“We cannot afford to forget the lessons of the crisis …. Amnesia causes financial crises.”
— US Treasury Secretary Timothy Geithner, March 2012
The recent financial crisis imposed significant costs on investors, economies and their societies. The risk of the crisis and its cost to investors might have been reduced if we had not forgotten the lessons from financial history.
Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history.
It is dangerous because it disarms investors, market participants and even regulators. It causes risk to be misread and creates bubbles which eventually burst, sometimes on a global scale.
The events that resulted in the financial crisis of 2008 were a perfect reminder of ‘financial history’ repeating itself. The most important question to ask ourselves now is: How does an investor develop an amnesia anti-dote?
Developing an amnesia anti-dote requires investors to learn the three lessons that are always overlooked. These apply to investors, financial institutions and regulators.
Innovation + leverage + the illusion of safety = “this time it’s different”
Innovation – The financial sector develops an array of products which are reinventions of the wheel hailed as innovation. The use of credit derivatives was initially seen as making the financial system safer but in fact transferred risk rather than mitigating it.
Leverage – Before most crises break they are often preceded by an expansion of lending. To sustain the growth in lending and encourage borrowing, innovation is used to justify risky lending which from an objective perspective should not be undertaken.
Illusion of safety – As the expansion of credit growth feeds into a rise in asset prices, a false sense of security develops among market participants so that the risks being undertaken by individuals and institutions are underestimated while collectively undermining the financial system. Innovation underpins this false sense of security because it creates the illusion that losses will not arise or will be manageable when they do.
This time it’s different – The combination of the first three factors lulls the investor and others into believing that we have entered into a new era of rising asset prices and lower risk.
Market failure
Financial institutions have the role of pricing risk and allocating capital in the markets. In doing so, they impose market discipline which then contributes to market integrity. Market integrity is vital for investors as it enables them to allocate their capital in a manner that aligns with their tolerance for risk.
However, financial history has shown that financial institutions often fail to impose discipline because they cannot exercise self-control and succumb to the “this time it’s different” illusion. Investors, however, need to be wary of financial institutions or instruments that convey they provide high returns with little or no risk.
During market upheavals, those with the least control, most highly leveraged fall first and may cause material detriment to the rest of the financial system and impose costs to society.
Ineffective regulation
Regulators have a variety of functions that can include protecting market integrity and ensuring investors are not exploited by regulated firms. The recent crisis, like those before it, was characterised by regulators that were unwilling or unable to supervise and enforce the regulations effectively. Given the frequency of market failure, investors need an effective regulator to maintain the integrity of the market. An effective regulator contributes to market discipline.
THE WAY FORWARD
Investors, financial institutions and regulators need to develop a financial memory so that the pain and costs of the financial crisis are not forgotten by current and future generations. To alert investment professionals and other investors, we should support broader industry and regulatory initiatives to monitor the impact of credit growth and financial innovation. We should encourage boards of financial institutions to undertake an annual “amnesia check” or encourage independent assessments. The assessment could consider the institutions’ risk assessments and the degree of probability they assign to those. It could also review the extent to which the determinants of management compensation have shifted over time.
We should encourage regulators to emphasise supervision rather than regulation, establish and operate supervisory processes that mitigate adverse behaviours, and aim for informed independence from market influence.
An investor should never forget that an effective regulator is a crucial source of market discipline and a vital component in maintaining financial market integrity. Hence, the quality of regulation is what is most important to investors.
This article is based on a paper “Financial Amnesia” published by the Chartered Financial Analyst Society of the United Kingdom (CFA UK). For the full version of the paper please email advocacy@cfauk.org.
(The author is Policy Adviser at the CFA UK)
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