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THE FINANCIAL CRISIS – ETHICAL MISTAKES OR MARKET FAILURES?

The global crisis 2008-2009 has resulted in many unexpected effects noticeable in economy up to now. But what was the cause for its occurrence? Was it the human nature that led to the catastrophic events or maybe simply market fiasco? Using two articles, “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña and “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture” by James Crotty I will make a comparison of various approaches towards the causes of financial crisis and analyze the roots of it.


The paper “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña presents the unique point of view on causes of the financial crisis. It shows the crisis from a moral and behavioral perspective and demonstrates the occurrence of many unethical and opportunistic actions. Nevertheless, the fact that the crisis has also an ethical dimension does not mean that it is the only cause of it – the paper is not rejecting the economic reasons but shows the other side of the coin, which is the crisis of the leadership institutions and the governance conducting to the failure of economic performance and social structures.

The financial crisis that occurred mainly in years 2007-2008 had tragic consequences that could be noticed all over the world to this day, but how and why did it even start? Let’s begin from roughly explaining its origins. It all began with a crisis in the US subprime mortgage market, which, combined with an unknown risk as well as a lack of transparency quickly transformed into full-fledged international banking crisis and recession.

From the very beginning, the most serious problem was the loss of confidence in the institutions involved in crisis, which became even bigger due to the bankruptcy of Lehman Brothers in 2008. The government tried to help the companies by introducing general fiscal stimulus programs, but only increased deficits and led to sovereign debt crisis. But that is not the end of it. The excessive lax policy of US created housing bubble. ”The overvaluation of assets, high debt and a feeling of euphoria gave rise to the first crisis, which began, as already noted, when the growth of housing prices stopped, slowing demand and causing many customers to default”1. The overly lax policy of the European Central Bank also had its impact. The second crisis arose from the burst of the housing bubble, which resulted in a significant loss of asset value and hence capital. It emerged not only in the countries where the bubble was created, but also in those which invested in some ‘toxic’ assets. Then the currency crisis impaired it even more. The third crisis was a sovereign debt crisis triggered by the fiscal stimulus program. Governments wanted to give financial support to banks all over the world but in reality increased their debt, which reduced the credibility of governments.

The possible causes of the financial crisis are countless and vary significantly; some call it an ethical crisis and believe that moral errors may explain why the crisis occured. In order to explore it more deeply Argandoña presents the analysis comprised of three levels: the first concerns the moral failings of individuals, the second covers organizational level, and the third deals with social and theoretical ethics. The main aim of this is to take a closer look and conclude by ourselves if this crisis was partly the crisis of management and governance of financial organizations.

The first part of the description covers the behavior of some individuals. The main cause for occurrence of the financial crisis is said to be greed, “defined as a selfish and excessive desire for more of something (such as money) than is needed”2. Human is portrayed as a weak being who follows his desire, sometimes blindly and carelessly. Of course, we are not talking about taking advantage of simple opportunities that the market offers, such as buying when prices are low and selling when they are high, which is just an example of human business sense and it should not be criticized. What should be criticized though is the situation when people saw the danger which could lead to uncontrollable effects and decided to ignore it in order to gain some personal benefits or recognition. That would mean that the human ignorance and selfishness contributed heavily to the emergence of the financial crisis.

geralt / Pixabay

Pride was also discussed as a potential drive force. People in a high position felt untouchable and above the law, so they thought they could do whatever they need to achieve success. It shows pure human nature, without embellishment. People are ready to do anything in order to be great. This includes immoral actions such as deception, lying, fraud, selling the values that they believe in, sometimes in extreme cases even murder. And I do not mean literally, but the effects of crisis affected many families and we do not know how many people have suffered for the mistakes that were made by people in power. All of this was used to increase commissions and profits earned by investors. The banker should be wise and rational, but in the world of numbers and rates that values rarely stay unchanged. Then it works like a chain, previous thing violates the next and all of the sudden we have a herd of reckless people following even more reckless leaders. But on the other hand, people have always been greedy and full of flaws., so it does not completely explain why in this particular time the crisis occurred. There may have been changes in social values or there were more than one reasons (which is most probable). This leads us to the second part of the analysis.

The second level comprises the crisis as a crisis of governance or leadership in various organizations, from commercial banks up to governments. People with very little knowledge or even no experience at all often held important positions. They had been using models they did not completely understand and very frequently in cases that did not match the assumptions made by the model. But the worst thing is that they were unsupervised. The superiors had neither the time nor the willingness to control the actions of their workers and because of that there were many errors. For example it was especially dangerous concerning the risk management market. People assumed too optimistic future and treated the possible failure as almost infeasible. That made it harder to find any mistake if they were not really looking for it, hoping or even believing in infallibility of the system. Also the mechanisms were based on the data covering recent decades, which were quite stable with no bigger slumps and because of that they were useless while predicting the crisis. The next mistake was thinking that the risks of assets were totally independent, not connected with each other. The risk was thought to be eliminated but in fact it appeared the other way, which was not expected and made it much more dangerous. The other causes that might have contributed into existing of a crisis are the incentives in the management of financial institutions. They were mostly financial and constructed in a wrong way, which made people to really show their greedy nature. The wanted effect was not achieved, because people focused mostly on the benefits they could receive and not the greater good. The benefits were connected with a short-term effects and usually they are less significant than the long-term ones, this combined with excessive manipulation was a perfect mixture to create if not a crisis, at least a ticking bomb. The other problems current before the crisis were ‘regulatory arbitrage’, which is moving the operations to countries with lax fee policy, lack of transparency, not adjusted regulation and control mechanisms. All of those are made and managed by people and therefore it also has an ethical dimension.

Tumisu / Pixabay

We already mentioned some personal and ethical mistakes and the third part of analysis comprises of the social conditions, which encouraged spreading of hazardous behavior among financiers but also regular people not connected with finance. Some experts deny that ethics played any role in financial crisis. They affirm, that economy is based on solid facts and ethics is connected with values that are understood differently and that is why we cannot compare it or treat it equally. In economy the human being is supposed to act rationally in order to make economy go to its equilibrium. But if it is so, then the people must have acted irrationally and foolishly to make the markets go crazy and create financial crisis. But is it really so? Big impact on creating financial crisis had governments, which had “changed its moral position”3. Throughout the years many goals were accomplished by them such as fighting for freedom, equality, welfare etc. and that enticed the creativity and competition of people, who did not have clear purposes to achieve anymore. The same features became the main drive of financial crisis. The important thing was the change of citizens’ attitude towards the authorities. Citizens of more posh countries tend to give up partly their autonomy to get security from the State in return. The times have changed enormously and it is no longer about not sufficiently appeasing citizens’ needs; there came time of ‘the individual’, and we do not look at the society as a whole anymore. That means that the State should treat each unit as a different one with a particular expectations and requirements. We should be prepared for a new era of respective ‘new rights’ – diversified among society. Furthermore, emotions gains more significant role; citizens are willing to take social, collectivistic responsibility for the actions in order to avoid individual one, which ultimately shifts this responsibility to the State. The importance of ethics is changing, the values are no longer clarified; basically it all depends on the interpretation of individual. Let’s consider multinational society. In this sort of society there often are different respective demands that are not being met completely because of the variety of them. Everyone would want to have something to say and the politicians are not able to fulfill everyone’s needs, sometimes inconsistent with each other. In situations like this politics without the support of ethics has a little chance of existing. Another thing is, that new ways of social movements are being formed, such as gathering only to fight for a certain cause, rather than meet regularly. If we consider even part of this true, then the reason for a crisis would be not fulfilling the needs of citizens by the state; technical as well as moral. The effectiveness of next measurements is unsure and actually the causes of crisis cannot be attributed to external events but those which takes place among society “such as aging populations, the breakup of the homogeneity of cultural models, and even climate change”4 and also to their behavior. That leads us to another conclusion. The markets are not self-regulatory or self-sufficient, they need the State supervision. And it should be a technical and moral obligation of the State, considering the well-being of a citizen as well as the whole economy.

In conclusion, ethics cannot be separated from economics. The decisions made e.g. by politicians have both ethical and economical dimension. Considering the causes of financial crisis in entirely economic way makes us to omit very important events or errors that are significantly important. Thus, we should accept the role of ethics plays in finance (all three dimensions) to fully and completely understand it and also to prevent the occurrence of another crisis.

In the other article of my choice there are also presented some causes of financial crisis, although the attitude to this topic quite differs. It claims that the biggest trouble that triggered occurrence of financial crisis was the problems of US subprime market but that some financial institutions also carry the burden of it. The article presents main structural flaws that help generate the crisis.

geralt / Pixabay

The first mentioned is NFA (New Financial Architecture) – which “refers to the integration of modern day financial markets with the era’s light government regulation”5. NFA had very lax regulations that made it very enticing for the investors. The flaw was that it was based on unrealistic assumptions and its scientific foundation turned out to be really weak.

Let’s consider incentives. The broker gets fee income and that it his incentive to sell more of mortgages. Because they were free of consequences (they did not had to return fees if their mortgages create losses), they try to maximize the amount of loans and mortgages they sell in order to maximize their gains. The best sellers get the best bonuses, simple math. The bonuses of Goldman Sachs exceeded $16 billion and after bank disasters dropped only by 4.7%. Merrill Lynch received bonuses of $1 billion, despite losing about $27 billion. AIG paid around $220 million of bonuses after suffering a loss of $20.5 billion. The list goes on. The worst is that the firms presented here were not some mediocre companies, they were thought to be one of the best and still, their behavior seems irrational. The risk did not matter for them; the only thing that was important was the numbers.
The other flaw was thinking that the banks stopped being risky, because they sold all of their loans to capital markets in the new ‘originate and distribute’ banking model. There was also a belief, that banks hedged the risk remained through CDOs. Both of assumptions were false. Moreover, it was very attractive for banks to keep CDOs, because it “could be held off-balance-sheet with no capital reserve requirements”6.

When the sales of CDOs suddenly dropped, banks were left with enormous amounts of the securities that they could not sell or trade. The global issuance dropped from $177 billion to $20 billion in just one year – which is 84%. This resulted in huge losses of the banks and was one of the main forces in existing of the financial crisis. Actually, the accumulation of risky assets was stimulated partly by non-competent regulations. The actual loans had high capital requirements, so the banks rated many CDOs with AAA-ratings, so they would be more attractive to acquire. Unfortunately little did people know; the assets were risky, illiquid, long-term, with value that could change really quickly for worse. But the banks had financial incentives to keep at least some of the risky assets in order to create higher profits.

Conclusions:

The presented examples are just the tip of the iceberg, the deregulations and shady business goes on and on. Although just from this short text we could conclude that the basic and main cause of the financial crisis was bad measure of the risk that a bank or investor can take, too many badly constructed incentives for bankers, simply human ignorance. The article tries to present logical and technical causes but in fact we can see a big connection to the previous paper. For example, bankers who tried to maximize their profits by selling not profitable, risky assets were motivated by simple, human greed. In my opinion the first article is just a more thorough, psychological analysis of the causes that are presented e.g. in the second article. I totally agree with the author of the first paper; we can’t look at the financial crisis and not see the connection with human nature. The emotions, feelings that drive the behavior are as much important as the models we use. I think that to fully understand not only the causes of financial crisis but the whole economics, we should embrace the occurrence of an ethical, emotional part of it; people are the ones that establish economics and if we create it, how can it not contain our nature?

Further Reading:

https://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008

Sources

  1. “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña, p. 2
  2. “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña, p. 3
  3. “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña, p. 7
  4. “Three Ethical Dimensions of the Financial Crisis” by Antonio Argandoña, p. 9
  5. “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’” by James Crotty, p. 3
  6. “Structural causes of the global financial crisis: a critical assessment of the ‘new financial architecture’” by James Crotty, p. 32