is enhancing the role of the market. The measures to improve clarity will enhance market discipline.
The development of effective resolution tools will also help diminish the moral hazard associated with "too big to fail." The FSB has identified those banks that are systemically important at the global level and developed a range of measures that, once implemented, will help to ensure that any financial institution can be resolved without severe disruption to the financial system and without exposing the taxpayer to the risk of loss.
The knowledge that this could happen should enhance market discipline of private creditors who previously enjoyed a free ride at the expense of taxpayers.
While solid progress has been made, it is not yet mission accomplished. In the coming months, jurisdictions need to articulate comprehensive plans to resolve each systemic institution. These should include effective cross-border agreements for handling a failure and a minimum amount of "bail-inable" liabilities and the publication of a presumptive path for resolution.
To take stock, the FSB will report to the G20 leaders at the St. Petersburg Summit on the extent to which "too big to fail" has been ended and, if not, what further steps are required.
Connecting with clients
Financial capitalism is not an end in itself but a means to promote investment, innovation, growth and prosperity. Banking is fundamentally about intermediation—connecting borrowers and savers in the real economy. Yet too many in finance saw it as the apex of economic activity.
In the run-up to the crisis, banking became more about banks connecting with other banks. Clients were replaced by counter-parties, and banking was increasingly transactional rather than relational.
These attitudes developed over years as new markets and instruments were created. The initial motivation was to meet the credit and hedging needs of clients in support of their business activities. However, over time, many of these innovations morphed into ways to amplify bets on financial outcomes.
An important example of a useful, but eventually misused, innovation is securitisation, which initially provided funding diversification for banks while spreading risk among investors with different loadbearing capacities.
However, in the run-up to the crisis, highly complex chains developed linking low-risk money market funds with high-risk structured investment vehicles (SIVs). Banks sold mortgages into the SIVs and many of the SIVs in turn wrote credit insurance contracts, often to the very banks that sponsored them, to "insure" the bank's proprietary credit positions.
These links with banks were simultaneously too weak and too strong. The shift of credit exposure from originating bank to the SIV eroded underwriting and monitoring standards. The further you separate borrower and creditor, the more you create anonymity of finance.
Similarly, the rapid expansion of banks into overthe- counter derivatives was initially motivated by the desire to provide hedges to their clients as end-users. These transactions eventually morphed into a mountain of intra-financial system claims, largely divorced from end-users, with banks and other financial entities trading among themselves.
As intra-financial sector claims grew, banks became increasingly detached from their ultimate clients in the real economy. In most professions, people see the "real" impact of their work: teachers witness the growth of their students; farmers, that of their crops. When bankers become disconnected from their ultimate clients in the real economy, they have no direct view of the impact of their work. The LIBOR-setter sees only the numbers on the screen as a game to be won, ignoring the consequences of his or her actions on mortgage holders or corporate borrowers.
Fortunately, there are some signs that global banks are returning to their roots. Complex securitisation chains have dissolved. Mechanistic reliance on credit ratings is declining. With higher capital requirements on trading activities (and the prospect of structural restrictions), traditional lending is looking more attractive.
But there arguably has not yet been a full recognition of the need for banks to return to what [TD Bank CEO] Ed Clark calls "old fashioned banking—activities that help grow their country and communities." To do this, some banks may need to reconsider their values.
The fifth "C"—core values—is the responsibility of the financial sector and its leaders. Their behaviour during the crisis demonstrated that many were not being guided by sound core values.
Many in the wake of the crisis looked first to how compensation affects behaviour. Indeed, an important lesson was that compensation schemes that delivered large bonuses for short-term returns encouraged individuals to take on too much long-term and tail risk. In short, the present was overvalued and the future heavily discounted.
To better align incentives with long-term interests of the firm and, more broadly, society, the Financial Stability Board developed Principles and Standards for Sound Compensation Practices. Core elements include deferred variable performance payments, paying bonuses in stock rather than cash, and introducing bonus clawbacks.
Of course, no compensation package can fully align the incentives of a bank's shareholders and its risktakers. Even if such a package could be devised, it would not internalize the impact of individual actions on systemic risks, including on trust in the banking system.
More fundamentally, to think that compensation arrangements can ensure virtue is to miss the point entirely. Integrity cannot be legislated, and it certainly cannot be bought. It must come from within.
Purely financial compensation ignores the nonpecuniary rewards to employment, such as the satisfaction received from helping a client or colleague succeed. When bankers become detached from endusers, their only reward is money, which is generally insufficient to guide socially useful behaviour.
Few regulators and virtually no bankers saw these limitations. Beliefs in efficient, self-equilibrating markets fed a reliance on market incentives that entered the realm of faith. As [American political philosopher] Michael Sandel has observed, we moved from a market economy toward a market society.
This reductionist view of the human condition is a poor foundation for ethical financial institutions needed to support long-term prosperity.
To help rebuild that foundation, bankers, like all of us, need to avoid compartmentalization or what the former chair of HSBC, Stephen Green, calls "the besetting sin of human beings." When we compartmentalize, we divide our life into different realms, each with its own set of rules. Home is distinct from work; ethics from law.
In the extreme, as Ed Clark observed, "Bank leaders created cultures around a simple principle: if it's legal and others are doing it, we should do it too if it makes money. It didn't matter if it was the right thing to do for the customer, community or country."
To restore trust in banks and in the broader financial system, global financial institutions need to rediscover their values.
For companies, this responsibility begins with their boards and senior management. They need to define clearly the purpose of their organizations and promote a culture of ethical business throughout them.
But a top-down approach is insufficient. Employees need a sense of broader purpose, grounded in strong connections to their clients and their communities. To move to a world that once again values the future, bankers need to see themselves as custodians of their institutions, improving them before passing them along to their successors.
It has been said "trust arrives on foot, but leaves in a Ferrari." After the Ferrari screeched out of the parking lot in 2008, what steps have been taken to rebuild trust?
There has been progress. As the new Basel capital rules are implemented and the reliance on ratings agencies diminishes, market infrastructure improves; and as banks—and, crucially, their investors—develop a better appreciation of their prospects for risk and return, business models are beginning to change.
Global banks have made significant progress in reforming their compensation practices so that rewards more closely match risk profiles. In addition, boards of directors and risk committees are taking more responsibility to ensure that remuneration packages and employee behaviour are aligned with updated institutional cultures.
Unfortunately, a spate of conduct scandals ranging from rigging LIBOR to money laundering has overshadowed these steady and material improvements.
This underscores that it remains the collective responsibility of banks, regulators and other stakeholders to rebuild trust in banking. Banks need to participate actively in reform, not fight it. Until recently, too few bankers acknowledged their industry's role in the fiasco. The time for remorse is far from over.
Ultimately, it will be down to individual bankers. Which tradition will they uphold? Will their professional values be distinct from their personal ones? What will they leave those who come after them?
In 2011, the New York Stock Exchange [NYSE] opened a new outpost in Mahwah, New Jersey, a bucolic township of 25,000 inhabitants about an hour's drive north of Wall Street. One reason for creating the facility was pretty standard. Trading technology infrastructure takes up a lot of space, so moving it from expensive Manhattan to low-cost Mahwah saves money for the exchange. But another reason for the move was more novel. The NYSE built the facility big enough to lease out space to third parties, deriving new revenue in addition to the cost savings. But who on earth would want to lease space in an NYSE facility in rural New Jersey? Turns out, finding takers wasn't a problem. In fact, trading firms were very eager for the opportunity. These firms understood that having their server in close proximity to NYSE servers would create a speed advantage; it would mean that trades from their co-located servers would reach the NYSE servers a few milliseconds faster than trades from servers not in the facility.
It was a nice money-maker for the NYSE because the rents are steep by rural New Jersey standards. But the NYSE immediately had a challenge: how would it allocate space within the facility? Some server bays were closer to the NYSE server and so had fractional time advantages over those that were farther away. Should the exchange auction off the real estate by location? Should the bay immediately beside the NYSE server cost five times the bay near the back door? Or should it be ten times? Any tiered pricing approach was likely to create an arms race within the building, which would be unseemly. No, the clever folks at the NYSE came up with a better solution. Regardless of where lessees were located within the facility, their servers would be connected to the NYSE servers with cables of equal length even if that meant coiling cables to inefficient lengths.
There would be no arms race within their facility! There is some fractured logic at work here. The NYSE obsessed about making sure that those who paid a special price for preferential placement in the trading queue were all equally advantaged and experienced profound fairness. But the exchange seemed utterly uninterested in a more profound unfairness—the fact that any trader not paying to rent space in the NYSE facility was distinctly disadvantaged.
Why does any of this matter? It matters because of the nature of modern trading. The bustling trading floor of popular imagination is no more. As much as 70 per cent of the trading on the NYSE is now high-frequency trading, in which a computer makes trading decisions based on miniscule arbitrage opportunities in market prices and shares are often held for fractions of a second. For this type of trading, getting your order to the front of the trading queue is not the most important thing—it is the only thing.
That is why Spread Networks invested hundreds of millions of dollars to build a fibre-optic link along the shortest route between the NYSE and the Chicago Board of Trade. The link cut transmission time to an estimated 13.3 milliseconds. But that is a proverbial slow boat to China compared to the two microwave networks under construction, which promise to cut the time to eight to nine milliseconds because microwave is more direct than fibre-optical cable.
Why does all of this infrastructure investment make economic sense? If traders using it can get their orders in a millisecond faster than the hoi polloi, they will have a proverbial licence to print money. Even a small technology advantage can translate into billions of dollars in trading profits.
It's all part of playing our emergent banking and capital markets game.
So, too, was the accounting approach Lehman Brothers used in the lead-up to its catastrophic crash and bankruptcy filing on September 15, 2008. Even though Lehman was getting into ever-deeper financial distress, its quarterly financial statements didn't look particularly bad. Lehman was able to camouflage its decline by using repurchase agreements, specifically the now-infamous Repo 105 vehicle. Repo 105 is a legitimate accounting technique that allows a firm to classify a short-term loan as a sale. Lehman used these repurchase agreements extensively. At the end of a quarter, Lehman would take out a massive short-term loan [as much as $50 billion in the second quarter of 2008], classify it as a sale, and use the loan to pay down its debt. So, its balance sheet looked just fine unless one scrutinized the footnotes very, very carefully.
After the quarterly statements were released, blessed both by Lehman's leading global audit firm and legal advisor, Lehman would repay the short-term loan and re-inflate its long-term debt. The public remained largely unaware of Lehman's precarious financial state and the methods it was using to stay afloat in the short-run. This was all perfectly legal—Lehman scrupulously followed the letter of the law regarding Repo 105. Lehman and its advisors were playing the game using all the tools available to them.
Co-located trading servers and Repo 105s: these are but two examples of gaming the modern capital markets game. I could give you so many more. In each case, the rules of the game were followed. There is no rule that says the NYSE can't rent out space in its facility and hard-wire traders directly to its servers. There are rules about Repo 105 transactions, and according to the finest auditors and lawyers on the planet, Lehman was following those rules.
So what is the concern then? The fundamental problem is that this kind of gaming threatens the underlying game. It makes the game unfair, unreliable and unsustainable. And, for all of us, that is deeply dangerous.
The underlying game here is business and it is a truly important game. Business is the game in which companies supply real and valued products or services to customers. Business is the game that generates value for customers, jobs for employees, and returns for investors. Done well, it creates net wealth and prosperity for society. The functioning of this game is central to the well-being and prosperity (or lack thereof) of every country on the planet.
Banking is a vital component of this game; in order to grow and thrive, companies need capital. So, for this game to work, two pillars must work in tandem: businesses and the banks that finance them.
Threats to either pillar threaten the game. The game is threatened if businesses, aided and abetted by prominent auditors and lawyers, hide mountains of debt from investors using obscure accounting provisions. It is threatened by unequal access, in which some firms have preferential and tangible speed advantages over others in the zero-sum game of stock trading.
These techniques may be profitable and enjoyable for the gamers—the high-frequency traders, the hedge funds—but they cannot exist without the underlying game. Yet, as these gamers parasitically feed off the game of business, they seem blissfully unaware that if they destroy the game, they will destroy themselves, too.
All games need rules, including economic games like trading, accounting and compensation. The prevailing view of our economic games seems to be, so long as we have rules and we enforce them, the game will be just fine. Gamers might manipulate the rules in their favour, but they won't damage the game in any meaningful ways.