Thursday, December 29, 2011

Financial Amnesia

A lack of financial memory is a significant contributor to the historic pattern of recurring financial bubbles.

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith in his book: A Short History of Financial Euphoria (Page 87)

Factors that led to the financial crisis and lessons learned were recently highlighted by the Chartered Financial Analyst Society of the UK (CFA UK), a leading trade body. Below, I've included some excerpts from CFA UK's Response to the Joint Committee on the draft Financial Services Bill.

As Galbraith points out in the above quote, every 20 years or so the new players involved in the financial system, the so-called smart money, become convinced "it's different this time" because of some new innovation, financial or otherwise:

CFA UK blames what it calls "financial amnesia" among financial professionals. That a failure to learn and heed lessons of the past led to the most recent financial crisis and will likely lead to future ones.

Galbraith would approve.

From CFA UK's Response to the Joint Committee on the Draft Financial Services Bill:

Financial amnesia is when financial market participants forget or behave as if they have forgotten the lessons from financial history. Financial market participants are composed of two main groups, regulated financial firms and regulators. Despite the history of bitter experience, the same mistakes occur with alarming regularity (see Appendix 1). The three key lessons that participants appear to forget are: 

Lesson 1: "Innovation", the illusion of safety and "this time it's different": "The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version" (Galbraith).The expansion of credit plays a key role in fuelling "innovation" while the creation of an illusion of safety results in a "this time it's different" approach that enables the continuation of unsustainable activity and risk taking. Sadly, each time it is always the same and never different.

Lesson 2: Regulated financial firms are prone to failure: It has been presumed that regulated financial firms by acting in their own self interest and in the interests of their shareholders, impose market discipline. History has demonstrated that because failure to impose market discipline is not uncommon, over-reliance on market forces can be misleading.

Lesson 3: Ineffective regulation. The frequency of market failure places a greater onus on the regulator to be more effective in encouraging and imposing market discipline. Sadly, regulators focus on the symptoms of failure rather than its root causes. Furthermore, regulators often ignore the root cause of their own inability to act promptly and thereby contribute to the risk of systemic governance failure. 

The letter goes on to say that regulators should learn from financial history and require:

1) Firms conduct themselves to the highest professional and ethical standards and place clients’ interests first.
2) Enhance financial capability so that consumers become a more robust source of market discipline on firms.
3) Establish a regulatory philosophy and approach which acknowledges that we live in a world populated by people who do not always act rationally and imperfect markets.

Those three things are desirable outcomes that make a ton of sense. The fact that such little progress has been made in achieving those outcomes never ceases to amaze.

While this was written in the context of the United Kingdom it clearly applies to the United States. Financial professionals and market participants more generally need a better awareness of financial history.

From this Financial Times article posted on CNBC:

Financial Amnesia a Factor Behind the Crisis

Fund managers and financial advisers should be forced to study financial history to reduce the likelihood of future market panics and crashes, according to a leading trade body for investment professionals.

The article goes on to say...

CFA UK, which represents 9,000 investment professionals, argues that the study of financial history should form a major part of all compulsory education for retail and wholesale investment professionals. "Financial amnesia disarms individuals, the market and the regulator," the body said. "It causes risk to be mispriced, bubbles to develop and crises to break."

It's an uphill battle because this recurring problem goes back a long way.

Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, said it was common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That's certainly not surprising. Yet, Mackay also made the point that "nobody seemed to imagine that the nation itself was as culpable". John Kenneth Galbraith made a similar assertion about the Crash of 1929 and other episodes of financial euphoria.

Here is a more complete version of the quote from Mackay. Describing the aftermath of the South Sea Bubble, he said:

"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon South Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South Sea company. Nobody blamed the credulity and avarice of the people-the degrading lust of gain...or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned."

The above doesn't seem much different than some of our more recent bubbles. An inevitable painful economic contraction followed the bursting of the South Sea Company bubble.

History repeats frequently when it comes to financial euphoria. As James Grant wrote in his book Money of the Mind:

"Progress is cumulative in science and engineering, but cyclical in finance."

We should do everything possible to avoid the next but, if the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it will happen again in some form.

Still, it's good to see someone like CFA UK taking what seems a leadership role. Requiring the study of financial history is a good start but is unlikely to even begin to solve the problem. The idea of undertaking an annual "amnesia check" (as is suggested in the Financial Times article) sounds good but is likely also insufficient. Whether changes with some "teeth" can modify behavior to the point that it prevents the next crisis remains to be seen. Considering the track record some skepticism seems more than warranted.

That, of course, doesn't mean it's not well worth trying to make improvements in this area. Any sincere effort to do so should be applauded.

I'd also go a bit further. It would help if financial education was more robust in general so, as CFA UK suggests above, "consumers become a more robust source of market discipline on firms."

Adam

Related posts:
When Genius Failed...Again
Smart Money?
The Madness of Crowds

* Three chapters of that book describe bubbles like the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.
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