Lessons Not to Learn

By Abdulkader Thomas
Column in Islamic Finance Asia
(Oct/Nov 2008 Ed.)

Northern Rock, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, WAMU, AIG. We started thinking about this list in mid-2007. The fallen and the at risk, the merged given risk… these new big names (how many less well-known names have failed, we don’t yet know) suddenly seem to have no end. What failed us?

Is it capitalism and Adam Smith’s “invisible hand” which has caused this mess? Perhaps so. In the Bush-Blair rush to deregulate markets, the theories which went into play were that the markets know better the needs of people. There cannot be market failures that require government intervention. Inefficiencies will be set right by the market. But, the market allocates resources according to price. Setting the correct price requires trust and information. If the provider of information is untrustworthy, the market will not function correctly. If resources are abundant, and market participants are worried that they will “miss their opportunity”, then there are risks to both the pricing signals and the quality of information.

Indeed, during the subprime build-up, cash was abundant. Bankers, brokers and home owners alike rushed to avoid missing their chance. Since the invisible hand was a fiction of Smith’s mind, the government has to step into the breach and protect the broad market from distortions in information and dishonest behavior. Oh, and probably the government shouldn’t print too much money either! But, the now hyper-critical Mr Greenspan is the person who ran the printing press and didn’t seem to mind the lack of market oversight. So, greed let us down.

Did Basel II let us down? Those who have attended my courses on risk management in Islamic finance know that I have often made two harsh criticisms of Basel II. The first is that it has inherent bias toward the large institutions of the OECD countries; you know, the institutions that are currently putting the global financial system at risk. The second is that Basel II concepts assert that independent ratings are valid analyses of risk. But, the complexity of securities derived from subprime instruments, and probably now credit insurance vehicles, has shown that ratings fall if their assumptions are based on incorrect assumptions, or lack seasoned analysts to interpret the environment in which the instruments are issued, or are based on concepts that are not adapted to changing markets.

For instance, highly tranched mortgage backed securities (MBS) created in the early 1990s were based on underpriced real estate and deep discounted mortgages. The concept continued through the mid-2000s. By then, the real estate was overpriced, and the mortgages may have represented a loan to value of up to 120%. So, if I buy an investment grade tranche of an MBS issued in 2004, my bank would have a superior capital allocation than if it had made and held a whole mortgage loan with a loan to value ratio (LTV) of 75%.

We can now see the essence of the crisis. It’s not securitization, it’s the erroneous assumptions ignored under Basel II, tolerated by rating agencies and regulators, the booming real estate market. Are there lessons from the 1997 Asian financial crisis that the Americans and others did not learn? Absolutely. The invisible hand allows industries to fail and people to suffer. The American and IMF (International Monetary Fund) advice was to let it happen.

But, Malaysia didn’t. Public works like the Putrajaya project most likely helped buoy the struggling economy. Government intervention in the financial markets rescued failing banks. And, at the end of it all, Malaysia’s financial system was intact, the infrastructure modernized and the people generally better off.So, it really is, as former US president Bill Clinton said in the 1992 presidential campaign, “the economy, stupid”. And, the economy is about the general welfare of the people, the citizens. That means the visible hand of public policy and government intervention is often needed to protect the markets so that the people may enjoy a broad level of well-being.

Oh, and interest. Okay, this is Islamic Finance Asia, and I am a promoter of Islamic finance. I would like to tell you that interest was an important part of the problem. And, it is. But, the reality is threefold:

A vibrant Islamic finance industry should help to diversify the financial system and help to reduce systemic risks;

Interest compounds problems and loans are significantly different from risk participations. Would a bank the size of the entire universe of Islamic banks (e.g. Lehman) fail if it had shared risk in lieu of borrowed money? Probably not as severely; and

Will the Islamic sector make its own mistakes, just different? Almost certainly.