The Culture of Risk
By
Raphaële Chappe*, Edward Nell** and Willi Semmler†
New School for Social Research, New York
I.
Introduction
Economists tend to study human interactions and the decision-making process abstracted from
culture. For instance, generally speaking microeconomic models of human behavior assume fixed
individual preferences and pay little attention to the role played by the cultural environment in
shaping those preferences. Yet some economists have not ruled out culture from their scope of
analysis, and have taken seriously the role played by culture in economic behavior. Veblen, for
instance, highlighted the limitations of the neoclassical modeling of individual preferences, its
neglect of social norms and inability to encompass evolutionary processes (Veblen, 1898).
Veblen’s critique focused on the static picture promoted by the neoclassical paradigm, with homo
economicus a passive calculator of pleasures and pains bearing “neither antecedent nor
consequent”, operating in “an isolated definitive human datum, in stable equilibrium except for the
buffets of the impinging forces that displace him in one direction or another”. (Veblen, 1898).
Instead, Veblen advocated for an approach that would understand human activity as an ongoing
process both shaped by and shaping human tendencies and dispositions:
He is not simply a bundle of desires that are to be saturated by being placed in the path of
the forces of the environment, but rather a coherent structure of propensities and habits
which seeks realisation and expression in an unfolding activity. According to this view,
human activity, and economic activity among the rest, is not apprehended as something
incidental to the process of saturating given desires. The activity is itself the substantial
fact of the process, and the desires under whose guidance the action takes place are
Economics Department, New School University, New York, and former attorney with Goldman Sachs,
chapr057@newschool.edu.
*
**
Economics Department, New School University, New York, NellE@newschool.edu
Economics Department, New School University, New York and Center for Empirical Macroeconomics, Bielefeld
University, Germany, semmlerw@newschool.edu
†
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circumstances of temperament which determine the specific direction in which the activity
will unfold itself in the given case. (Veblen, 1898).
In this paper, in line with Veblen’s argument, we develop a cultural approach to understanding
individual interactions on Wall Street. More specifically, we argue that the cultural environment
played a critical role in leading to the 2007-2008 financial crisis. The existence of cyclical financial
crises is explained by economists in terms of many different factors, including the macroeconomic
environment (low interest rates, external imbalances, etc.), deregulated markets, leverage cycles
and credit expansion, asymmetric information, “animal spirits”, “irrational exuberance” and other
psychological and behavioral explanations. Analyses of the recent financial crisis have focused on
the leverage cycle in the housing and mortgage securities, liquidity spirals, the macroeconomic
environment of low interest rates and external imbalances, and the unbalanced international
financial flows. Yet we believe that the cultural environment on Wall Street is an important factor in
predetermining decisions of market participants -- at the meso level of decision-making (rather than
from a micro or macro perspective).
In a broad sense, the notion of culture in a sociological or anthropological framework describes a
set of commonly shared attitudes. Culture can be thought of as a process or as a state (Jackson,
2009). As a process, culture can help explain the evolution and reproduction of social behavior and
institutions. As a state (way of life, the arts), it focuses on the final products of cultivation at the
social level. When conceived as a process, culture is more significant for economic and other
social analysis to the extent it can shed light on the relations between individuals and society
(Jackson, 2009: 22). In this paper we put forward the notion of the culture as a process whereby a
set of values collectively shared by influential market participants and Wall Street employees
(transmitted through the social environment at the firm or market level) have evolved over time
from a relatively risk-averse environment (which we refer to as the culture of trust) into a very
aggressive environment which has come to encourage speculative and reckless risk-taking (which
we refer to as the culture of risk). We argue that the culture of risk is partly responsible for the
breakdown in financial markets experienced in the 2007-2008 financial crisis. As such, it has
completely betrayed the social role of financial markets, which is to efficiently allocate capital so as
to promote rather than stifle economic growth. To understand culture as a process, we should be
asking why and how this change came about.
We draw from the risk society literature to develop a systematic analysis of the culture of risk.
Modernity is characterized by the emergence of new forms of risk. Businesses have looked to
financial markets to solve real problems by financial means, which has led to a massive
commodification of risk and the development of a whole new range of financial products enabling
the pricing and trading of risk. Playing a central role in the design and marketing of such products,
financial institutions have emerged as expert systems, with expertise in risk management. Yet the
recent financial crisis has been characterized by a widespread failure of the internal risk
management models used by many financial institutions. We suggest that this failure is in part
attributable to a misguided heavy reliance on calculable, probabilistic views of the future. The
culture of risk, in our sense, is characterized by an inability to recognize the existence of radical
uncertainty, and the widely shared overconfident view that all forms of risk can be managed. The
commodification of risk has in turn led to an increase in risk and uncertainty, with a financial system
characterized by increasing complexity. This process is reflexive in nature, with the very reliance
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on financial experts creating more complexity, more uncertainty, and new forms of global risks,
including systemic risk.
We first identify the role played by financial engineering in creating complexity and new forms of
manufactured risk in financial markets (Section II). We discuss the failure of risk management
systems and controls used in the financial industry evidenced in the 2007-2008 crisis, and the role
played by the marginalization in mainstream economics of the concept of uncertainty (Section III).
We suggest that the scientific promise of risk management was actually a convenient justification
for large risk-taking, and that there were in fact incentives to turn a blind eye to the possibility that
risk was improperly understood and managed. Wall Street came to view large risk taking as the
norm under the pressure of some structural shifts in financial markets -- with the rise of proprietary
trading, the end of the partnership culture, and a transition to a compensation structure based on
risk-unadjusted measures of firm profit (Section IV). With the dominance of risk analysis operating,
at the policy level, to diverge attention from our radical ignorance about the future, policy-makers
chose to deregulate markets. Along with deregulated markets came organized irresponsibility and
the absence of clear causality leading to individual liability (Section V).
Though undesirable cultural features do not lend themselves well to quick fixes, we argue that the
dangers posed by the prevalence of the culture of risk cannot be ignored and beg for a collective
discussion on what policy measures could restore common sense and accountability to Wall
Street. Rather than take the narrow view that the recent financial crisis is the result of yet another
bubble, that we must patiently wait for the economy to recover, and that the issues at hand
involved technical details of complex financial products to be debated solely amongst experts, we
suggest that we take this opportunity to acknowledge the social, legal and economic implications of
the shift to the culture of risk.
II. The End of the Culture of Trust and the Commodification of Risk
The Culture of Trust
In the 19th Century and early 20th Century the main image of the banker or financier was that of
the ‘trustee’, who was the prudent and scrupulous manager of other people’s money, someone
who could be trusted, and who was wise, rather than smart, farsighted and reliable, taking a long
view and planning carefully and conservatively for the future. We could expect such a person to be
politically conservative, but this would be a traditional conservative in the old-fashioned sense,
celebrating the staid and quiet values of community and hierarchy – “a place for everything and
everything in its place” – not the disruptive uproar of radical individualism.
Of course, there were plenty of speculators then; indeed, con-men and frauds abounded. But, in a
sense, they were on the fringes, on the edges of the system. The culture of trust espoused the
values of prudence and thrift, along with hard work, careful foresight and good judgment. Going
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into debt should not be undertaken lightly; debts should be paid on time, promises should be kept,
and one’s reputation must be protected and preserved. In the culture of trust, you see your banker
as the person to whom you entrust your money, your savings. Banks can be trusted. And this has
an important economic consequence: the commercial banking system is able to provide the greater
part of the money supply in the form of bank deposits, and/or bank notes, in place of government
paper money.
The culture of trust was suited to an economy made up of a large number of privately held family firms,
operating small-scale technologies; in these conditions the main issue in finance consisted in finding
suitable and safe placements for household savings. Investment was financed by lending or by issuing
bonds; equity markets were still small. But the economy changed as small family firms grew into or
were displaced by large oligopolistic corporations operating mass production systems. The
development of family firms into modern corporations was accompanied by higher levels of complexity
in financial markets. First, as compared with the family firm of the craft economy, corporations need
more sophisticated forms of financing -- commercial paper, credit for working capital, financing for fixed
capital, and stocks. Companies tended to retain and reinvest earnings, so that stocks are held for
appreciation and capital gain as opposed to dividends (Nell, 1998: 265). Capital funds were in search
of the highest return, creating arbitrage with the bond markets. Second, the level of profits were a key
determinant of the system behavior, and it is mainly determined by the structure of aggregate
investment. Investment takes place now because of the expectation of future investment and profits.
Third, bankers were essentially characterized as merchants of debt:
“The financial instability hypothesis takes banking seriously as a profit seeking activity. Banks
seek profits by financing activity and bankers. Like all entrepreneurs in a capitalist economy,
bankers are aware that innovation assures profits.” (Minsky, 1993: 6)
The picture that we see emerge is a profit-driven economy that relies heavily on investment, and a
need for financing that has generated a financial system characterized by complexity and
innovation. Further, with the rise of mass production and a global interconnected economy,
success became dependent on the ability to take on new forms of risk. Recent developments in
social theory have placed risk at the center of the discussion on modernization and globalization.
The change from external, or natural risks to manufactured risks is well described in the work of
German social theorist Beck on risk society (Beck, 1992) or Giddens’s work on modernity (1990).
The accelerating pace of technological innovation and scientific discoveries has led to an increase
in risk and uncertainty. We can identify four new, global, real hedging problems for corporations: 1)
hedging foreign exchange risk, 2) hedging inflation risk, 3) hedging risk that new technologies will
not work, that new markets and products will not develop as expected, and 4) hedging risk of
setting up operations in new political environments. New business opportunities hinged on the
willingness to take on these new forms of risks. Successful businesses are successful risk-takers.
The response to the emergence of new risks was to try to solve real problems by financial means –
buying fire insurance instead of rewiring the house. In each case financial hedging may be useful,
but it is easy to see that a real solution would be better, although it might be out of reach as a
practical matter in the here and now. The claim that these risks could be managed privately by the
market fit very well with free-market ideology, and not coincidentally, offered a whole new field of
enterprise for financial firms. Based on this claim, the business of finance developed to provide
4
large corporations hedging products and solutions. This offered a whole new field of enterprise for
financial firms, as there was lot of money to be made (… and lost, too, though few in the financial
world admitted that at the time) through pricing and selling off risks.
The Commodification of Risk: Explosion of Derivative Markets, Financial Innovation and
Trading Volume
The full-scale commodification of risk began in the 1980s. The 1980s was a decade of financial change
and bull markets. High-tech stocks emerged with the appearance of new technologies, such as the
personal computer industry, software entrepreneurs, and biotechnologies. Merger activity and
leveraged buy-out reached record levels. In addition to derivatives, new financial products were being
created, for example high-yield bonds, also known as “junk bonds”, which became widely popular with
investors (junk bonds eventually collapsed in the late 1980’s, and charges of insider trading were
pressed against top managers). Wall Street firms started to rely more heavily on program trading to
handle the large volume of trading and the mathematical complexity of instruments. But the real
commodification of risk really started with the explosion of derivative markets.
Derivatives can be used to transform the underlying economic risk or exposure of a security, for
example by allowing investors to structure different payoffs or cash flow patterns. The term “derivative”
indicates that the value of the financial instrument is derived from the value of an underlying instrument
(the reference value is referred to as the ‘notional principal amount’). Derivatives are priced in
accordance with expectations formed regarding the value of this underlier. This allows for the risk of
change in the value of the underlier to be priced and traded. For example, companies can reduce their
exposure to currency fluctuations by entering into a currency future, a contract in which parties agree to
exchange currencies at a set exchange rate on a given future date. Both parties achieve certainty
about the future exchange value of a currency (the certainty of not losing money), at the cost of giving
up the chance of a gain if the rate evolved in their favor. Futures can also exist with other underliers,
such as commodities. Options differ from futures in that they give the buyer (call option) or seller (put
option) the right but not the obligation to enter into the future transaction.
In 1973, Fischer Black and Myron Scholes developed a mathematical model to price options. While
options had always been traded, the existence of a mathematical model ensured some level of
consistency and rigorousness that allowed for a higher degree of precision. Following the development
of the Black-Scholes option-pricing model, options became an essential tool in modern portfolio
management, and derivatives markets exploded (the fact that many derivatives could be privately
negotiated outside of any regulated trading platform further accentuated the growth of the industry).
The Black-Scholes pricing model allowed for the development of more complex derivatives. This
resulted in the creation of a myriad of new financial instruments to allow for different types of risk
(related to different underliers such as equity, currency, interest rates, credit default) to be traded and
reallocated to market participants. Credit default swaps (CDSs), for example, played a key role in the
recent financial crisis. CDSs are essentially a form of insurance against default risk, whereby the CDS
buyer makes premium payments (the CDS “spread”) to the protection seller who agrees, in exchange,
to pay the principal amount owed by a reference entity in the event of a default event.
5
Risk can also be outsourced with securitized products, also financial derivatives in that their value is
derived from underlying assets. The securitization process allows for the creation of securities backed
by a pool of risky mortgages and loans, whereby each security (or “tranche”) entitles investors to a
share of the cash flow produced by the underlying assets, mortgages or loans (both interest and
principal). The recent housing boom was financed with credit derivatives and securitized products,
resulting in a huge issuing of Mortgage Backed Securities (MBSs) and Collateralized Debt Obligations
(CDOs) that helped to outsource risk. In short, MBSs derive their values from underlying mortgages
assigned to a Special Purpose Vehicle (SPV), an entity designed to hold the pool of mortgages. To the
extent that risky mortgages are pooled together, investors are exposed to the risk profile of the total
pool rather than individual assets, and the risk of default is diluted. Different tranches carry different
priorities of repayment, thus re-assigning the risks into different classes, and are priced accordingly.1
During the housing boom, securitization allowed for fairly illiquid high-risk assets to be packaged
together and converted into securities with different risk profiles, including securities that obtained very
good ratings (AAA) from the rating agencies. Financial institutions derived fees from the engineering
and marketing of such products (the “originate and sell” model), with the possibility of earning low risk
profits, rather than retaining the products on their balance sheets and putting their own capital at risk.
It is no surprise that this high degree of financial innovation was accompanied by an inexorable
increase in trading volume. By the end of the 1990s, over a billion of shares were traded on a daily
basis on both the NYSE and the NASDAQ. In contrast, record trading 20 years before would have
amounted to a mere 70 million shares per day (Geisst, 2004: 368). Today a large fraction of trading is
actually executed by computer algorithms designed to capture trading opportunities that exist only for
fractions of seconds. This is known as “high-frequency trading”, and involves moving in and out of
positions several times each day, with models placing trades on the basis of live streaming market
data. High frequently trading really took off after the Securities and Exchange Commission (SEC)
authorized electronic exchanges in 1998, and accounts today for about two-thirds of U.S. stock-market
volume (Wall Street Journal, 2010). The rising use of computers and algorithms to trade stocks is
arguably a source of liquidity to markets, but high-frequency trading may also create vulnerability to
technical glitches. The “flash crash” on May 6, 2010 is one example of such potential market
disruptions. With no warning signs, automated trades caused the Dow Jones Industrial Average to
suddenly plunge 9 percent and recover within minutes.
The derivatives market has seen explosive growth in the past decades, empowered by sophisticated
computers programs allowing for the pricing and trading. The total notional value of Over-The-Counter
(OTC) derivatives traded in the G10 countries as of the end of December 2010 is roughly $600 trillion,
with the value of the instruments being traded around $21 trillion.2 Generally speaking, market values
rather than outstanding notional amounts are a better measure of the riskiness or credit risk exposure
The regular interest payments from those mortgages are income to the SPV. Different tranches are assigned to
investors with appropriate attachment points. If the number of defaults remains below the lower attachment point, the
investors in that level simply collect the pre-arranged premium. However, once the percentage exceeds the lower
attachment point, defaults are paid out of the capital posted by the investors of that tranche. Once the upper
attachment point is reached, the next tranche takes over since the lower tranche is effectively exhausted. Investors in
the MBS will demand compensatory interest commensurate with the assumed default risks and recovery values.
These are paid with the interest income from the mortgages. The difference between the two cash flows is profit to the
SPV investors. As long as it is profitable to construct these instruments, liquidity in the mortgage market will only be
limited by the default probabilities, the recovery values, and the rates obtainable elsewhere.
2 As per the Bank for International Settlement, statistics at end-December 2010.
1
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associated with OTC derivatives, since notional principal amounts greatly exceed the amounts
potentially owed under the instruments. However, derivatives can also have a leveraging effect,
whereby they multiply gains and losses and the potential total liabilities in financial markets. For
example, investors can buy and sell CDS without owning any debt of the reference entity. These are
called “naked credit default swaps” (in essence speculating on the creditworthiness of reference
entities) and constitute most of the market in CDS (as much as 80 percent). This explains how the CDS
market grew to an astonishing notional value of $62.2 trillion in 2007. CDS do not simply manage the
risk of default, they also paradoxically increase the overall credit risk exposure in the system in that a
single default event can trigger liabilities between CDS counterparts that are a multiple of the
underlying debt of the reference entity.
III. The Triumph of ‘Risk’ Over ‘Uncertainty’: The Failure of Risk Management in the
Financial Sector
As a direct consequence of this rising complexity and interconnectedness, there has been a
significant increase of new forms of manufactured risk – financial manufactured risk. This created
risk environment is one of the defining characteristics of Beck’s risk society3, and the analysis is
directly applicable to the capitalist economy viewed as a complex financial system. Minsky (1993)
noted that the modern capitalist world is characterized by:
“an increasing complexity of the financial structure, in connection with a greater
involvement of governments as refinancing agents for financial institutions as well as
ordinary business firms (both of which are marked characteristics of the modern world)
[which] may make the system behave differently than in earlier eras”. (Minsky, 1993: 4-5).
What Minsky is referring to here is increasing institutionalized financial complexity, resulting from
layers of intermediation between investors, the ultimate owners of wealth, and the units that control
and operate that wealth (firms). Due to the explosion in trading volume and the high degree of
financial innovation, financial markets and products (instruments of financial intermediation) have
become increasingly complex. Giddens (1999) gives the example of Barings Bank, which collapsed
as a result of the unchecked activities of rogue trader Nick Leeson. Giddens makes the point that
such rogue traders “are involved with systems which even they themselves do not understand, so
dramatic is the onrush of change in the new electronic global economy.” (Giddens, 1999: 2).
Recent social theory dealing with modernity has focused on the increase of new forms of risk, and
shared risk as a social challenge. In Giddens’ analysis, a distinctive feature of modernity is the
‘disembedding’ of social systems, a mechanism defined as “the ‘lifting out’ of social relations from
The dark dimension of this development, in Beck’s analysis, is the idea that risk may have emerged as a threat to
human civilization itself. Ecological risk, for example, threatens the entire planet and in that sense, transcends any
conflict between social classes (Beck, 1995). Financial risk of course is not a direct threat to human civilization, but
there is a real possibility that it might be a threat the sustainability of capitalism, as financial crises become more and
more severe.
3
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local contexts of interaction and their restructuring across indefinite spans of time-space.”(Giddens,
1990: 21). This mechanism entails a high degree of abstraction by “removing social relations from
the immediacies of context” (Giddens, 1990: 28). Giddens distinguishes two types of disembedding
mechanisms, the creation of symbolic tokens (such as money), and the establishment of expert
systems (systems of technical accomplishment or professional expertise). Modern societies require
individuals to place a high degree of ‘trust’ in both institutions. In environments of risk, these
institutions are entrusted to manage and reduce risk. Here we would like to argue that financial
institutions have emerged as expert systems, with expertise in risk management. Risks were not to
be avoided or minimized, they had to be actively managed. Taking risks had now become the route
to high rewards. For this purpose, the field of financial engineering was developed to design new
financial instruments and strategies through the use of advanced mathematical tools and models.
As we discussed, in recent decades the financial sector saw increased productivity and financial
innovation at an astonishing pace, and the commodification of risk at a massive scale.
Risk management is firmly based on advances in academic work – in business, finance and
economics. First, the Efficient Markets Theory tells us that free markets will always price things
correctly. Second, Black-Scholes and associated equations provide formulas for pricing risks.
Finally, developments in time series econometrics make it possible to apply these insights to real
time market activities. All of this is based on the idea that risk is something that can be quantified
and priced, that the future can be made predictable with probabilistic calculations. This is the notion
of risk as fundamentally different from real uncertainty.
In economics the distinction between risk and uncertainty was first explored in Frank Knight’s Risk,
Uncertainty and Profits (1921/1940). Knight distinguishes between forms of indeterminacy that are
predictable and lend themselves to probabilistic calculation (risk), and forms of indeterminacy that
entail an inability assign probabilities to various potential outcomes of a given situation (this could
be because it is impossible to identify all possible outcomes, or because although all event
alternatives are known, probabilities cannot be computed). We could further distinguish between
two kinds of uncertainty, which David Dequech identifies as ambiguity and fundamental uncertainty
(Dequech, 2000). Ambiguity refers to situations where uncertainty exists only to the extent existing
relevant information is missing. Yet the information exists at the time the decision is made, and if it
were known, the situation would be characterized by risk rather than uncertainty. Fundamental
uncertainty is altogether different in essence to the extent that the relevant information simply does
not exist at the decision time. Under fundamental uncertainty, some essential information about
future events does not exist and cannot be inferred from any data set (Dequech, 1999).
John Maynard Keynes was the first economist to grasp the full significance of radical uncertainty
for economic analysis. Keynes was particularly interested in the behavior of investors, consumers
and businessmen. Much of their actions, he argued, were driven by ‘animal spirits’ – ideas and
attitudes very much determined by intangible psychological motivations (this has inspired the title
of a recent book by George Akerlof and Robert Shiller, Animal Spirits: How Human Psychology
Drives the Economy, and Why It Matters for Global Capitalism). Events determined by human
decisions are fundamentally different than say the outcomes of a game of roulette, and do not lend
themselves to the calculation of probabilities. To the extent such events (such as wars, inventions,
investment decisions, or even changes in prices and interest rates) have economic significance
and are by their very nature radically uncertain, the reliance on probabilistic calculus to form
expectations of the future is tempting yet mistaken and unscientific:
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“The orthodox theory assumes that we have a knowledge of the future of a kind quite
different from that which we actually possess. This false rationalization follows the lines of
the Benthamite calculus. The hypothesis of a calculable future leads to a wrong
interpretation of the principles of behavior.” (Keynes, 1972: 122).
Yet mainstream economists have not embraced the notion of radical uncertainty as being
indispensable to understand the world. The notion of calculable risk has permeated the field, and
there has been a triumph of risk over uncertainty (Reddy, 1994). In the second edition of Theory of
Games and Economic Behavior (1947), J. von Neumann and O. Morgenstern formally incorporated
risk into economic theory with the concept of ‘expected utility theory’.4 Expected utility is risk-based
in that it assumes a well-defined event space with known probabilities. This gave rise to a whole
new range of risk analysis problems, techniques and models, all of which assume risk to be well
defined and disregard the practical consequences of the future as being uncertain.
The only critics were outsiders to the economics profession, heterodox economists or practitioners.
For example, George Soros has repeatedly warned that the general theory that markets tend
towards equilibrium is flawed to the extent financial markets do not merely discount the future but
also help to shape it by affecting the fundamentals they are supposed to reflect (Soros, 1994).
Based on his analysis of this self-reinforcing mechanism in markets, Soros developed his theory of
reflexivity. The theory, which deconstructs the notion of objective market fundamentals, is
damaging to the claim that the future can be entirely managed with probabilistic computations, and
that radical uncertainty can be completely eliminated. Post-Keynesians have developed their own
alternative theories of how financial markets operate, to explain the erratic behavior of financial
markets, and the amplitude of price swings in boom and bust cycles. Minksy’s financial instability
hypothesis (presented as an interpretation of the substance of Keynes’ General Theory) posits that
the economy has financing regimes under which it is stable (the efficient market hypothesis would
roughly hold), and financing regimes under which it is not.5 There will be a natural tendency for the
economy to transition from a stable system into an unstable system, giving rise to boom and bust
cycles.6 (Minsky, 1993). This inherent instability of financial markets is also difficult to reconcile with
measurable risk and the future consisting of known outcomes and probabilities.
Under expected utility theory, a lottery is defined as a list of outcomes with assigned probabilities. The notation (x, p)
is used to denote the prospect (x, p; 0, 1-p) that yields x with probability p and 0 with probability 1-p. Expected utility
provides that:
4
.
The overall utility of a project is the expected utility of its outcomes, thereby applying the expectation operator of
probability theory to lotteries.
5 Minsky distinguishes three distinct financing regimes. Hedge finance is a situation where cash flows can fulfill all
payment obligations (interest and principal). Typically, hedge finance is associated with reasonable debt to equity
ratios. Speculative finance involves situations where income cash flows do not support repayment of principal.
Liabilities are typically rolled over – examples of this could include governments with floating debts, or corporations
with floating issues of commercial papers. Finally, ponzi finance entails an inability to cover both interest and principal
payment obligations with operational cash flow.
6 Over periods of prosperity, speculative and ponzi financing will naturally increase under the pressure of monetary
constraint (such as that resulting from the Central Bank’s attempt to keep inflation under control): driven by their own
profit-seeking objective, bankers (using the term generically for all intermediaries in finance) will strive to innovate.
However, cash flow shortfalls will lead firms to cover their positions by selling assets, eventually leading to a collapse in
asset values.
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The recent financial crisis has been characterized by a widespread failure of the internal risk
management models used by many financial institutions. The risk officers of the failing institutions
relied heavily on such models, and were for the most part claiming that risk management and
stress testing systems in place for thousands of trading positions (of mind-boggling complexity)
were well under control. Quoted in Business Week (2006) just before the 2007-2008 crisis, Bear
Stearns chief risk officer Michael Alix asserted that “the machine works”, and Lehman’s Chief
Administrative Officer David Goldfarb that “we are in the business of risk management 24/7, 365
days a year". Such confidence was obviously misplaced. The failure of Bear Stearns, triggered by
the collapse of two internal hedge funds that had heavily invested in CDOs and went bankrupt in
Summer 2007, perfectly illustrates how financial institutions took large risks they did not fully
understand when investing in complex products, and how enormous risk taking became the norm
on Wall Street. Credit Rating Agencies (CRAs) also did not properly assess the risk profile of new
products (e.g. structured and securitized products, credit derivatives) and gave favorable ratings to
CDOs that turned out to be quite risky. While investments holding AAA ratings traditionally have
had a less than 1 percent probability of default, analysts have determined that over 90 percent of
AAA ratings assigned to MBS and CDO securities issued in 2006 and 2007 had to be downgraded
to junk status shortly thereafter (U.S. Senate, 2011).
Why did internal risk management fail so spectacularly? The triumph of the claim that risk can be
managed, and the failure to acknowledge that the future is to a large degree uncertain has been
one of the contributing factors to this failure. The world is not as straightforward as a game of
roulette and does not lend itself to simple probabilistic calculations:
“Manufactured risk refers to new risk environments for which history provides us with very little
previous experience. We often don’t really know what the risks are, let alone how to calculate
them accurately in terms of probability tables.” (Giddens, 1999: 4)
For example, in the case of MBSs, complex phenomena such as default correlation (i.e. the possibility
that different mortgages might not be independent of each other, whereby one mortgage defaulting
increases the chance of another mortgage defaulting) were important drivers in pricing of securitized
products, yet they were not properly understood nor modeled. Further complications can be introduced
in asset-backed securitized products by mixing different risky assets of different types, taking more
complex positions within the tranches, and by investing in multiple products. All of this is usually
simulated with computers, which can keep track of the details. However, once mortgage delinquency
rates rose, senior tranches of securities were much quicker to lose value than anticipated. Original
pricing did not correspond to the true risk profile given default correlation, leading to sudden and
unanticipated losses in value.
There are also serious limitations to the current theoretical approaches to risk management.
Generally speaking, models are based on a historical simulation of past risks and returns, and
make simplifying assumptions about the real world, such as normal distribution of returns. This is
true of mortgage deficiency simulations for MBSs. This is also true of Value at Risk (VaR), the main
tool for banks’ internal risk management, which is designed to estimate the expected maximum
amount that could be lost on bank’s portfolio as result in changes in prices of underlying assets essentially how much the portfolio can lose with a given probability (95 percent or 99 percent) over
a stated time horizon. There are many conceptual problems with the approach. First, it is
10
backward-looking in nature, based on a historical simulation of past risks and returns, which does
not embrace the inherent uncertainty of future returns (there is no guarantee the future will
resemble the past…). Second, VaR does not seek to give the magnitude of the amount that will be
lost the rest of the time (events with a low probability, e.g. 5 percent or 1 percent). Hence investors
get lulled with a false sense of security, ignoring “abnormal” events. One example (given in
Business Week, 2006) is the estimate by JPMorgan Chase & Co. in its 2005 annual report that
trading portfolios were at risk of losing $88 million on any given day. The amount seems negligible,
but a closer look at the annual report would have indicated the possibility that the amount at risk
could increase to a staggering $1.4 billion over a four-week period – not so negligible after all. Yet
because of its relatively low probability, this risk would stand to be unnoticed. Third, VaR
conveniently assumes a normal distribution of returns, despite evidence to the contrary. This
assumption has led to the discarding of fat tails, i.e. the possibility that rare events might not be as
unlikely as previously thought. For all these reasons, critics of VaR, such as Nassim Taleb, have
argued that it is no more than an alibi that bankers give shareholders (and potentially the bailingout taxpayer) to show documented due diligence regarding risk-taking.
Thus at a theoretical level, VaR arguably does not adequately capture the risk profile of financial
institutions. Other tools of modern finance, such as CAPM, the Efficient Market Hypothesis, and the
Black-Scholes model are also based on the assumption that market prices are normally distributed,
and as such are equally flawed in their approach. Mathematician Benoit Mandelbrot and others
have been working to develop more robust theoretical foundations of market behavior that would
abandon the normalcy assumption and allow for the possibility of fat tails.7 While Mandelbrot’s
approach (based on fractal geometry) has launched a new field of study in finance and risk
management, it has not yet led to a robust workable theory of market behavior. Further, any such
theoretical framework would still be subject to the epistemological problem (highlighted by Soros in
his theory of reflexivity) that investor reliance on the model could alter forecasted behavior.
New investment vehicles (e.g. hedge funds) are also in dire need of some new risk metrics. One
issue is that the traditional risk measures of alphas, betas and Sharpe ratios are static in nature
(i.e. based on return distributions at a given point in time). Hedge funds may display nonlinearities
and non-normal characteristics that are not captured by linear regression models.8 A new set of
risk analytics designed to address the unique features of hedge fund investments is being
developed9, but the risk literature shows that we are far from fully understanding and quantifying
risk for actively managed investments.
Another problem is that risk management has become homogenous. Professionals tend to use the
same models learned at the same schools. The models are based on the same information (historical
data) and methodology, essentially reflecting the same view of the world. In the mid 1990s, CRAs
See for example Mandelbrot and Hudson (2006).
For example, Brooks and Kat (2002) have found that published hedge fund indexes exhibit high kurtosis, indicating
that the distribution has “fat” tails. Examining data from the Tass database from 1995 to 2003 for various hedge fund
categories, Malkiel and Saha (2004) have confirmed that hedge fund returns are characterized by high kurtosis and
that many hedge fund categories have considerable negative skewness, implying an asymmetric distribution. The
shape of the probability distribution of returns affects the Sharpe ratio. For example, Bernardo and Ledoit (2000) show
that Sharpe ratios are misleading when the shape of the return distribution is far from normal.
9 Lo (2008a) has proposed new measures of performance that capture both static and dynamic aspects of decision
making on the part of the hedge fund manager.
7
8
11
started disclosing their rating models (the application software) to banks. For example, in 1995
Standard & Poor developed its LEVELs model, a statistical-based approach to determining losses
expected on a given bond. The version of the model was subsequently made commercially available to
investment banks and securities originators.10 This led to further homogenization as financial products
could be designed with those specific guidelines in mind (so as to secure targeted ratings) rather than
on the basis of an independent risk assessment.
What we have established thus far is that the increasing complexity of financial markets in terms of
trading volume, interconnectedness and financial innovation has led to the emergence of new forms of
risks – financial manufactured risks. While financial institutions have positioned themselves as experts
in risk management, the 2007-2008 financial crisis shows that many institutions took very large risks
they did not fully understand, and to a large extent, relied on flawed risk models. Risk management
tools gave investors and shareholders the illusion of controlled risk taking. One main characteristic of
what we label the culture of risk is the excessive reliance on statistical tools that assume probabilizable
risk, the failure to acknowledge that the future is to a large degree uncertain. In the Culture of Risk, risk
is not properly understood nor managed, in spite of claims otherwise and academic advances in
business, economics and finance.
Yet there is something more perverse taking place here. The claims to expert knowledge on the
part of the financial sector have actually increased risk. In Giddens’ analysis, a key characteristic of
modernity, ‘reflexivity’ is characterized by the fact that “social practices are constantly examined
and reformed in the light of incoming information about those very practices, thus constitutively
altering their character.” (Giddens, 1990: 38). This occurs at the level of social institutions to the
extent institutions entrusted to manage social risk are not detached from social relations, and can
influence the very events they are analyzing:
“The reliance placed by lay actors upon expert systems is not just a matter – as was
normally the case in the pre-modern world – of generating a sense of security about an
independently given universe of events. It is a matter of the calculation of benefit and risk
in circumstances where expert knowledge does not just provide that calculus but actually
creates (or reproduces) the universe of events, as a result of the continual reflexive
implementation of that very knowledge.” (Giddens, 1990: 84).
The reflexivity of social institutions can help understand how financial institutions and markets can
themselves become a new source of risk to the extent their claim to manage risk actually increases
risk (Reddy, 1996: 243). We see this very mechanism at work in financial markets, as complex
securities, which were supposed to outsource and diversify idiosyncratic risk, have actually
accelerated the boom and subsequent collapse.11 Those innovations provided the underlying
See U.S. Congress (2008a), testimony of Frank Raiter.
The recent crisis can be analyzed in the light of the combination of two leverage cycles, both in the housing sector
and in the market for these complex securities. Geanakoplos and Farmer (2009) develop models to explain the double
leverage cycle, in the housing and securities sectors, and conclude that the introduction of CDS contracts into the
mortgage market in late 2005 was an important trigger for the collapse of 2007-2009. Semmler and Bernard (2009)
propose a baseline model that replicates financial market boom-bust cycles and demonstrates the magnifying effects
arising from the pricing of the new financial market instruments.
10
11
12
financial intermediation mechanism through which the asset price boom and busts were fueled. 12
We find that the explosion of new financial products designed to offer market based solutions to an
increasingly complex and global world actually tends to increase the overall risk of the system. In
Risk Society, Ulrich Beck highlights that “along with the growing capacity of technical options grows
the incalculability of their consequences” (Beck, 1992: 22). Financial engineering increases
complexity and radical uncertainty such that managing individual risk, on a widespread scale,
increases rather than reduces systemic risk. The term “systemic risk” is used to describe the
possibility that the failure of one financial institution can disrupt the financial system as a whole
through a series of correlated defaults, if there is enough interconnectedness between financial
institutions. The collapse of Bear Stearns’ internal hedge funds in 200713 illustrates that investment
activities conducted by hedge funds have the ability to destabilize the economy and increase
systemic risk.
The first characteristic of the culture of risk, as we have just outlined, is an epistemic fallacy, the
widespread claim that risk can be quantified and managed. The flawed assumption of normal
distribution of data has made risk models particularly vulnerable to unpredictable and
consequential events (which Nassim Taleb has dubbed “black swans”). As noted by Beck, “in the
risk society the unknown and unintended consequences come to be a dominant force in history
and society” (Beck, 1992: 23), a remark equally applicable to financial markets. Nassim Taleb’s
entire book The Black Swan (Taleb, 2007) is devoted to this very point, and advocates for a greater
degree of humility on the part of risk experts. In spite of claims to the contrary, in the culture of risk,
risk-taking is not controlled nor managed. It is also reflexive in nature, with the very reliance on
financial experts creating more complexity, more uncertainty, and new forms of global risks,
including systemic risk.
IV. Are There Real Incentives To Manage Risk?
The critical question remains as to why risk managers and Credit Rating Agencies relied on flawed
models. Were they simply not aware of their theoretical limitations, or did they choose to ignore
these issues? To some extent, this reliance can be explained by the appeal of the scientific
promise of calculable risk. The claim that risk can be quantified and managed is a move "against
the gods" (Bernstein, 1998), inherently connected with the aspiration to control fate. Yet we argue
that financial institutions also lacked real incentives to properly manage risk. Three simultaneous
and related trends explain what incentives led to the gradual shift in attitudes towards risk taking on
the part of financial institutions, and the prevailing willingness to take on large risks that were not
Liquidity spirals emerged as a result of underlying self-reinforcing feedback mechanisms. The tightening of margins
led to lower security prices, which slowed the issuance of new mortgages and adversely impacted homeowners’ ability
to refinance. This in turn increased default risk, thereby making downpayment requirements more stringent, reducing
demand for housing, making housing prices fall and thereby further increasing security margins, prompting the whole
sequence to repeat.
13 The Bear Stearns funds had heavily invested in CDOs and hoped to make big returns from the flourishing housing
sector. As mortgage default rates increased, top-tranche mortgage backed securities suddenly declined in marketable
value to become “toxic” assets.
12
13
fully understood: first, commercial banks and investment banks coming to rely on proprietary
trading to generate a greater and greater fraction of revenue; second, the end of the partnershiptype organizational structure for the major Wall Street firms; and third, the compensation structure
rewarding traders for indiscriminate growth in revenue at the expense of the risk profile of the
institution. With firms going public and heavily engaging in proprietary trading, top traders were
now aggressively investing shareholder’s funds rather than their own, taking on risks that would
maximize their own remuneration in the short run rather than firm value in the long run. As
described in Section V, the deregulation policies pursued in the past thirty years left these market
developments unfettered.
Arguably these trends were the product of globalization, market forces and policy decisions rather
than of the cultural environment on Wall Street. However, we suggest that they have led to a set of
commonly shared attitudes towards risk-taking within the financial sector, and their continued
reproduction at the individual and institutional level. This cultural environment has come to regard
the compensation paid out to top traders and executives as economically justified without actual
evidence that it is the case. We suggest that a portion of Wall Street bonuses might well constitute
economic rent (excess return), creating incentives for risk-taking.
The Rise of Proprietary Trading
The 1990s saw the rise of alternative investment vehicles, such as hedge funds and private equity
funds. A hedge fund is any privately organized pooled investment vehicle administered by
professional investment managers whose interests are not sold in a registered public offering.
Hedge funds are normally structured as limited partnerships, where a general partner manages the
fund for a fixed fee (usually a percentage of assets under management) and a percentage of the
gross profits from the fund (the “carry” or “carried interest”). The investors are limited partners with
no managerial oversight. One of the first significant and sizeable hedge funds was Long Term
Capital Management (LTCM), founded in 1994 by John Meriwether and Nobel Prize winners Myron
Scholes and Robert C. Merton. The fund failed spectacularly in 199814 and had to be bailed out by
a consortium of creditors. Since the Federal Reserve intervened to prevent this near-collapse, the
size of the hedge fund industry has exploded. Roughly, the industry has grown approximately by a
factor of five in the past ten years, from $387 billion in 1998 to $1.8 trillion in 2008.15
This growth is in part attributable to the fact that the industry has been (until recently) to a large
extent unregulated, which has given hedge funds a competitive advantage over more traditional
investment vehicles, like mutual funds. For example, hedge funds have no regulatory trading
restrictions, which has allowed for very active management. This active management is said to
generate return in excess of the required rate of return (as determined by the Capital Asset Pricing
Model) for any diversified investment, for example an index fund. This additional return is called the
Its trading strategy was to exploit very small pricing differences between government bonds through the use of
sophisticated algorithms. In order to make a decent profit on very tiny spreads, LTCM was heavily leveraged, twenty to
thirty times of capital or more.
15 By comparison, over the same period U.S. GDP and the mutual fund industry have grown by only 64 percent and 69
percent respectively.
14
14
"alpha". Presumably, it is the ability to deliver high alphas that is responsible for the rise of the
hedge fund industry. Hedge funds are involved in virtually every kind of market and invest in every
kind of assets, from equity, loans, mortgages, distressed debt, to project finance, derivatives etc.,
employing a wide variety of trading strategies. In terms of assets under management,
attractiveness of returns, and recruitment of top traders, hedge funds became a serious
competitive threat to investment banks.
Investment banking had traditionally been relationship driven. Starting in the 1980s, as the financial
sector became fast-paced, globalized and competitive, with increasing competition from foreign
firms, the existence of long-term relationships became less important than the ability to deliver a
deal efficiently. Corporate clients became more transaction-driven, shopping around for the best
securities firm. In this new competitive environment, margins began to gradually decline. There
was also growing competition from commercial banks, which further contributed to driving down
underwriting fees. The traditional bank loan business started to decline in the 1980s, as companies
turned to securities issuance to raise capital, forcing commercial banks to compete with investment
banks in the underwriting business and securities markets. Glass-Steagall was repealed in 1999
under the lobbying pressure of large commercial banks.16 With commercial banks able to directly
compete in the underwriting business and rely on their ability to extend significant credit facilities to
clients to secure issuance business, underwriting fees were driven down as commercial banks
started to run a “volume based” business (Prins, 2004: 45). In this environment, investment banks
had to find other sources of profit to stay competitive. They turned to proprietary trading for larger
and larger fractions of their revenue.
Proprietary trading desks can be thought of as internal hedge funds within the bank. Proprietary
trading refers to the use of the firm’s own capital to actively trade financial assets, as opposed to
traditional investment banking fee-based activities, such as underwriting and consulting. The rise of
proprietary trading within investment banks was accompanied by an increase in the risk profile of
financial institutions. First, proprietary trading is more volatile than the traditional investment
banking fee-based activities, giving rise to more volatile returns and increased responsiveness to
market swings. For example, in 2007 the “Trading and Principal Investments” division of Goldman
Sachs accounted for $13.3 billion of the $17.6 billion of the firm’s pre-tax earnings. Yet in 2008, in
the midst of the financial crisis, the division generated a loss of $2.75 billion (when the firm
generated pre-tax earnings of $2.34 billion). Proprietary trading is also more capital-intensive in
nature (as compared with the traditional fee-based underwriting and consulting businesses, or
even market-making activities), and requires intense use of the firm’s own capital to fund both
liquid and illiquid positions. High leveraging became a well-established business strategy
indispensable to remain competitive and finance, allowing investment banks to turn high profits
with minimal capital. Lacking a wide deposit base, which provides abundant and cheap funding to
commercial banks, investment banks instead turned to other sources of borrowing, such as shortterm secured loans from repo markets.17 Leverage ratios of the major investment banks increased
The Federal Reserve first approved Bank of America’s acquisition of Charles Schwab (brokerage operation) in 1983.
A 1987 Supreme Court decision allowed some subsidiaries of commercial banks to conduct investment-banking
operations, provided the revenues were small enough. Large banks started lobbying for the repeal of Glass-Steagall,
arguing that the ability to deliver a full-range of financial services was essential for U.S. banks to be able to compete
with foreign firms.
17 A repo is also known as a Repurchase Agreement. The borrower sells a security to a lender, but simultaneously
agrees to buy the same security at some future date for a fixed price. The agreement is economically equivalent to a
16
15
to roughly 35-to-1 and even 40-to-1 before the 2007-2008 crisis.18 It is not surprising that this was
accompanied by an increase in the amount of firms’ capital put at risk on a single trading day. For
example, in March 2006 Goldman Sachs’s VaR jumped to $92 million, an increase of 135 percent
as compared with $39 million in 2001 (Business Week, 2006). This business profile was inherently
risky in that investment banks continually borrowed with short maturities, but held risky and
potentially illiquid positions - its weakness became all too apparent when credit markets (including
repo markets) dried up in 2008, and investment banks like Goldman Sachs and Morgan Stanley
had to resort to a change in regulatory status (electing to convert to Bank Holding Company status)
to access the Federal Reserve emergency lending facilities (lender of last resort).19 The risk/reward
profile for most hedge funds and proprietary trading desks is not as well understood as that for
traditional investments. The implications of all this for systemic risk became too apparent in the
recent crisis, where the failure of major financial institutions had the potential to severely disrupt
markets.
One significant new provision in the Dodd-Frank Act is the restriction of proprietary operations
undertaken by commercial banks (provision known as the Volcker rule). Banks can now place up to
3 percent of their Tier 1 capital in hedge fund and proprietary trading investments. Banks are also
prohibited from holding more than 3 percent of the total ownership interest of any private equity
investment or hedge fund. This falls short of a complete disallowance of proprietary desks, which
had been originally suggested and would have been equivalent to restoring Glass-Steagall.
Further, there are some notable exceptions to the ban. There is a list of permitted activities,
including investments in U.S. government securities, transactions made in connection with
underwriting or market making related activities, transactions on behalf of customers, and “riskmitigating hedging activities” in connection with individual or aggregated holdings of the banking
entity. There is no doubt that in the coming years legal work will have to be done to interpret the
language in the bill to define which activities fall within the scope of the exceptions to the Volcker
provision. There is enough ambiguity to allow banks to get away with a lot, if they can successfully
interpret the rules as they see fit.20 While all major banks are scaling down trading operations and
investments in hedge funds, it has even been suggested that the big players (such as Goldman
Sachs and Morgan Stanley) are not truly abandoning proprietary trading, but instead are shifting it
secured borrowing, whereby the borrower uses a financial security as collateral for a loan at a fixed rate of interest
(roughly, the difference between the sale and repurchase price). Repo markets have allowed investment banks (and
broker dealers) to access cheaper financing, using their inventory of securities as collateral.
18 The SEC loosened its capital requirements in 2004. Under its Consolidated Supervised Entities program, the SEC
allowed broker-dealers with capital of at least $5 billion to increase their debt-to-net capital ratios to as high as 40-to-1.
19 The stand-alone large investment bank is now a thing of the past. By the late Fall of 2008, the five major U.S.
investment banks (Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns) had either
failed or abandoned their status as independent investment banks. Goldman Sachs and Morgan Stanley decided to
convert to Bank Holding Companies, and thus become regulated by the Federal Reserve instead of the SEC. This was
in great part motivated by the need to ensure that they would have access to a loan facility from the Federal Reserve,
since the Federal Reserve acts as a lender of last resort (but only for banks member of the Federal Reserve System).
In the future, these two firms will have to adhere to stricter requirements regarding regulatory capital, which may affect
the extent and nature of their proprietary trading desks. The banks might increase the level of deposit taking on their
balance sheet, although the extent to which they will engage in retail banking is yet to be determined. We can expect
that in line with the repeal of Glass-Steagall, Wall Street might reorganize to form even larger financial institutions
offering a complete range of financial services, including commercial banking, broker-dealer services and insurance.
20 Will investments in funds that mostly trade government securities (for example fixed income arbitrage funds) be
allowed? Will activities conducted to facilitate customer relationships qualify as activities done “on behalf of
customers”? What types of activities will constitute “risk-mitigating hedging activities”?
16
into trading desks that deal directly with customers, so as to qualify as a permitted activity (see
Lewis, 2010a and 2010b).
The End of the Partnership Culture
As the major Wall Street houses started as family firms, loyalty to the firm was first and foremost a
family affair. As the firms grew in size, this model gradually developed into a partnership-type
organizational structure, where the business model was based on trust, loyalty and confidentiality –
characteristics that often made it possible to do deals and perform transactions quickly and
efficiently. However, the partnership model itself was not sustainable as Wall Street firms continued
to grow in size. Eventually, most of these firms were taken public to remain competitive. The last
major firm to do an IPO was Goldman Sachs (in 1999), although the firm kept the title “Partner
Managing Director” so as to preserve a sense of the existence of a partnership. However, the new
climate of extreme competition between firms and markets, which began in the 1980s, has led to
the gradual erosion of this partnership culture.
First and foremost, the organization of investment banks as publicly owned corporations introduces
issues of moral hazard and conflict of interest between management and shareholders (a principalagent problem absent from the partnership model, where the firm is trading with management’s
own funds rather than shareholders’ equity). Traders’ primary motivation became their own
remuneration rather than the maximization of firm value. This in turn meant that management had
financial incentives to justify large bonuses in current periods (ex. hitting short term quarterly
earnings targets) rather than maximize long-term firm value. Michael Lewis in his book Liar’s Poker
describes how Salomon’s lack of system for allocating costs became problematic when the firm
became public. Instead of focusing on profits, trading managers began to focus on “indiscriminate”
revenue growth, as it is often possible to create revenue without necessarily booking profit (Lewis,
1989: 109). In a classic moral hazard problem, banking executives have a lot to gain from risk
taking, but little economic penalty. Shareholders, not managers, suffer the major economic loss in
the event of bankruptcy. Further, with the rise of large investment firms that were sufficiently large
to present a threat to the economy, basking in the dominant view that they were “too big to fail”,
these firms found that, when on the brink of bankruptcy, they could rely on state institutions for
safety nets - as we saw with the bailout of huge firms such as AIG.21 Further, in a partnership
loyalty was structural in nature in that traders were required to reinvest a substantial portion of
earnings in the firm and stood much to lose from leaving the partnership. When firms went public,
the loyalty started to gradually break down. For example, Goldman partners reportedly sold nearly
As Stiglitz points out in a recent book, the effort to rescue the banking system was inherently flawed (Stiglitz, 2010).
Firms used the threat of systemic risk to shift all risk to the government, reduced to the role of “garbage disposal” (the
expression is Stiglitz’s) for toxic assets created by financial institution. The implementation of the multi-trillion dollar
bailout for the banks orchestrated by the Bush and Obama administrations was inconsistent - some institutions were
rescued, others not, without clear guidelines underlying the decisions. Goldman Sachs received billions from AIG
(funded by the AIG bailout) as settlement of credit default swaps, while other market participants received only 13
cents on the dollar in settlement of credit default swaps. The expectation that banks are entitled to a socialized takeover of losses while privately pocketing gains is obscene. For these reasons, Stiglitz refers to the bailout as the “Great
American Robbery”.
21
17
$700 million of stock in the period of adversity that followed Lehman's bankruptcy. This cashing out
would have been unthinkable in the 1960s or 1970s.22
In the partnership environment, employees would rise through the ranks and develop
professionally within a single organization. Many firms would not even hire top managers
externally. But in the new environment, with all major firms public, employee retention – and
motivation - became a key issue. Higher employee turnover became the norm. At Salomon in the
early 1980s 75 percent of new hires would be gone after three years, in sharp contrast with prior
years when 85 percent of hires would remain with the firm (Lewis, 1989: 38). This new generation
of traders began to demand higher levels of compensation and “a higher cut” of trading profits. Top
traders would seek more lucrative employment opportunities elsewhere if the firm did not quickly
comply, an attitude which Lewis describes as “hit and run” (Lewis, 1989: 127-8). With the decline of
the partnership model, compensation became the key factor to motivate employees to be loyal to
the firm. More recently many investment banks have struggled to keep top employees from
pursuing more lucrative opportunities with hedge funds or private equity funds.
In the partnership culture, long-term client relationships were key to a firm’s success. Yet as
discussed in the fast-pace globalized and competitive environment that emerged in the 1980s, the
importance of long-term relationships declined. Hence it should not come as a surprise that with
the loss of the partnership culture, big investment banks came to develop an institutionalized sense
of entitlement to huge profits, even if such profit levels entailed potential conflicts with client
interests. Goldman Sachs pocketed huge profits by marketing securities (CDOs) to investors, while
betting against those very products (see New York Times, 2009). In a public response to the New
York Times, Goldman Sachs saw no conflict of interest or ethical issue, viewing its own bets as
“prudent hedging management” and justifying their marketing of CDOs as a mere response to
client demand. The SEC charged Goldman Sachs with fraud related to the structuring and
marketing of subprime mortgage CDOs. The accusation was that Goldman Sachs omitted to
disclose key facts to the investors, including the role played by a major hedge fund (Paulson & Co.)
in the selection of the underlying mortgages, and the fact that the bank had taken short positions
against the CDOs. The case was ultimately settled for $550 million on July 15, 2010.23
Risk Transfer and Compensation
The Wall Street bonuses are part of the Wall Street mystique, with a large portion of total
compensation coming in the form of company stock, or stock option, thus linking compensation to
the profitability of the firm (or a division of the firm). Traders’ bonuses are also typically based on
During the great depression a significant part of the firm’s partnership capital was used to cover the losses of The
Goldman Sachs Trading Corporation, which had collapsed.
23 Even if Goldman Sachs did not break the law, arguably Goldman’s actions were harmful to their clients, and to
financial markets as a whole. There were misrepresentations made to investors. In its marketing material, Goldman
represented that it had “aligned incentives” with the Hudson Mezzanine (a $2 billion CDO it created in 2006), and that
the underlying assets had been “sourced from the street”. While it was technically true that Goldman had made a small
investment in the product, failure to disclose the firm’s much larger bet against the securities in essence was clearly
misleading. Further the assets came from Goldman’s own balance sheet rather than randomly selected from other
broker-dealers.
22
18
their division’s profit and loss. This is not limited to Wall Street, as the use of stock- and optionbased executive compensation for CEOs has increased dramatically in the past few decades. The
median exposure of CEO wealth to stock prices tripled between 1980 and 1994 (Hall and Liebman,
1998) and doubled between 1994 and 2000 (Bergstresser and Philippon, 2006). In the standard
economic labor market model, firms employ workers to the extent that the marginal product of the
worker is greater than or equal to the firm’s marginal cost of employment. Firms hire a given worker
at a given wage rate only to the extent it is profitable for the firm given the worker’s contribution to
output. Further, the wage rate must be high enough to attract workers (the banking industry
frequently claims that high rewards are necessary to attract the best talent). In theory tying
employee compensation to the success of the firm is designed to ensure that executives have
incentives to deliver their best efforts and maximize firm value. Aligning the interests of executives
with those of the firm minimizes the principal-agent issue. Further, stock options increase retention,
since employees often do not gain immediate control of those stocks and stock options. 24
Beck’s discussion of the risk society has placed the distribution of risk, rather than wealth, as the
central social issue in modernity. There is, arguably, a big difference between risk in the financial
markets and other forms of risk, such as ecological risk discussed in Beck (1995). Though specific
populations and parts of the world might be more affected by ecological damage, ecological risk does
not necessarily respect divisions between poor and rich countries, and potentially transcends class
struggles between capital and labor: “In the ecological conflict, where what are at stake are negatives,
there is no direct intermeshing of opposing interests.” Beck (1995: 4). In contrast, we find that while the
increase of risk in our financial system threatens most investors (through pension funds and 401ks),
executives on Wall Street have stood much to gain from this increase. Higher risk levels are associated
with higher volatility in returns, and accordingly higher bonuses in record years, with no possibility of
retroactive recovery of such bonuses in bad years.
What we find is that this compensation structure has not necessarily led to a maximization of
shareholder value. Recently, we saw executives of major collapsing financial institutions (AIG,
Lehman, etc…) walk away with millions of dollars in compensation, refusing to accept any blame
for improper risk management of their institutions. The link of high bonuses to short-term profits
gives incentives for excessive risk-taking on the part of CEOs. For executives, there is more to gain
from high volatility (allowing executives to cash out at high inflated stock value), than slow but
steady appreciation in value with lower underlying risk levels. Studies show that the manager’s
appetite for risk is highly correlated with compensation package’s sensitivity to stock return volatility
(Knopf, Nam, and Thornton, 2002, Coles, Daniel, and Naveen, 2006). The compensation structure
for hedge fund managers, with managers earning a carried interest (up to 20 percent of profit)
gives the fund manager a similar incentive for volatility in returns -- as such, it has been described
as having option-like features (Cochrane, 2005).25 The asymmetry is that high volatility leads to
above average returns and bonuses in good years, yet when the company experiences above
average losses, shareholders are unable to retrieve bonuses paid to executives in prior years. This
results in a persistent principal-agent issue. In the words of former Goldman Sachs partner and
hedge fund manager Leon Cooperman:
There can be a waiting period (the “vesting period”, usually 3 to 5 years) during which the employee cannot sell the
stock or exercise the option. If the employee leaves the firm before the vesting period is over, he or she can lose all
entitlement.
25 The value of an option increases with the volatility of the underlier.
24
19
“We are not an investor in [investment banks]. I determined many years ago that if you
want to make money on Wall Street, you work there; you don't invest there. They just pay
themselves too well. I would rather look elsewhere for investment opportunities.”26
In the case of AIG, the company (and its executives) grew rich by taking on excessive risk. It
transpires that top executives still received high bonuses even when the company lost over $5
billion in the final quarter of 2007 (losses attributable to its Financial Products Division, the division
which issued about $527 billion of CDSs). Based on the findings of U.S. Congress (2008c), the
compensation committee that met on March 11, 2008 followed management’s recommendation to
exclude the unit’s unrealized market valuation losses from the calculation of bonuses. Martin
Sullivan received a golden parachute worth $15 million. Joseph Cassano, the executive in charge
of the Financial Products Division, was terminated without cause in February 2008 when his
division imploded.27 He had received more than $280 million over 8 years. The compensation
committee did not seek to recover any of this past compensation. In fact, he was allowed to keep to
$34 million in unvested bonuses. In such situations, we find that the standard economic labor
market model breaks down. It is hard to argue that bonuses correspond to the marginal product of
the worker when the company is on the brink of collapse, and when compensation is not based on
a true (risk-adjusted) measure of firm profitability.
Since compensation committee members are themselves executives in the industry (there are no
or few outsiders on the Boards), they have a vested interest in keeping a high overall
compensation level, which may jeopardize their fiduciary duty to the shareholders of the company.
Many Wall Street executives operate like a guild system of insiders who have acquired the power
to pay themselves (and each other) with no effective input from shareholders. Quite frequently,
severance agreements are put in place from the very beginning, so that executives will walk away
with millions of dollars regardless of what happens to the company (as was the case with AIG).
Boards also often do not go through an outside search for a new chairman (as was also the case
with AIG). The board terminated Mr. Sullivan after AIG lost $13 billion in two quarters, but allowed
him to retire and receive his bonus. Had he been terminated for cause, he would not have been
entitled to the payment. It is very hard to argue that in such instances compensation committees
are acting in the best interest of the shareholders. The overall pay level in the industry may thus
well include an element of “rent-taking”, meaning that collectively bonuses are not determined by
competitive market forces and exceed value created for firms in the financial sector. This is
perfectly compatible with the notion that individually firms aggressively compete for the best
resources, and that high rewards may be necessary to attract the best talents to a given firm.
There are no easy legal recourses available to shareholders to retrieve bonuses paid to executives
in prior years. It is difficult to bring legal charges against compensation committees even when the
allowance of bonuses shows very poor governance, as is clearly the case with AIG, when the
company was on the brink of collapse. It is also very difficult to press charges against executives
for improper risk management, to the extent that poor risk management is merely a bad business
decision rather than an illegal business practice. Executives do not go to jail for making bad
business decisions. Unless there is a failure to comply with securities law, or actual fraud, it is
Cited in Dumortier (2009).
Mr. Cassano remained on AIG’s payroll earning $1 million a month to unwind the very financial products the division
had sold during his leadership.
26
27
20
difficult to recover damages from executives, or recover prior bonuses paid on the basis of profits
that did not take into account the increase in the risk profile of the institution. One possible legal
ground for action is the charge of misleading investors. In the case of AIG, U.S. Congress (2008c)
explored the possibility that misleading financial statements and incorrect information had been
communicated to shareholders.28 The SEC conducted an inquiry regarding Cassano possibly
misleading investors by understating the sharp decline of asset values on AIG’s balance sheet, but
eventually decided not to bring criminal charges.
In his testimony to Congress, Congressman Christopher Shays stated that: “Company
compensation is a telling indicator of a corporate culture detached from larger market realities and
the fundamental fiduciary duty to be frugal stewards of other people’s money” (see testimony of
Christopher Shays, U.S. Congress, 2008c). Referring to the compensation of Fannie May
executives (from 1998 to 2003, CEO Franklin Raines alone took over $90 million in salary and
bonuses), Shays added: “In the context of a $6 trillion mortgage securities portfolio, those paydays
may seem like small change, but it’s indicative of a prevalent and noxious rot that threatens the
moral underpinning of the entire capitalist business model.” The critical issue here is that corporate
culture has allowed compensation to be misaligned with value creation for the shareholder. The
compensation structure creates incentives for high volatility and uncontrolled risk-taking.
We of course do not mean to suggest that top executives should avoid risk-taking on the part of
financial institutions at all cost. We have merely outlined that incentives exist to disregard the
proper measure of the true levels of risk being assumed. The high degree of trust placed in the
concept of risk as a form of indeterminacy that can be controlled and measured with probabilistic
models served as a convenient discourse for legitimizing business decisions. The
acknowledgement that forms of indeterminacy are not predictable, for instance that AIG could not
properly value its CDS portfolio (and associated liabilities), would not provide the same support for
business leadership.
Compensation needs to be based on a risk-adjusted measure of firm profit. Regarding corporate
governance and executive compensation, the recent Dodd-Frank Act only includes measures to
encourage management to shift focus from short-term profits to long-term growth, rather than strict
guidelines. The Act provides for strengthened independence of compensation committees.29
Unfortunately, this is unlikely to impact the size of Wall Street bonuses, since compensation
committees have a vested interest in keeping a high overall compensation level (being themselves
executives in the industry). The Act also requires the disclosure of executive compensation as
compared with the company’s stock performance over a five-year period. The disclosure might
alert shareholders to the issue of a discrepancy between executive compensation and stock
performance, but will not prevent the issue from occurring in the first place. Unless bonuses are
reduced, or at least assessed on the basis of long-term profits rather than short-term (yearly)
results, incentives for risk taking and stock volatility will still exist, and it will be business as usual.
For example on December 5, 2007 investors were told that the company was confident in the reasonableness of
valuation methods, in spite of the fact that PWC had stated concerns regarding risk management just days earlier.
29 All directors on compensation committees of publicly traded companies are to be independent from executives
whose compensation they are supervising. In addition, the committees will have the authority to hire independent
compensation consultants.
28
21
The fact that 2010 was a record year in terms of Wall Street bonuses (the highest in history) while
economic recovery in the U.S. is still fragile, to put it mildly, bears no good sign for the future.
V. The Culture of Risk and Regulation
The Deregulation of Financial Markets
The advent of a risk society presents many policy issues regarding how to manage, at the political
level, the emergence of manufactured risk. New politics and new values are needed to rethink
collective choices to be made in light of the implications of the new risks being faced. A real tension
exists whereby government officials must acknowledge that they are taking specific risks seriously,
while maintaining credibility if the risk turns out to be less serious than expected (Giddens, 1999:
5). Risks originating in the financial sector are no exception and must also be politically managed.
As we discussed, financial engineering thrived as an industry and created in the process new
forms of risks (including risk to the system as a whole with the potential to disrupt markets with
great repercussions for the entire economy) that were not, in spite of experts’ claims to the
contrary, controlled nor understood.
The political decision in the U.S. was to deregulate markets. The first major triumph of deregulation
was the repeal of Glass Steagall in November 1999, with the Gramm Leach Bliley Financial
Modernization Act. The Act created a new regulatory status, the Financial Holding Company
banks, which allowed commercial banks, securities firms and insurance companies to affiliate
under common ownership. All the main commercial banks (Citigroup, JP Morgan Chase, Bank of
America) converted so as to be able to offer a complete range of financial services. Financial
Holding Companies were under the regulatory supervision of the Federal Reserve, while the SEC
had supervision over securities firms and investment banks. The rise of proprietary desks within
both commercial and investment banks, and their increasing contribution to profits relative to
market making activities, can be partly explained by the repeal of Glass Steagall. The second
major deregulation initiative was the Commodity Futures Modernization Act of 2000 (CFMA), which
provided that over-the-counter derivatives (privately-negotiated instruments traded outside of an
exchange platform) would continue to be substantially unregulated. The Act was initiated at the
request of Treasury Secretary Robert Rubin, Federal Reserve Board Chair Alan Greenspan, and
SEC Chair Arthur Levitt.30 The third deregulatory trend was the lack of supervision for hedge funds.
Until the recent Dodd-Frank Act, hedge funds were under no obligation to disclose balance sheets
and income statements, and typically remained secretive about their positions and strategies, even
to their own investors. Review of financials by an independent auditor was also not required.31
Rubin, Greenspan and Levitt had issued a letter asking Congress to prevent the Commodity Futures Trading
Commission (“CFTC”), the regulator of commodity exchanges, from bringing swaps and other OTC derivatives within
its regulatory oversight.
31 The Investment Company Act of 1940 deals with the regulation of investment companies. Unlike their mutual fund
counterparts, most hedge funds fell outside the scope of the Investment Company Act of 1940 by availing themselves
of applicable exemptions, such as having one hundred or fewer beneficial owner and not offering its securities in a
public offering, or because investors were all "qualified" high net-worth individuals or institutions. This explains why
30
22
Many funds did voluntarily register with the SEC. However, limited resources jeopardized the
SEC’s ability to properly monitor the activities of fund managers.32
The rationale for unregulated markets was to preserve the competitiveness of U.S. firms. The
repeal of Glass Steagall, of course, was hailed as a major victory in this respect. The free-market
ideology was also guided by a modern version of Adam Smith's ‘invisible hand’ -- the notion that
privately negotiated transactions maximize economic welfare (neoclassical economics provides
theoretical justification for this, with the first fundamental theorem of welfare economics) 33. The
overarching theme was that trusting the banks’ internal risk management systems was the
regulator’s best bet – after all, financial firms were experts in risk management. This is essentially
the approach found in the Basel II framework for determining capital adequacy requirement.
Another illustration is the decision to leave derivative markets unregulated. The growth of derivative
markets was seemingly generating profits for all (for example all market participants were finding
the CDS market attractive, at least in the short-term34), so there was no real incentive on the part of
the regulator to ensure transparency and appropriate risk management. Derivatives were just
‘machinery’ allowing managers to take intelligent risks. As such, they would be used wisely. The
market alone would decide whether a counterpart to a derivative was appropriately capitalized or
posted adequate collaterals. Any regulation could entail the standardization of instruments, which
would reduce the economic value of derivatives to the parties. Inherent was the assumption that
investors would be in a position to make their own determination of the risk / return profile of
financial instruments and financial institutions.
Of course, all of this depended upon the characterization of risk as quantifiable and fully
manageable – the triumph of risk over uncertainty. First, as was evidenced in the crisis, the
reliance of the regulator on the firm’s internal risk management proved to be misguided. The
hedge funds have deliberately chosen not to raise capital on public markets. Hedge fund advisers had also been
exempt from regulation under the Investment Advisers Act of 1940, in spite of the SEC’s unsuccessful attempt to
impose mandatory registration. The Investment Advisers Act is a companion statute to the Investment Company Act,
and was primarily designed to introduce record keeping, anti-fraud standards to the investment advisory profession.
Under the Act, investment advisers must register with the SEC. Hedge fund managers were typically exempt from
registration under the private adviser exemption, whereby is exempt from registration any investment adviser who
during the course of twelve months has had (1) fewer than fifteen clients and (2) did not hold himself out generally to
the public as an investment adviser.
32 It turns out that Madoff himself had voluntarily registered with the SEC in September 2006. Many hedge fund
managers had voluntarily registered with the SEC to give the market a higher level of confidence and potentially
minimize the amount of due diligence performed by new investors. In spite of some red flags (for instance, the fund
relied on a small unknown auditing firm, and the returns were too high to match proclaimed the low risk trading
strategy), the SEC failed to detect irregularities. The SEC did not have the resources to review all funds, and tended to
focus funds with high-risk trading strategies. Because he claimed to engage in very low risk “plain vanilla” option
trading, Madoff did not attract any specific scrutiny.
33 The first fundamental theorem of welfare economics provides that any competitive equilibrium leads to a Pareto
efficient allocation of resources.
34 CDSs were successful with commercial banks because they allowed for the removal of credit risk with respect to
given corporate bond portfolios without selling the underlying bonds – hence they are a quick and easy way to free-up
regulatory capital. CDSs offered investors a way to bet on a company’s credit risk without actually trading or investing
in corporate bonds. Insurance companies such as AIG were sellers of CDSs because they could book the spread (the
cost of the credit protection) without fully disclosing or backing the payouts that might have to be made under such
instruments. Investment banks, of course, were earning fees to design and engineer the instruments (with many
variations), while also taking positions under CDS contracts (sometimes very successfully, as Goldman Sachs
managed to do).
23
entities that failed had remained in compliance with the SEC’s Consolidated Supervised Entity
regime’s rules at all relevant times (there was no violation of capital requirements). The banks did
not fraudulently mislead investors regarding the excessive leverage. Second, investors relying on
financial statements found that the reporting did not convey an accurate representation of risk
levels of the company. Accounting rules demand that a fair value be assessed for balance sheet
purposes. Yet in many instances (e.g. when direct market information cannot be used there, for
instance if there is an illiquid market), the assessment of a fair value requires judgment calls from
management (e.g. regarding discount rates, fair value estimates for assets that are not regularly
traded, reserves associated with accounts receivable). Many accounting rules (FASB standards,
etc.) do indeed require such judgment calls to be made. Accountants, who are not trained in risk
assessment, do not have the expertise to challenge these estimates. The extent to which financial
statements are subject to interpretation, management policies, and judgment calls is not something
that can be fully appreciated by investors short of disclosing the nature and rationale of those
decisions. Financial statements simply do not go into that level of detail. Hence, it is possible for
financial statements to give a false representation of the financial condition of a company, and
mislead investors regarding risk, without necessarily involving accounting fraud, or the
communication of false material information.
For example, a proper assessment of AIG’s exposure to the sub-prime market would have required
a different valuation of the CDS positions on AIG’s portfolio. Building a fair value assessment is
extremely difficult when there are few market comparables due to the highly customized nature of
derivative contracts (Joe Cassano made this very point in a December 2007 presentation to
investors).35 The AIG valuation process relied upon models36 ascribing probability of default to
underlying securities, attempting to price the value of the degree of correlation of default between
the underlying mortgages (there was no observable market comparables for pricing the degree of
default correlation). To date, there has not been evidence of AIG fraudulently misleading investors
to the extent that no clear legal accounting violations could be established -- AIG’s valuations did
not breach any corporate accounting standards for balance sheet reporting. Was any false
information conveyed to investors regarding a material issue? The company disclosed its
methodology, and represented that its fair value assessments were the product of a very thorough
set of procedures. Chief risk officer Bob Lewis asserted that there were portfolio reviews for all
businesses that carried exposure to any sort of credit exposure, and specifically to mortgages.
Chief credit officer Kevin McGinn asserted that the entire “super senior” tranche of CDSs was
inspected by the risk committee. Whether proper risk control procedures were in place is certainly
a material issue, factual in nature. However, it is perfectly possible for AIG to have followed those
very procedures, while still completely underestimating the real cost of the CDS portfolio and the
risks undertaken by the company, and misleading investors in the process.
The real question of interest to shareholders and investors, whether the methodology used to
evaluate risk and price instruments gave a true risk assessment of the business, is altogether a
different issue, which involves the determination of what appropriate methodology should have
been used. This is a question for which there are no clear-cut legal standards. In fact, as we
discussed in our overview of the shortcoming of VaR and other risk models, it is a question for
As per the final transcript of the AIG Investor Meeting held on Dec. 05, 2007.
AIG apparently used a valuation model originally developed by Moody’s in 1996, the Binomial Expansion Technique
model.
35
36
24
which there are no clear-cut theoretical guidelines. If we are to take seriously the epistemic fallacy
of the characterization of risk as fully quantifiable and manageable, there are many instances in
which a company’s risk officers could (and should) realize that we simply do not have enough
information to make informed risk assessments. In this regard, AIG missed the mark in that it failed
to disclose to investors that its auditor has expressed reservations regarding its risk controls, and
that appropriate models required to value a significant share of its portfolio might not even exist at
all, so that radical uncertainty could not be done away with – in short, that risk management was
not under control. Yet as we have already discussed, the acknowledgement that forms of
indeterminacy are not predictable would not necessarily have been a good political move for AIG
executives. After all, the acknowledgement that ‘we simply do not know’ does not justify lofty
salaries and bonuses. Further, since executives do not go to jail for making bad business
decisions, there is little incentive to be cautious. Legal and accounting rules provide a framework in
which this culture perpetuates itself. Poor judgments in risk analysis do not constitute breaches of
legal or accounting standards if they are not made in bad faith. As such, the legal system is not
sophisticated enough to allow for the proper disclosure of risk to investors.
Hence, we come to another characteristic of the culture of risk, the dominance of risk analysis
operating, at the policy level, to diverge attention from our radical ignorance about the future.37 The
faith that the market would provide sufficient risk disclosures to investors provided support for
efforts to deregulate financial markets. Yet the current legal and accounting standards of financial
reporting are insufficient to expose deceptive representations of a company’s true risk profile and
financial situation. In the absence of material factual misrepresentations to its stakeholders, or
gross negligence, there does not seem to be any legal protection for investors against negligent
risk management. Bonuses are safe.
Organized Irresponsibility
In the recent financial crisis, arguably a combination of multiple factors and agents is responsible for
the breakdown of markets. Mortgage brokers were engaging in unsound mortgage issuance practices.
Investment banks underwrote securitized products and other securities without doing proper due
diligence and risk disclosure (as we have already described they had no financial incentive to do so,
being compensated on the basis of how many securitized products they could structure and market
rather than on proper risk disclosures and the long-term quality of the products). CRAs did not correctly
assess mortgage default rates and gave high credit ratings to many securitized products that failed
when, as it turns out, much of the economy was hinged on the performance of these products. 38
In this respect, it could be argued that this dominance was not democratically legitimate (Reddy, 1996).
There is an unacceptable conflict of interest in the “issuer pay” business model of the CRAs, as revenue is derived
from customers that are looking for favorable rather than accurate ratings, so that the CRAs’ independence is highly
compromised. The industry is also highly oligopolistic in nature, with only three large CRAs that have come to
dominate the business (Moody’s, Standard & Poor’s, and Fitch), which has deprived financial markets of diversity of
risk assessment methodologies and opinions. This is partly the responsibility of the SEC. In 1975, the SEC created a
major barrier to entry into the rating business by creating the category of “nationally recognized statistical rating
37
38
25
Business executives sought short-term gains and bonuses by taking on unregulated risk (increasing
leverage in order to enhance profitability, trading in complex financial instruments, etc.) with no
guarantee that long-term results would remain positive. The regulator is also to blame, as the SEC
allowed investment banks to have very dangerous leverage levels, where firms could be wiped out with
any minor downward market value adjustment to their assets. The lack of transparency in derivatives
markets is the result of the deregulatory trend. What we see emerge is a multiplicity of agents and
incentives, and an intricately interconnected web of interactions that together produced a full
breakdown of markets. As a result of this complexity, specific individual liability cannot be identified
because of unclear joint causality.
The greatest financial crisis since the Great Depression has not led to a single criminal prosecution
or conviction of any high-profile Wall Street executive. Consider, for example, the issue of who
bears responsibility for the collapse of AIG. Martin Sullivan was CEO from March 2005 to June
2008. Robert Willumstad took over as CEO in June 2008. According to their testimony to Congress
(U.S. Congress, 2008c), AIG did not fail because of poor risk management. It failed because it was
“caught in a vicious cycle and hit by a global financial tsunami”. Mr. Willumstad apparently stated
that he did not believe that AIG “could have done anything differently”. Executives refused to
accept any blame for what happened to the company. Yet there were clear failures on the part of
upper management to address serious concerns regarding risk controls. On November 29, 2007,
the company’s auditor, PriceWaterhouseCooopers (PWC) informed Mr. Sullivan that AIG could
have material weakness relating to the risk management of the Financial Products Division. PWC
also told the board’s audit committee in March 2008 that AIG’s risk control group did not have
appropriate access to the Financial Products Division. A former SEC enforcement official, Mr.
Joseph St. Denis, hired to address accounting issues, resigned over Mr. Cassano’s disregard of
concerns voiced regarding the Division’s valuation of liabilities. Mr. Cassano apparently told him
that he was “polluting” the accounting valuation process.39 While the company’s executives held
specific accounting rules (mark-to-market, which forced the company to book unrealized losses) as
the main culprit for its financial woes, it is apparent that a more fundamental problem was that AIG
got away from its core competency of insurance without dedicating proper care to its risk
management. The company did not have proper models to value its CDS portfolio. AIG executives
failed to address material questions and concerns (some of which voiced by the company’s
auditor) relating to the valuation of the CDS portfolio, and ignored internal audits and warnings.
There was at the very least some negligence in the area of risk managements, for which
executives accepted no blame at all. And as it turns out, as we have already pointed out,
executives do not go to jail for making bad business decisions.
Consider Goldman’s defense to fraud charges related to the structuring and marketing of subprime
mortgage CDOs. Lloyd Blankfein’s position (April 2010 testimony to the Senate) was that Goldman
was simply acting as a market-maker in these securities. However, this argument does not hold.
Market-makers typically engage in both purchases and sales of a particular security, taking
advantage of the price difference between "bid" and "offer" prices, while Goldman never had any
interest in buying the CDOs that were being marketed -- in fact it was aggressively trying to sell
them. We find that instead of selling something that already existed, Goldman was really creating
organization” (NRSRO). The Credit Rating Agency Reform Act of 2006 provided specific barrier-reduction provisions
so that there are now ten NRSROs. In spite of this, only three major NRSROs still dominate the market.
39 See Congress, 2008c, Chairman Waxman’s opening statement.
26
new products in the form of synthethic CDOs. As such, Goldman was really behaving as an
underwriter rather than market-maker (Eisinger, 2011). The SEC settled the Goldman Sachs
investigation for a mere $550 million (barely 14 days worth of earnings). The settlement sent the
firm’s shares up 4.4 percent. While it will likely result in new disclosure standards in the mortgage
and securitization industry (Goldman Sachs is required to increase training for employees who
structure or market mortgage securities), and possibly a more scrutinized internal approval
process, it did not provide an opportunity for the firm to reflect upon the appropriateness of the
conflict of interest associated with the marketing of the CDOs. In fact, the firm admitted no legal
wrongdoing, and merely acknowledged that marketing materials contained “incomplete
information”. More recently, Sen. Carl Levin has expressed the desire that Goldman Sachs
executives be criminally prosecuted. At the time of writing, it is unclear whether such criminal
prosecutions will be pursued.
The idea that society is now confronted to risks that are not accountable according to the prevailing
rules of causality, guilt and liability has been developed in the sociological literature on risk (see for
example Beck, 1992, 1995). There is a fundamental change in the attribution of responsibility.
Beck's famous term ‘organized irresponsibility’ describes the fact while some destructive
consequences of risk might clearly originate in human or organizational decisions, no individual
responsibility can be identified. There is first and foremost a problem of causality. Beck (1995: 7)
suggests that the issue of causality as a factual and philosophical matter can be quite complex.
Considering the example of factory accidents in the nineteenth century as an example, Beck
(1995) highlights different possible causes of an accident: the worker who might have stuck an arm
in a machine, the engineer who designed the machine, the entrepreneur who was turning the
screw for higher production. Another example is that of farmers contaminating soil with chemicals:
are the farmers responsible, or are they merely “the weakest link in the chain of destructive
cycles”? (Beck, 1992: 32). What of the responsibility of the fertilizer industry, or government
authorities that could have limited the production of these toxic chemicals? In both examples there
is not necessarily a clear causal link allowing for a clear allocation of responsibility. This is the
result of the increasing complexity of production processes, the “systemic interdependence of the
highly specialized agents of modernization”, where causal links are difficult to establish (Beck,
1992: 32). We believe the analysis to be applicable to risks arising in the financial sector, and
particularly helpful to understand the lack of accountability in the recent financial crisis.
Recent Regulation – Dodd-Frank
In Beck’s analysis, the disturbed relationship between risk and responsibility can be restored with
social agreements leading to new legal standards: “the causality problem had to be, and even in
the social area still has to be, settled by agreement (that is, social agreements) worked out through
conflict, and legal standards had to be established.” (Beck, 1995: 7). The Dodd–Frank Act signed
into law by President Obama on July 21, 2010 was the U.S. regulatory overhaul designed to
address the issues uncovered in the financial crisis. In addition to measures that specifically target
the mortgage industry40, there are many key provisions in the Act, all designed to prevent a
For example, in order to better align the interests of financial institutions that sell securitized products and the
investors that purchase them, institutions will be required to retain at least 5 percent of credit risk. New disclosure
40
27
meltdown of the sort that recently occurred, including monitoring systemic risk, reducing excessive
growth and complexity, creating more transparency with respect to hedge funds and derivatives.
We have already briefly discussed the Act’s restriction on proprietary trading, and some measures
addressing the issue of executive compensation and corporate governance. There are other key
provisions regarding the regulation of derivatives and the hedge fund industry. The Act gives the
SEC and the Commodity Futures Trading Commission the authority to regulate over-the-counter
derivatives, and requires central clearing and exchange trading for derivatives that can be cleared,
including credit default swaps.41 There are registration requirements for investment advisers to
private funds with assets under management of $150 million or more. Hedge funds will have to
register with the SEC and disclose assets under management, use of leverage (including offbalance sheet leverage) and other information regarding trading practices. 42
One prevalent focus is to design preventive measures that allow for a better monitoring of systemic
risk. The Act specifically contemplates the creation of a regulatory agency designed to look after
the stability of the financial system as a whole, the Financial Stability Oversight Council. The
Council would be empowered to require that financial institutions that may pose risks to the
financial system be regulated by the Federal Reserve. It would make recommendations to the
Federal Reserve regarding capital, leverage, liquidity, and risk management requirements. The Act
also provides for an orderly liquidation mechanism whereby Treasury, the FDIC and the Federal
Reserve would agree to unwind failing financial institutions that are systemically relevant, at the
cost of shareholders and unsecured creditors. For this purpose, there are data-gathering measures
designed to allow the regulator to consider the financial system as a whole, and aggregate
information across institutions to develop systemic scenario analyses. For instance, the SEC is
empowered to collect systemic risk data with respect to the hedge fund industry. There are also
data collection and publication requirements for derivatives markets, through clearing houses. The
SEC would make all of this information available to the Federal Reserve and the Financial Stability
Oversight Council.
The enactment of Dodd-Frank should have offered an opportunity to reexamine the dominant
paradigm of risk management and the triumph of risk over uncertainty. Yet vesting the Financial
Stability Oversight Council with the authority to monitor systemic risk might be, to some degree,
symptomatic of a failure to do so. Measures that increase transparency are a welcome
development, of course, but how will the regulator use the data? What criteria are to be used by
the regulator to determine whether an entity is too big to fail, or too interconnected to fail? Systemic
risk is not a concept that is currently well understood at a theoretical level. There are currently
some attempts to develop formal measures of systemic risk. For example, Adrian and
requirements would also ensure that issuers disclose more information regarding the quality of the underlying assets.
There are also measures that specifically target the mortgage industry, such as the prohibition of financial incentives
for subprime loans and mortgage pre-payment penalties, and the requirement of additional disclosures on mortgages
(and specifically variable rate mortgages).
41 The SEC and the CFTC would pre-approve contracts before clearing. The use of a clearinghouse would guarantee a
trade and bring much more transparency to derivatives market. Banks will be able to continue trading derivatives,
although in certain circumstances will have to conduct this business in a separately capitalized entity.
42 Other information to be disclosed includes counterparty credit risk exposures, trading practices, valuation policies
and practices of the fund, types of assets held, and side arrangements or side letters (whereby certain investors in a
fund obtain more favorable rights or entitlements than other investors). Hedge funds would also have to have assets
audited by public accountants.
28
Brunnermeier (2009) develop the concept of CoVaR as an indicator capturing the marginal
contribution of a particular firm to the whole systemic risk.43 The approach attempts to overcome
the shortcomings of the VaR method (such as fat tails) by using historical data over a long period
of time, from 1986 to 2008. However, the robustness of this methodology remains to be tested.
Further, given the complexity of the global financial system, it is unlikely that one single measure
will suffice. And, as pointed out by Andrew Lo in his testimony to Congress (Lo, 2008b), the
increased complexity and connectedness of financial markets requires new approaches in risk
management -- a fundamental shift in our linear mode of thinking, to better understand chaotic
behavior and complex systems. This new paradigm remains to be developed – if it can. If the
regulator does not really have clear guidelines for decision-making and monitoring systemic risk,
the creation of a Council specifically entrusted with the crucial task of identifying and neutralizing
financial institutions that are systemically relevant might give the market the wrong impression that
risk has indeed triumphed over uncertainty when nothing could be further from the truth. The
current environment presents new forms of increasing systemic risk. For instance, although the
hedge fund industry as a whole played no significant role in the 2008 financial crisis (see U.S.
Congress, 2008b), there is the potential for hedge fund failures to contribute to destabilize the
economy because of the size of the industry. It is unclear whether the Council even has authority to
unwind hedge funds or make recommendations regarding their leverage and risk management.
VI. Conclusions
The rise of the culture of risk is closely connected to the massive commodification of risk in
financial markets. There are, in our view, three key characteristics of the culture of risk. First is the
prevailing paradigm of the notion of calculable risk and the triumph of risk over uncertainty. We
have seen that this paradigm still dominates the fields of finance, economics and risk management,
in spite of recent and not-so-recent dissenting voices such as Keynes, Minsky, Soros and Taleb. Its
influence is pervasive, and has shaped the views of policy makers, regulators and financial firms
alike (there are different facets and manifestations, such as the reliance on internal risk
management systems developed by market participants, and the view that markets tend towards
equilibrium). All of this has operated to diverge attention from issues of radical ignorance, and the
shortcomings of relying on probabilistic calculations of the future. Second, the fact that corporate
culture has allowed compensation to be misaligned with value creation for the shareholder. And
third is the issue of ‘organized irresponsibility’ and the lack of accountability and clear specific
individual liability. In the culture of risk, responsibility is diluted as every agent feels that they are
only a small (insignificant) piece in a complex system of production. There is a widespread inability
to accept blame on the part of executives in financial markets. The default position is to
characterize the financial crisis as an uncontrollable sweeping ‘financial tsunami’ rather than
confront poor decisions on the part of individual executives.
Thinking of culture as a process, we have identified different trends that have led to this cultural
shift, in a general context of deregulation: commercial banks and investment banks coming to rely
43
CoVaR is calculated as the VaR of the whole financial system conditional on individual firm being in distress.
29
on proprietary trading to generate a greater and greater fraction of revenue, the end of the
partnership-type organizational structure for the major Wall Street firms, and the bonus style
compensation structure. These developments have created insufficient incentives for controlled
risk-taking on the part of Wall Street executives and traders. The concept of risk as a form of
indeterminacy that could be controlled and measured with probabilistic models was simply
convenient, in the short term. There was no incentive to challenge it.
It will be a matter of time before we can assess whether the Dodd-Frank Act was a successful
effort. There are of course welcome developments, such as the increased transparency and the
focus on systemic risk. Yet we suggest that the major shortcoming of this regulatory overhaul is the
failure to address the key characteristics of what we have described as the culture of risk: first, the
epistemic fallacy of risk management; second the corporate culture of executive compensation tied
to short-term profits rather than risk-adjusted long term measures of profit; and third, the absence
of clear causality leading to individual liability, especially regarding negligent risk management.
More fundamentally, the sheer complexity of the Act itself means that its implementation will lead to
a further increase in the complexity of financial markets, potential loopholes, etc. The danger here
is the continued emergence of new forms of manufactured risk in the risk society.
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