Recently, I got accross through a friend a very interesting article from George Soros' webpage. It deals with the causes of the financial crisis. Here I present some extracts from it together with some comments.
The article is very interesting and touches to start with with the reason for the crisis that we have all heard already:
"The misconception is derived from the prevailing theory of financial markets, which, as mentioned earlier, holds that financial markets tend toward equilibrium and that deviations are random and can be attributed to external causes. This theory has been used to justify the belief that the pursuit of self-interest should be given free rein and markets should be deregulated. I call that belief market fundamentalism and claim that it employs false logic. Just because regulations and all other forms of governmental interventions have proven to be faulty, it does not follow that markets are perfect."
We tend to believe that if regulators let the system be, it must be ok, but as Soros says,
"It is important to recognize that regulators base their decisions on a distorted view of reality just as much as market participants-perhaps even more so because regulators are not only human but also bureaucratic and subject to political influences"
The point I wanted to stress, though, is the effect that has had on the crisis the absolute ignorance of banks when it came to calculate the risks of some of the products they sell:
"Financial engineering involved the creation of increasingly sophisticated instruments, or derivatives, for leveraging credit and "managing" risk in order to increase potential profit. An alphabet soup of synthetic financial instruments was concocted: CDOs, CDO squareds, CDSs, ABXs, CMBXs, etc. This engineering reached such heights of complexity that the regulators could no longer calculate the risks and came to rely on the risk management models of the financial institutions themselves."
Anyone working in investment banks can tell you that the fact that regulators trusted the risk models from the banks is the real problem. Some of the risk models that banks had (have!) for credit products are a joke. You get 20-year-olds managing millions in risk they don't even understand. It all boils down, I must say, to very simplistic models in the first place (quants!). It is the need to produce new models as fast as you can that leads to innacuracies. Again, the hurry coming from the ever present greed.
About this problem of all-too-complex products, Soros says
"Sophisticated financial engineering of the kind I have mentioned can render the calculation of margin and capital requirements extremely difficult if not impossible. In order to activate such requirements, financial engineering must also be regulated and new products must be registered and approved by the appropriate authorities before they can be used."
But the problem is, in my opinion, that you can never be sure that the regulator knows what he is doing! How do we know that they understand the products. I believe there should be a limit in the leverage products can offer (leverage = potential gains vs initial investment), because the higher the leverage, the higher the inherent risk and potential damage. Actually, Soros points this out as well at the end:
"Since the risk management models used until now ignored the uncertainties inherent in reflexivity, limits on credit and leverage will have to be set substantially lower than those that were tolerated in the recent past."
Of course, that would make banks less profitable and, therefore, limit the speed to which management can get rich, which is a good thing. However, that's certainly not the panacea we are looking for, and one feels that something of a greater magnitude is necessary. A full change in the financial systems, which may be even too much to take for the leaders of our world, including Mr Obama.