I am more afraid of an army of one hundred sheep led by a lion than an army of one hundred lions led by a sheep.

~Charles Maurice, Prince de Talleyrand-Périgord

When the financial crisis erupted in 2008, many questioned the leaders and regulators in place at the time. How could the global financial system be humming along one minute and completely bankrupt the next? Clearly, those in charge either made some very questionable decisions or failed to inform the public of the potential consequences of those decisions. Most likely it was both.

When it came to constructing solutions for the crisis, however, we continued to listen to and implement the ideas of the same people who brought us to the brink. In turn, those people followed policy prescriptions similar to the ones that got us into trouble in the first place. Were there no other options available? There were. They were simply ignored. And what role did we the public play? Were we willing sheep, helpless dupes, or both?

While I've been thinking and writing about this exasperating situation for some time now, the reality of it hit home once again this past weekend as Joe Nocera published an excellent exit interview with outgoing FDIC chairwoman Sheila Bair. Ms. Bair added a refreshingly candid piece in the the Washington Post. I highly recommend reading both.

Notes from the Exit Interview

Here are a few points that stood out to me from Nocera's article:

  • “Not long after she took charge in June 2006, Bair began sounding the alarm about the dangers posed by the explosive growth of subprime mortgages, which she feared would not only ravage neighborhoods when homeowners began to default — as they inevitably did — but also wreak havoc on the banking system. The F.D.I.C. was the only bank regulator in Washington to do so.”
  • “Just a few months ago, she went so far as to send a letter to Standard & Poor’s, the credit-ratings agency, suggesting that its ratings of the big banks were too high because they reflected an expectation of government support. If a too-big-to-fail bank got into trouble, she wrote, the F.D.I.C. would wind it down, not bail it out.”
  • “the last female financial regulator to be labeled difficult was Brooksley Born, the head of the Commodity Futures Trading Commission in the mid-1990s. Fearful that derivatives were becoming a threat to the financial system, Born wanted to regulate them but was stiff-armed by Alan Greenspan and Robert Rubin.” I had the same sense of déjà vu. (If you get a chance, watch the PBS documentary called The Warning that I wrote about in Market Integrity Should Not Be an Oxymoron.)
  • “She favored “market discipline” — meaning shareholders and debt holders would take losses ahead of depositors and taxpayers — over bailouts, which she abhorred. She didn’t spend a lot of time fretting over bank profitability; if banks had to become less profitable, postcrisis, in order to reduce the threat they posed to the system, so be it. (“Our job is to protect bank customers, not banks,” she told me.)”
  • Ms. Bair felt the authorities should have let Bear Stearns fail: “Banks and bank-holding companies are in the safety net. That’s why they have deposit insurance. Investment banks take higher risks, and they are supposed to be outside the safety net. If they make enough mistakes, they are supposed to fail. So, yes, I was amazed when they saved it. I couldn’t believe it.”
  • The FDIC was the lone regulatory agency that foresaw and tried to stem the toxic impact of subprime mortgages. The responses of the Fed, the Office of the Comptroller of the Currency and the Office of Thrift Supervision “were at best tepid and at worst hostile.”
  • As head of the FDIC, Sheila Bair also fought against U.S. adoption of the Basel II accords. Already taken up by most European countries, Basel II “would allow banks to hold capital on a “risk-weighted” basis, meaning that assets with lower risk would require less capital. (As it turned out, triple-A-rated mortgage bonds stuffed with bad subprime mortgages were considered very low risk under the Basel proposal. That is why so many banks loaded up on them in the years leading up to the crisis.) To make matters worse, the Basel II accords, as they were called, permitted banks to evaluate their assets with their own internal risk models.”

It turned out that Bair's approach, often labeled “difficult” by bankers and fellow regulators, left U.S. banks in a slightly better position than their European counterparts when the credit crisis hit. If they had listened to her ideas with regard to tightening capital requirements and regulations in the first place, however,  perhaps the crisis could have been averted.

In Her Own Words

I can remember watching media coverage of the financial crisis as it unfolded in 2008 and 2009 and wondering what some of the key players were really thinking behind the spin and the rhetoric. Sheila Bair's Washington Post article on Short-Termism and the Risk of Another Financial Crisis provides a glimpse into what she feels is the primary cause of our economic and financial problems. Given that many of the “solutions” employed continued the policies of short-termism that she abhors, it's easy to see how frustrating that period of time must have been for the FDIC chairwoman.

Bair begins her op-ed with an incredulous observation that we have quickly returned to “the same untenable business practices that brought [the financial system] to its knees less than three years ago.” She notes that “too many industry leaders, as well as some government officials, compare the crisis to a 100-year flood. ‘Who, us?' they say. ‘We didn’t do anything wrong. Nobody saw this coming.' ”

In reality, plenty of people saw this coming. They did the best they could to try to stop it, but no one at the political or public level was listening:

“The truth is, some of us did see this coming. We tried to stop the excessive risk-taking that was fueling the housing bubble and turning our financial markets into gambling parlors. But we were impeded by the culture of short-termism that dominates our society. Our financial markets remain too focused on quick profits, and our political process is driven by a two-year election cycle and its relentless demands for fundraising.”

Just as she did back in 2006, Sheila Bair wants to “sound the alarm again.” The problems created by short-term thinking are “actually getting worse, not better.” Will we listen this time?

I once wrote that strong leadership is one of the missing links in our current, distorted version of capitalism. If so, the only way to change that is to find a way to better educate the public about the long term consequences of short-termism – no small task given our “gotta have it now” society.

(There's a lot more to both of these articles, so I would urge you to go and read both in their entirety.)

Should we have listened to Sheila Bair and others who warned of the longer term consequences of a lack of market discipline? Why are we still ignoring them?