Fix flawed system to prevent crisis

Some consensus on the causes of the financial crisis has emerged from a number of inquiries including the US Financial Crisis Inquiry Commission and the Levin-Coburn report. However, opinions differ sharply on how to prevent it happening again.

Sales of inappropriate mortgages in the US played a big part in the first wave of shocks to the financial system in 2008. Could enhanced social analysis of the borrowers have made the mortgage providers better informed and this prevented the crisis? It seems unlikely. Most mortgage providers were making rational decisions with all of the evidence they needed. Their personal remuneration depended on the number of mortgages sold, not the longer-term default rates on those mortgages.

So while the risks were taken on for quite rational individual reasons, the business model was simply not sustainable. And these risks were spread throughout the system.

The large investment banks packaged up those mortgages and sold on these bundles of assets across the financial system in a way that was meant to spread risk but instead ended up infecting every corner of the system. Perhaps the banks misunderstood the risks or perhaps they simply ignored them. Either way, the failure could be attributed to poor governance: banks had inadequate procedures in place to assess risk or to prevent personal greed.

In retrospect it was clear that individuals and governments had acted in ways that simply could not go on

Could better governance analysis therefore have prevented this happening? Again, it is not the full story. Even armed with analysis indicating weak controls and risks to the system as a whole, shareholders might have elected to continue enjoying those high returns for as long as they kept on coming.

Investors supported activities that many knew were unsustainable, because they gauged it was in their interest to do so. They reaped the benefits while they lasted and others bore the costs when they crashed.

Underpinning this unstable financial edifice was the massive accumulation of debt. It is now increasingly evident that it was not only home-buyers who had overextended themselves – consumers of all sorts of products and services found themselves with unmanageable levels of debt. So too did governments. The whole structure started to crumble. In retrospect it was clear that individuals and governments had acted in ways that simply could not go on. Their activities were not generating income to meet their expenditure.

This cannot be explained by a specific failure in ESG (environmental, social and governance) analysis, only in terms of structural flaws in the system as a whole.

Three key areas of focus for investors emerge from this assessment:

  • Incentives need to be better aligned – the financial crisis showed that the bank employee, the fund manager, the pension fund trustee and the company executive are not always incentivised to deliver sustainable returns for the investor;
  • Risks to the entire system need to be addressed more effectively – investors can benefit in the short term from market failures whereby the costs of bad investments fall on others within the system. We saw this in the toxic derivatives in the financial crisis. It can also apply to carbon-intensive assets or assets that depend on depleting resources. Investors might think that they can exit an investment in time, but in fact there is a real danger of holding “stranded assets” that have lost their value. Investors can do more to identify and plan for future financial, social and environmental risks and opportunities; and
  • ESG analysis is not in itself enough to drive sustainable investment – the financial crisis showed that it can offer insights, but building resilient portfolios requires a much deeper assessment of how companies create and destroy value in the way they do business.

The financial crisis showed the massive damage that a flawed financial system can do. Unless there is a fundamental change in approach, we may face renewed conomic, social and environmental storms that will make the current financial crisis look like a breeze.