FAITH AND FINANCE !!

FAITH AND FINANCE ? !!

WHILE TEACHING COURSE IN FINANCE –

?NOT ACADEMIC BUT REAL FINANCE WORLD REFLECTION !!

?MORE THAN WRAPPING FINANCE IN FAITH –

?SOMETHING MORE SUBSTANTIVE NEEDS TO BE DONE –

?WHAT ? - LET’s EXAMINE ………. ?????? !!!!!!

?Finance and faith – unusual combination – Do they go together ??? In my opinion they should go together. All financial crisis had their root cause in lack of faith.?What causes?financial crisis? And how can the world avoid a periodic recurrence of it again and again? Those questions have appeared time and again among economists,policymakers, financiers, and voters over the last couple of decades especially recently. Crisis has occurred whenever finance world drifted away from faith. ?Little wonder: the pandemic and the crisis like that of 2008 not only entailed the worse financial shock and recession in the United States since 1929; it also shook the world’s ?global reputation for financial competence.

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If we examine the scenario before the 2008 crisis, Wall Street seemed to epitomize the best of twenty-first century finance. The United States had the most vibrant capital markets in the orld. It was home to some of the most profitable banks; I remember in 2006 and early 2007, Goldman Sachs' return on equitytopped an eye-popping 30 percent. American financiers were unleashing dazzling innovations that carried new fangled names such as "collateralized debt obligations," or CDOS. Thefinanciers insisted that these innovationscould make finance not only moreeffective but safer, too. Indeed, WallStreet seemed so preeminent that in and around 2003, I remember reading a book the Japanese banking crisis, Saving the Sun. After reading I presumed that one of the ways to"fix" Japanese finance was to make it more American.

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Just after five years when I read this book , the supposed success had been reduced to ashes. The brilliant innovations with strange abbreviations, contributed o a massive credit bubble.When it burst, investors around the world suffered steep losses, mortgageborrowers were tossed out of theirhomes, and the value of those oncemighty U.S. banks shriveled as markets froze and asset prices tumbled.Instead of a beacon for the brilliance ofmodern finance, by 2008, the ?finance of some developed nations ?seemed to be a global scourge.

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Why did it happen? Numerous explanations have been offered in the intervening years: the U.S. Federal Reserve kept interest rates too low, Asia's savings glut droveup the U.S. housing market, the bankshad captured regulators and politiciansin Washington, mortgage lendersmade foolish loans, the credit-ratingagencies willfully downplayed risks.

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All these explanations though they are true – but I look at it in another, less common way at financial crisis that also offers insight: being an avid lover of humanities I looked at it anthropologically. Just as psychologists believe that it is valuableto consider cognitive biases whentrying to understand people, anthropologistsstudy half-hidden culturalpatterns to understand what makeshumans tick. That often entails examininghow people use rituals or symbols,but it can also involve looking at themeaning of the words they use. Andalthough financiers themselves do notspend much time thinking about thewords they toss around each day, thosewords can be distinctly revealing.

These words are- ?"finance," "credit," and "bank." Today, those terms are usually associated with abstract concepts involving markets and money, but their historical roots, or etymology, are rather different. "Finance" originates from theold French word finer, meaning "to nd," in the sense of settling a dispute or debt, implying that finance is ameans to an end. "Credit" comes from the Latin credere, meaning "to believe."And "bank" hails from the Old Italian word banca, meaning "bench" or "table,"since moneylenders used to ply their trade at tables in the market, talking to customers or companies. "Company"also has an interesting history: it comes from the Latin companio, meaning "with bread," since companies were, in essence, people who dined together.All of this may sound like a historical uriosity, best suited to some pursuit of art.But the original senses should notbe ignored, since they reveal historicalechoes that continue to shape the cultureof finance. Indeed, thinking about the original meanings of "finance, “credit,"and "bank" - namely, as activities that describe banking as a means to an end, carried out with trust, by social groups helps explain what went wrong with the world of ?financein the past and what might fix it in the future.

?Let’s study these words one by one -

?FIRST - FINANCE

?To deeply analyse the word ‘FINANCE’ I would like to quote from the study which I read?I think in 2012-13 ?compiled by the economists Thomas Philippon and Ariell Reshef on a topic dear to bankers' hearts: their pay. After the crisis, Philippon and Reshefset out to calculate how this?fluctuated over the years in the United States,relative to what professionals who didn't work in finance, such as doctors and engineers, were paid. They found that in the early twentieth century-before the Roaring Twenties-financiers were paid around 1.5 times as much as other educated professionals, but the financial boom pushed this ratio up to almost 1.7times. After the Great Depression hit,it fell, and stayed around l.1-almost parity-during the post war years. But it soared again after a wave of deregulationin the late 1970s, until it hit another peak of 1.7 times as much in 2006-justbefore the crash.

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If you show these statistics to people outside finance, they sometimes blame the latest uptick in bankers' pay on greed:pay rose when the markets surged, theargument goes, because financiers wereskimming profits. If you show them tofinanciers (as I often have), they usuallyoffer another explanation for the recentsurge: skill. Wall Street luminaries tendto think they deserve higher pay becausefinance now requires greater technicalcompetence.

?If you examine from the premise of truth, both explanations are correct: as bankers' pay has swelled, the financial sphere has exploded in size and complexity, enabling financiers toskim more profits but also requiringgreater skill to manage it. In the United States in the immediate post war decades, the financial sector accounted forbetween ten and 15 percent of allbusiness profits and around 3.5 percentof GDP. Deregulation had unleashed a frenzy of financial innovation.

?I studied Finance in this era and how I wondered about ?these innovations - ?derivatives, swap[s etc etc - ?financial instruments whose value derives from an underlying asset. They were mathematically created – and were real bubbles. And sine they were bubbles, they were bound to bust. Derivatives enabled investors to insure themselves against risks-and gamble on them. It was as if people were placing bets on a horserace (without thehassle of actually owning a horse) andthen, instead of merely profiting fromthe performance of their horses, creatinganother market in which they couldtrade their tickets. Another new toolwas securitization, or the art of slicingand dicing loans and bonds into smallpieces and then reassembling them intonew packages (such as eDos) that could be traded by investors around theworld. Through my dabbling in Hospitality Industry in recent years another ?best analogy I can give here is culinary:think of a restaurant that lost interestin serving steaks and started offering upsausages and sausage stew.

?There were (and are) many benefits to all this innovation. As finance grew,it became easier for consumers and companies to get loans. Derivatives and securitization allowed banks to protect themselves against the danger of concentrated defaults-borrowers all going bust in one region or industrysincethe risks were shared by many investors, not just one group. These toolsalso enabled investors to put theirmoney into a much wider range ofassets, thus diversifying their portfolios.Indeed, financiers often presented derivatives and securitization as the magic wands that would conjure the HolyGrail of free-market economics: anentirely liquid world in which everything was tradable. Once that was achieved,the theory went,the price of every asset would accurately reflect its underlying risk. And since the risks would beshared, finance would be safer.

?I wondered that actually it was ?a compelling sales pitch, but a deeply flawed one. One problem was that derivatives and securitization were so complex that they introduced a brandnew risk into the system: ignorance.It was virtually impossible for investorsto grasp the real risks of these products.Little to no actual trading took place with the most complex instruments. Thatmade a mockery of the idea that financialinnovation would create perfect freemarkets, with market prices set by the wisdom of crowds.

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Worse still, as the innovation became more frenzied, finance became so complex and fast growing that it fed onitself. History has shown that in mostcorners of the business world, wheninnovation occurs, the middlemen get cutout. In finance, however, the oppositeoccurred: the new instruments gavebirth to increasingly complex financialchains and a new army of middlemenwho were skimming off fees at everystage. To put it another way, as innovationtook hold, finance stopped lookinglike a means to an end-as the wordfiner had once implied. Instead, Wall Street became a never-ending loop of financial flows and frantic activity inwhich financiers often acted as if theirprofession was an end in itself. Thiswas the perfect breeding ground for an unsustainable credit bubble – which was to bust.

?CREDIT

?The second most important word in the world of Finance is CREDIT. Credit is also crucial in understanding how the system spun out of control, in this crisis. The complexity of Finance at times becomes mind boggling – I remember reading somewhere that back in 2009, Andy Haldane,a senior official at the Bank of England,tried to calculate how much information an investor would need if he or she wanted to assess the price and risk of aCDO. He calculated that for a simpleCDO, the answer was 200 pages of documentation,but for a so-called CDO-squared(a CDOof CDOS), it was "in excessof 1 billion pages."Worse still, since aCDO-squared was rarely traded on theopen market, it was also impossibleto value it by looking at public prices, asinvestors normally do with equities orbonds. This is the complexity – complexity led to confusion. Complexity is good but confusion is bad. Making money out of complexity may be a sin, but making money out of confusion is certainly not acceptable. Complexity because of slack management by professionals of finance, and lack of insights, hind-sights and foresights leads to confusion – and people make money out of that. That meant that when investorstried to work out the price or risk of a CDO-squared, they usually had to trustthe judgment of banks and rating agencies. They had to. Faith had to be tied up more strongly – the culture of faith.

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In some senses, there is nothing unusual about that. Finance has always relied on trust and faith. People have put their faith in central banks to protect thevalue of money, in regulators to ensurethat financial institutions are safe,in financiers to behave honestly, in thewisdom of crowds to price assets, in precious metals to underpin the value ofcoins, and in governments to decidethe value of assets by decree. Finance is all about faith.

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What was startling about the pattern before the 2008 crash, however, was that few investors ever discussed whatkind of credit-or trust-underpinnedthe system. They presumed that shareholderswould monitor the banks, eventhough this was impossible given thecomplexity of the banks and the productsthey were peddling. They assumedthat regulators understood finance,even though they were actually little better informed than shareholders.Financiers trusted the accuracy of creditratings and risk models, even thoughthese had been created by people witha profit motive and had never beentested in a crisis. Modern financemight have been presented as a wildly sophisticated endeavour, full of cutting edge computing power and analysis, but it ran on a pattern of trust that, inretrospect, looks as crazily blind as thefaith that cult members place in theirleaders. It should not have been surprising,then, that when trust in theunderlying value of the innovativefinancial instruments started to crack,panic ensued.

BANK

?Invariably in all major financial crisis I have always wondered - Why did nobody see these dangers?To understand this, it pays to ponder that third word, "bank," and what it (andthe word "company") says about the importance of social patterns. These patterns were not often discussed before the 2008 crisis, partly because it oftenseemed as if the business of money was leaping into disembodied cyberspace.In any case, the field of economics hadfostered a belief that markets were almostakin to a branch of physics, in the sense that they were driven by rational actorswho were as unemotional and consistent in their behaviour as atoms. As a result,wise men such as Alan Greenspan (whowas Federal Reserve chair in the periodleading up to the crisis and was laudedas "the Maestro") believed that financewas self-correcting, that any excesseswould automatically take care ofthemselves.

?As always the theory sounded neat. But once again, and as Greenspan later admitted,there was a gigantic flaw: humans are never as impersonal as most economists imagined them to be. On the contrary,social patterns matter as deeply fortoday's bankers as they did for those renaissance-era Italian financiers.Consider the major Wall Street bankson the eve of the crisis. In theory, theyhad risk-management systems in place,with flashy computers to measureall the dangers of their investments. Butthe Wall Street banks also had siloed departments that competed furiously against one another in a quasi-tribal wayto grab revenues. Merrill Lynch was one case in point: between 2005 and 2007, it had one team earning bigbonuses by amassing big bets on CDOS that other departments barely knewabout (and sometimes bet against).Traders kept information to themselvesand took big risks, since they caredmore about their own division's short term profits than they did about thelong-term impact of their trades on thecompany as a whole- to say nothing ofthe impact on the wider financialsystem. Regulators, too, suffered fromtribalism: the economists who trackedmacroeconomic issues (such as inflation)did not communicate much with the officials who were looking at microleveltrends in the financial markets.

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Then there was the matter of social status. By the early years of the twenty first century, financiers seemed to be such an elite tribe, compared with the rest of society, that it was difficult for laypeople to challenge them (or for them to challenge themselves). Like priests in the medieval Catholic Church,they spoke a language that commonersdid not understand (in this case, financialjargon, rather than Latin), and theydispensed blessings (cheap money) thathad been sanctioned by quasi-sacredleaders (regulators). If an anthropologisthad been let loose in a bank at that time,he or she might have pointed out thedangers inherent in treating bankers asa class apart from wider society and therisks raised by bankers' blind spots andthe lack of oversight. (And a fewanthropologists, such as Karen Ho, did do studies on Wall Street, noting thesepatterns.) Sadly, however, these dangerswent largely unnoticed. Few peopleever pondered how the original, socialmeanings of "bank" and "company"might matter in the computing age, andhow tribalism was undermining neatmarket theories.

?CURRENT SCENARIO A PROLOGUE OF THE PAST

?Just look at the global state of Finance now in 2019-20. Almost a ?decade after the crisis, it may be temptingto see this story as mere history.In 2019, Wall Street is confident again.No, the market is not as complacent asit was before 2008; financiers are still(somewhat) chastened by the 2008 crashand hemmed in by tighter scrutiny andcontrols. Regulators forced banks tohold more capital and imposed newconstraints on how they make loans ortrade with their own money. Formerly gung ho investment banks, such as Goldman Sachs, are moving into the retail banking sector, becoming ever soslightly more like a utility than a hedgefund. The return on equity of mostmajor banks is less than half of pre-crisislevels: that of Goldman Sachs was just above ten percent in early 2019. Everyone insists that the lessons of the credit bubble have been learned-and the mistakes will not be repeated. May be so. But memories are short, and signs of renewed risk taking are widespread. For one thing, financiers are increasingly performing riskier activities through non bank financial institutions, such as insurance companies and private equity firms, whichface less scrutiny. Innovation andfinancial engineering have resurfaced:the once reviled "synthetic CDOS" (CDOS composed of derivatives) have returned.Asset prices are soaring, partly becausecentral banks have flooded the systemwith free money. Wall Street has lobbiedthe Trump administration for a partial rollback of the post crisis reforms. Profitshave surged. And although pay in finance efell after 2008, it has since risen again,particularly in the less regulated parts ofthe business.

What's more, America now looks resurgent on the global stage of Finance. In Europe, banks' have been hobbled by bad government policy decisions and a weak economy in the euro zone. In Asia, the Chinese banking giants are saddled with bad loans, and Japans massive financial sectoris still grappling with a stagnant economy.

?To me it seems that the lessons of crisis have not been learnt completely. Today, as before, there is still a tendency for investors to place too much faith in practices they do not understand. The only solution is to constantly question the basis of the credit that underpins credit markets. Just as there was in 2007, there is still a temptation to assume that culture does not matter in the era of sophisticated, digitallyenabled finance.

That is wrong. Banks and regulators today are trying to do a better job of joining up the dots when they look at finance. But tribalism has not disappeared. Wall Street banks still have trading desks that compete furiously with one another. Regulators remain fragmented. Moreover, as finance is being disrupted by digital innovation, a new challenge is arising: the officials and financiers who understand how money works tend to sit in different government agencies and bank departments from those who understand cyberspace. A new type of tribal fracture looms: between techies and financiers.

?Policymakers need to ask what Wall Street's mighty money machine exists for in the first place. Should the financial business exist primarily as an end in itself, or should it be, as in the original meaning of "finance," a means to an end? Most people not working in finance would argue that the second vision is self-evidently the desirable one. Just think of the beloved film It's a Wonderful Life, in which the banker played by Jimmy Stewart sees his mission not as becoming fabulously rich but as realizing the dreams of his community. When finance becomes an end in itself, the public is liable to get angry. That's one reason for the wave of populism that has washed over the globe since the crisis. This populism has to stop, at the macro level.

?And at micro – level does the Finance professional really know how to build a financial system that is the servant, not the master, of the economy? Sadly, the answer is probably no; at present, it is hard to imagine what this would even look like. No matter what, however, if these professionals -along with regulators, politicians,and shareholders-wish to reduce the odds of another crash and another populist backlash, they would do well to tape the original meanings of"finance," "bank,” and "credit” to theircomputer screens.

?The answer is in FAITH ….. FAITH ……. and FAITH.

?How ??????

?SOMETHING MORE …….. !!!!!

?Will be answered in next?post.

?sudhanshu