The Financial Times published two interesting pieces last week (here and here) on the efforts of major banks to take blame for the current financial crisis and to suggest areas for reform. FT characterizes these efforts as attempts to avoid increased regulation of the financial sector. According to the second article, a report issued by the Institute of International Finance(IIF), an organization representing more than 375 of the world’s largest financial companies, “acknowledges big problems in managing risk (the core function of banking), in setting the pay of bankers, in ensuring banks hold sufficiently liquidity, in the use of stress testing to judge banks’ ability to cope in difficult times, and in the use of credit ratings.” The IIF’s entire report can be found here.

 

The report raises some interesting issues, particularly bank liquidity and risk management. Bank liquidity has been a concern ever since the barriers between depository banks and investment banks came down in 1999. Those barriers were erected after the Depression to prevent speculation from destroying depositors’ savings. Reformers have long argued that investment banks should be regulated like ordinary banks, which are required to maintain much larger cash reserves. After billions in losses (with possibly more losses to come) and the specter of major financial institutions teetering on the edge of bankruptcy these call have been renewed.

 

Poor risk management was and is an extremely big factor in this crisis. Most of the subprime investment vehicles, the CDOs and such, that financial institutions sunk so much money into were AAA rated. On the books these were not risky investments. Even more heavily regulated institutions, like thrifts, credit unions, and pension funds which are restricted from making risky investments, purchased these instruments on the basis of their AAA rating. Banks and investors either ignored or were prevented by a lack of transparency from discovering the shoddy underwriting practices for so many of the subprime mortgages. (For a much more detailed discussion of this issue see these comments by the Comptroller of the Currency.) Banks are now afraid to lend to each other because they don’t know what lurks on each others balance sheets.

 

But after all the chaos caused by the credit crisis, including what will most certainly be a recession in the US and an economic slow down in the rest of the world, simply saying “We’re sorry and we’ll fix it - trust us” is a tough argument to make. Deregulation of the financial sector has been the norm in the U.S. for the last 25 years. The public placed its trust in financial institutions, and the institutions, as the IIF report details, violated that trust. That second FT article points out that a year ago the IIF put out a report on bank liquidity that included proposals for self regulation, but the proposals were largely ignored by the industry. If the credit crisis does lead to increased regulation it seems that the industry has no one to blame but themselves.