The Financial Crisis: Who is to Blame?

Financial crisis is a many-headed hydra and unravelling its causes a Herculean task. In The Financial Crisis: Who is to Blame?, Howard Davies makes significant progress, presenting a relatively clear and apolitical analysis of the many, varied and connected causes of the 2007-10 crisis.

Davies blames everything from basic human fear and greed through to global regulatory failures. An unstable international macroeconomic environment was a crucible for crisis and ideological forces played a role too; in some ways, the crisis was a dying breath for laissez-faire capitalism. Globalisation and computerisation enabled the rapid, borderless movement of financial assets, contributing to financial fragility. National and global borrowing and savings imbalances, together with loose monetary policy and euphoric boom-time borrowing, catalysed eventual bust.

His main focus, however, is on the failures of "light touch" regulation, and regulatory failures are thoroughly explored here. Regulatory arrangements did not prevent banks' capital shortages; predatory lending grew without much constraint, particularly in the US, precipitating the crisis in sub-prime lending. The 1999 repeal of the Glass-Stegall Act allowed US banks to grow until they were too big to fail. In the US, five major independent investment banks were regulated by the Securities and Exchange Commission and three of these either became bankrupt or had to be rescued: it was, says Davies, a 21st-century financial system overseen by 19th-century regulation.

In Britain, tripartite arrange-ments dividing responsibility for financial regulation between the Treasury, the Bank of England and the Financial Services Authority led to a clumsy handling of the September 2007 Northern Rock crisis.

Internationally, the Basel Committee on Banking Supervision, while reflecting the consensus of central bankers, agreed only in 2004 the strict risk and capital management requirements outlined in Basel II. Basel II was implemented slowly and is now being superseded by Basel III.

Regulatory failures allowed financial institutions and their confederates to get away with weak corporate governance at best and fraudulent practices at worst. Boards of directors lacked expertise and authority. Trading practices were too complex and esoteric. Financial innovation led to the design of poorly understood derivatives (financial products derived from an underlying asset); Warren Buffett viewed these as financial weapons of mass destruction.

Many products were designed just so they could be sold, which meant that the links between borrowers and the ultimate holders of their debt became far removed and opaque; the people who effectively held the debt had no knowledge of the risks embedded in the products they were buying. Rogue traders could flourish in environments in which bosses did not understand the products being traded. Large bonuses encouraged excessive risk-taking and short-termism on the assumption that downside consequences would be absorbed by government bailouts. Accounting standards exacerbated the problem, as "mark-to-market" (valuation of assets at market prices) exacerbated collapses in asset values. Auditors were also culpable - Lehman Brothers and Bear Stearns were both given clean bills of health just months before their collapse. Investment banks are auditors' customers, so auditors' independence was, perhaps inevitably, compromised - a problem manifested in the unquestioning application of accounting rules.

More whimsically, Davies also outlines some psychological forces, citing recent analyses such as Susan Greenfield's hypotheses about the impact of computer games, which apparently have contributed to the under-functioning of traders' prefrontal cortices (popularly associated with deliberative reasoning). Similarly, he cites recent studies of the links between risk-taking and oestrogen/testosterone levels.

Other potential culprits are the academic economists who promulgated the myths of rational decision-making and informationally efficient financial markets (in which asset prices adjust completely to reflect new information and so capture the true long-term value of assets). The media were complicit too; while there were some useful exposes, financial journalism was "the watchdog that didn't bark", choosing instead to fuel the collective euphoria and hero worship that characterises boom times.

Davies comes to no clear conclusions about ultimate culprits, but to do so would be simplistic; in the worlds of economics and finance, lags between decisions and actions are complex and it is practically impossible to separate cause from symptom. In any case, dissecting the origins of a crisis is perhaps not as important as regulating against future crises. Effective prophylactics must be designed and properly coordinated to slow the growth of financial fragility in the future. This is perhaps the most crucial problem he identifies: the "half-life of lessons from disasters is shorter than one might think". So before we all forget how awful the crisis really was, we must "embed these painful learnings into new laws and regulations".