Financial crisis: Why and what's the reason for?

There’s an old Bob Dylan song called ‘Who killed Davey Moore?’ It’s the tale of a boxer killed by a fatal punch and the song recounts the protests of those involved – the referee, the crowd, the gambler, his manager and his opponent – that they weren’t the ones really responsible for his death. “It wasn’t me that made him fall,” they all cry. “No, you can’t blame me at all.”

That song springs to mind whenever anyone apportions blame for the 2008 financial crisis. There are no shortage of culprits. And given that the world may experience similar economic tremors in the near future, the question of who is to blame is extremely relevant.

Who really did make the system fall?

Culprit # 1 Senior Bankers

Bankers are, unsurprisingly, the most likely suspects. Adjectives like reckless and greedy have clung to banks like leeches since 2008 (which may be an apt analogy). But according to Dutch author Joris Luyendijk, the fatal flaw was not so much greed as wilful incompetence. The recently released movie The Big Short exemplifies, he says, the atmosphere in run-up to 2008. Days in which extremely clever finance geeks took advantage of the fact that senior managers in most banks had no idea what was really going on in their organisations. The impenetrable financial products they devised combined to make them vast fortunes and lay the seeds for financial meltdown.

Luyendijk quotes former UK Chancellor Alastair Darling who laments the fact that top managers in US and UK banks “failed to understand – or even ask – what was making them so much profit and what were the risks.”

He attributes this failure to lack of personal liability. In the days before the Big Bang, financial firms were organised as partnerships, rather than publicly floated corporations which any person, or hedge fund or other company could buy shares in. Partnerships ensured managers kept an unblinking eye on their organisation’s activities, says Luyendijk, because if things went awry they were personally liable for the cost of mistakes. But when partnerships were taken over by publicly floated banks or the investment divisions of major banks began marketing their own financial products, this discipline was lost.

I believe that while deliberate blindness on the part of senior managers was a factor in the financial crisis, it is far from a complete explanation. Firstly, bank executives were not as unaware as Luyendijk or The Big Short suggest. From pooled mortgages, to Libor and Forex fraud, the idea that senior executives were utterly oblivious to the machinations going on beneath them is not credible. When apologies become necessary, incompetence is always preferred to culpability.

In 2004, it was agreed that banks needed to have capital or deposits worth a mere 8% of the risky loans they had on their books. That agreement, known as Basel II, was “largely written by the banks themselves” says Mark Blyth in his book, Austerity: The History of a Dangerous Idea. Banks became massively indebted in the early 21^st century (they still are) and that was a conscious decision on the part of senior managers; a way of securing more profit by increasing the amount of money they loaned out. European banks, especially, became chronically ‘over-leveraged’ and may yet have to be recapitalised ‘on a scale yet unimagined’. To blame all this on unruly traders is way too convenient.

Second, the financial crisis was not just about the risk-laden products, the famous mortgage backed securities, collaterized debt obligations and credit default swaps, that boomeranged on the institutions that devised them. It spread across the world with such devastating effect because other institutions – other banks, companies, governments and NGOs – bought those toxic assets. And they bought them because they seem to embody the irresistible combination of low risk and high yield.

Lastly, risk-taking by banks was not merely an internal transgression. They were subject to pressure, possibly decisive pressure, from outside …

Culprit # 2 Shareholders

“In the run-up to the financial crisis, shareholders failed to control risk-taking in banks,” concluded the UK Parliamentary Commission on Banking Standards, “and indeed were criticising some [directors] for excessive conservatism. Some bank leaderships resisted this pressure, but others did not.”

So it wasn’t just that senior executives in banks failed to control super-intelligent and ambitious underlings who could reel off all the prime numbers up to 100 in 2.5 seconds. As directors of publicly floated companies, they were also under constant pressure to deliver greater and greater profits for the owners, the shareholders. And aware that if they didn’t succeed, they needed to look elsewhere for regular remuneration. In the words of Citigroup chief exec Charles O Prince in 2007, (in an article written by Luyendijk) “as long as the music is playing, you’ve got to get up and dance.”

To whose tune were the senior bank managers dancing? Other banks, primarily. Financial behemoths like Barclays, JP Morgan and Deutsche Bank top a list of 147 multinationals who literally own each other through interlocking shareholding. Other major shareholders include hedge funds, fantastically wealthy individuals and pension funds.

What these owners have in common is a need to maximise yield. According to Paul Mason, economics editor of Channel 4 News, big institutional investors such as pension funds, in their pressing need for higher returns on their investments, have become “crucial drivers of instability”. The signature products of the 2008 crisis, mortgage backed securities and collaterized debt obligations, seemed, before they exploded, low risk. So major shareholders were happy to buy them and to breezily criticise banks for ‘excessive conservatism’.

What lies at the root of this predilection for risk-taking among shareholders is the same weakness that Luyendijk criticises bank executives for – that if things go drastically wrong, they know they won’t be accountable. Just as bank executives are cushioned by a lack of personal liability, so shareholders enjoy the protection of limited liability.

Limited liability means that shareholders can lose only their investment in a company; they are never on the hook for the entirety of its bad debts. It is a right granted by the state. Limited liability first originated in Britain in the 1850s and was opposed in an earlier time by the father of market economics, Adam Smith, because of the dangers he saw in separating ownership and management.

The situation is complicated by the fact that, while shareholders seem very adept at pressurising the managers of the corporations they own to maximise profit without heed to public welfare, they are positively impotent when it comes to reining in harmful behaviour. Senior managers seem able to set their own pay which has mushroomed to 180 times that of the average worker in Britain. When shareholders do revolt over excessive executive pay – as they did at Shell in 2009 - they find that their opinion is merely advisory. In many ways, the senior management of large, shareholder-owned corporations are a law unto themselves.

So some have concluded that protecting the public from the selfishness of corporations requires removing both the limited liability of shareholders and the personal liability of company directors. “The most effective way of curbing predatory practices is to withdraw limited liability and hold the shareholders and directors of these enterprises personally liable,” argues Essex University’s Professor of Accounting, Prem Sikka.

Sikka wants alternatives to the corporate model – mutuals, cooperatives, not for profit and worker owned enterprises – to thrive and be promoted by government. “All are subjected to community pressures and control by employees, savers and consumers,” he says. “They see something beyond making a fast buck.”

The trouble is, during the crisis of 2008/9, the eyesight of these supposedly alternative enterprises seemed as myopic as anyone else’s.

Culprit # 3 the global market

The list of mutuals in Britain felled by the financial crisis is embarrassingly long. The Dunfermline Building Society, the Scarborough Building Society, the Chesham Building Society, the Derbyshire Building Society and the Cheshire Building Society all either collapsed or had to be bought by other financial institutions. In the case of the Dunfermline, the Bank of England bailed it out and ran it for a time.

Building societies don’t have shareholders. They are owned by, and in theory accountable to, their members – people who have mortgages or savings with them. But, though they didn’t create the banks’ financial ‘weapons of mass destruction’, they were just as reckless with the way they lent money.

In May last year, regulator Andrew Bailey, the chief executive of the Prudential Regulation Authority, warned building societies that they must not return to the ‘fatal’, high risk lending that helped trigger the financial crisis. He cited evidence that building societies were resuming the pre-crisis practice of making loans many times larger than their customers’ income and property.

These failings are not limited to Britain. In 2009 two of Germany’s famous state-owned Landesbanken, were forced to merge after they had borrowed too much capital and invested it in toxic US sub-prime mortgage assets. Four others had to be bailed out by state governments in Germany to the tune of millions of euros.

In Spain, savings banks, known as cajas de ahorros, are owned by non-profit foundations and dedicated to charitable activities as well as savings and mortgages. But they were at the heart of the implosion of Spain’s housing bubble. Of 45 cajas in existence at the start of the crisis in 2007, only two survived. The rest collapsed and had to be taken over by banks or the government. The effects have been catastrophic. Hundreds of Spaniards have been evicted every single day and the unemployment rate has reached a staggering 25%.

The financial crisis may have been hatched in corporate-land but it unfolded like a virus throughout the world because of markets. And allegedly alternative enterprises were as starry-eyed about these markets as anybody else.

Why then did alternative enterprises, which presented themselves as different to soulless, money-grubbing corporations, turn out to be not so different after all? Partly, because of a lack of real accountability. Though they were accountable in theory, they weren’t in practice. German Landesbanken had advisory boards that were meant to keep senior management in check but merely rubber-stamped their activities. In Britain, the Cooperative Bank’s woes can be attributed to the fact that its elected board didn’t have the knowledge or confidence to challenge the ‘incredibly optimistic’ assumptions of the management team. In this sense, the corporate and mutual sectors suffer from a similar affliction – out of control senior executives.

We don’t live in democratic societies. People don’t have the knowledge, time or inclination to hold the powerful to account. Without a conscious change in that level of knowledge and intention, mechanisms of accountability will remain empty shells.

But perhaps the problem is deeper still. The Marxist economist Andrew Kliman argues it is foolhardy, in a capitalist economy, to expect nationalised or worker controlled banks to behave differently to their corporate equivalents. “In order to survive, a state-run (or worker-run) bank must pursue the goal of profit maximisation, just like every other bank,” he says. “As long as there is capital, what are actually in control are the economic laws of capitalism.”

Those economic laws of capitalism mandated that building societies and other mutuals compete with major banks for market share and profitability. And doubtless many members, at the time, agreed with these aims. Governments in Britain have since the 1980s relied on rising house prices to ensure re-election. When that measure goes into reverse, as it did for the Conservatives in the early ‘90s, they watch as erstwhile supporters desert them in droves. Pensions funds are a ‘crucial driver of instability’, yet many millions rely on them to deliver high investment returns to fund their pensions.

This is not to descend into the ethical void and assume that everyone is equally guilty. Some people are infinitely more culpable than others. A tiny elite get to set their own pay. A tiny elite have been bailed-out by government and their wealth rescued by state action. A tiny elite get to make – and rig – the rules of the game. But, as in Dylan’s Davey Moore parable, it is the rules of the game that need altering. The blame game confers only an ephemeral pleasure. A bit like shopping.