One year ago the great Wall Street House of Lehman Brothers filed for bankruptcy, setting off the great global meltdown in financial markets. No one wanted to buy Lehman Brothers, no one wanted to lend it working capital, and neither the United States Treasury nor the Financial Services Authority of Great Britain wanted to save it.
Lehman Brothers was leveraged against its capital 44 to 1. It had played the game of moral hazard and lost. It sustained its holdings with short term borrowings in the commercial paper and overnight repo lending markets. But as the value of its collateral - mostly securities and much of this in paper backed by sub-prime mortgages - fell, it was unable to continue borrowing at a level sufficient to sustain its investments.
Months previously Bear Stearns had collapsed for similar reasons and AIG would collapse shortly after as a result of the collapse in demand for sub-prime mortgages, securitized mortgages, and CDOs.
Where are we a year later?
The US Federal Reserve announced yesterday that “the recession is over” but that a full recovery, especially in employment, will be slow in coming.
No meaningful reforms of financial services have been enacted by the United States Congress or similar measures taken by the G8 or G20 governments to prevent future market dysfunctions. The word from Washington DC is that efforts to reform financial services are losing momentum. The New York Times asserts editorially that “the important work of regulatory reform remains undone.”
And, the proposed reforms of the Obama Administration do not go to the heart of the matter - bad risk management in using “other people’s money” in a speculative, highly liquid but highly leveraged trading boom. The Obama Administration proposed reforms call for more regulatory supervision by government of private sector credit decisions. They do not create incentives and disincentives within trading markets to enable private firms to become more responsible and ethical.
As a result, Gordon Gecko’s mantra of “greed is good” can still broadcast its devious enticements in global capitalism.
In his remarks on Wall Street on Monday, President Obama said “Instead of learning the lessons of Lehman and the crisis from which we are still recovering, they are choosing to ignore them. They do so not just at their own peril but at our nation’s.”
Last year, responding to the meltdown in credit markets and the collapse of Wall Street, the Caux Round Table made seven recommendations. Hindsight indicates that our analysis was absolutely on target. The disappointment is that little has been done to implement such needed reforms.
A year ago we said:
“Capitalism’s so called immune system of laissez-faire market discipline has failed the test and the underlying causes of this systematic breakdown - greed and narrow self interest - must be addressed”, said Lord Dan Brennan QC, the Chairman of the Caux Round Table and past Chairman of the Bar of England and Wales.
“Failures to properly assess risk and a dysfunctional and shortsighted system of incentives and remuneration have been at the heart of the problem”, said Stephen Young, Global Executive Director of the CRT.
“Compensation of senior executives, traders and fund managers was, and still is in most cases, built on narrow self interests and decoupled from long-term wealth creation. Rewards rose with excessive risk taking and have been provided in ways that have largely shielded senior corporate officers and fund managers from liability for their decisions”, Young said.
“Also at the core of the problem has been a failure of governance. Boards of directors were not sufficiently encased in an environment of sound risk management, responsibility, transparency and ultimate accountability. And financial regulation failed to offset the inherent dysfunctionality of the markets”, Young added.
Lord Brennan noted that “despite the need for urgent action to address the underlying causes, there are inadequate reforms on the table. Business leaders and boards are largely silent, and politicians, regulators and central banks are flat out putting out the fires.”
Two recent books – House of Cards by William D. Cohan and A Colossal Failure of Common Sense by Lawrence G. McDonald and Patrick Robinson - substantiate the Caux Round Table critique of Wall Street and the other firms that failed to perform as needed. House of Cards describes the collapse of Bear Stearns and A Colossal Failure of Common Sense takes you through the collapse of Lehman Brothers.
Another book most deserving of your consideration is The Myth of the Rational Market by Justin Fox. Fox presents as intellectual history the formulas and mathematical proofs offered by financial market theorists to support belief that market pricing always gets it right.
What we learn from these books is that real risk was not managed at all; it wasn’t taken seriously by the boards of both Bear Stearns and Lehman Brothers. It was all a “house of cards” with no sustainable foundation and it was also a failure of “common sense.” And, the driver of this irrationality was indeed short-sighted greed and personal hubris in CEOs, aided and abetted by supine boards and corporate cultures of fear and money-getting.
Designers and builders of real houses take risk seriously and common sense also puts prudence and reason in the driver’s seat of decision-making. Common sense does not leverage 44 to1 in order to fatten annual compensation packages. Wall Street millionaires did not get the basics right and we have all suffered for that.
The Caux Round Table’s Seven Point Reform Plan to Restore Trust in Business and in the Global Financial System
September 2008 (read more on the Seven Point Reform Plan press statement here)
Require board directors to consider interests beyond shareholders, which may affect the company’s success, by codifying the principle of “enlightened shareholder value” in company law.
- Require corporate board directors to disclose all material risks and uncertainties to the future development, performance and sustainability of the company and its business in the annual report.
- Specifically, require corporate boards to disclose annually the material risks and impacts flowing from:
- workplace and employee issues;
- customer, product and service issues;
- supply chain matters;
- environmental risks; and
- social and community issues and concerns.
- Require minimum standards of corporate governance knowledge and expertise for corporate board directors.
- Require corporate board directors to have the skills and expertise to:
- responsibly execute their duties of trust and profit, given business is not without consequence for society;
- oversee the full spectrum of financial, governance, social and environmental risks to the company; and
- ensure business practices meet minimal ethical standards.
Require corporate boards to have a dedicated board committee responsible for risk oversight across the full spectrum of risks - financial, governance, social, environmental.
- Require the Board Risk Committee have an independent chair and a majority of independent directors on the committee
- Require corporate boards to commission independent assurance reports annually on the effectiveness of their company’s risk management processes and to disclose the assurance report findings.
Regulate executive remuneration structures to ensure that they are consistent with prudent risk management, align with long-term wealth creation, and do not reward poor performance.
- Require corporate board directors to make annual disclosures (and at the time of the appointment of any CEO) detailing:
- conflicts of interest and other risks embedded in both short-term and long-term executive performance incentives, including how the Board proposes to manage such risks; and
- the degree to which the remuneration structure aligns executive interests with those of shareholders, including during times of company stress and underperformance.
- Require all equity linked remuneration to be in the form of common equity escrowed for a minimum period of five years, regardless of continued employment.
- Prohibit Board members and key executives from borrowing or hedging against the common equity they hold in the company, unless there is full and timely disclosure of all such borrowing or hedging.
- Cap termination payments at one year’s remuneration unless there is prior shareholder approval of a higher amount.
Implement stronger and globally co-ordinated financial and banking regulatory reforms to prevent systemic risk build-up or market manipulation.
- Harmonise regulation and co-operation of financial supervisors / regulators across the G20, including cross-border supervision of globally significant financial entities, to enhance financial system stability and close opportunities for regulatory arbitrage.
- Broaden regulatory coverage to all financial entities and transactional activities that pose material systemic risk to financial stability.
- Strengthen capital adequacy of all systemically important financial institutions in line with their underlying risk profiles.
- Weed out or strictly regulate market products, behaviours and activities that are not consistent with the principles of market stability, long term value creation, and a fully informed market.
Regulate all financial markets instruments and investment activities that materially impact on financial system stability and on superannuation and pension system viability.
- Broaden regulatory coverage to all financial entities, products and transactional activities that pose material risks to financial stability or to superannuation and pension fund viability.
- Enable regulators to intervene in and control excessive speculation and risk accumulation in all systemically important financial markets and instruments.
- Market participants, including derivative and hedge funds, required to disclose trading and other information necessary to adequately access market and systemic risk.
- Establish fully regulated exchanges for credit derivatives and other systemically important instruments.
- Require registration and ensure regulatory oversight of credit ratings agencies whose ratings materially impact on financial and investment markets.
- Review the practice of paid ratings and consider possible reform to ensure independence of ratings.
Reform and adequately resource the IMF and other multilateral institutions to ensure they are effective forces for economic and social justice globally.
- Ensure the IMF and other international financial institutions and multilateral development banks are resourced to assist emerging and developing economies in dealing with the flow-on from the global financial crisis.
- Broaden Financial Stability Forum membership to all G20 members and strengthen its role including via the development of an early warning system for threats to global financial stability.
- Strengthen measures to oppose and prevent trade protectionism while renewing initiatives within the World Trade Organization towards a global free trade agreement.