Fundamental Changes Are Required To Avoid Putting Good Money After Bad

In the financial markets, there is a trading 'strategy' which, although it is often given other names, essentially boils down to 'double or quits' in the everyday language of the betting office.

If a trader takes on a position in the market - and then loses, he can make good his losses by taking on successively larger positions until, eventually the dice falls in his favour, at which point he can make good all of his earlier losses.

The problem with this approach is, of course, obvious - the size of the position that they are required to take can escalate very rapidly, and the size of the associated risk also mushrooms. Before long each unfavourable throw of the dice can lead to huge losses, and even the deepest of financial pockets will soon be emptied.

Although simple common sense shows that this is a dangerous strategy, it is a surprisingly common one. Under extreme pressure to make good losses, the judgement of traders can be distorted sufficiently for them to embrace such a game of financial Russian Roulette.

In practice, most of the time they get away with it of course, but when things go wrong, losses can be enormous. One of the most famous practitioners of this strategy was Nick Leeson, who single handedly broke Barings Bank, there have been other spectacular examples in the years since.

In the situation that we find ourselves today, the government must be careful not to find itself falling into the same trap - when the numbers are so large, the resources of the state are not infinite, and they cannot afford to throw the dice too many times before the UK would find itself following a similar path to that previously trodden by Barings.

Before deciding on what action should (or indeed should not) be taken, it is worth considering what the objectives should be. In our view, at least part of the current problems are being caused by the fact that there is a wide perception that the measures being taken by the government are essentially short-term, to 'stop the rot' at whatever cost.

Unfortunately, without a clearer view of 'what comes next' the markets will be disposed to view almost any rescue measures as insufficient, and there will come a point where the resources that would need to be committed will undermine the long-term financial stability of the country as a whole.

If it were within our gift, the priorities that we would set are, in order, as follows:

1. To stimulate the economy and resolve the immediate liquidity crisis.
2. To ensure that such a situation cannot arise again.
3. To recover as much value as possible for the taxpayer.

How Could these Goals be Achieved ?

In our view, it is becoming apparent that resolving the immediate crisis cannot be achieved without there being a clear and credible longer-term strategy in place.

A key objective must be to obtain the maximum possible leverage for any financial support that is given, and to try to do this in such a way that in the medium-term the taxpayer does not lose too much, and preferably even makes a return, commensurate with the risk being taken.

At least part of the strategy that is being adopted by the UK government appears to rely on the fact that if the government stands squarely behind the banks with a blank cheque in its hand, then this will calm the markets and remedy the situation. In effect, the offer of a blank cheque means that it would never actually have to be cashed.

Unfortunately, if the markets call their bluff - as they appear to be doing - then the situation could quickly spiral out of control.

Calls For Greater Regulation

Whenever any serious problems emerge within a bank or other financial institution there is always a knee-jerk chorus of calls for 'greater regulation'. It is clearly true that regulation and regulatory scrutiny appears to have been woefully inadequate. However, we do not believe that such increased regulation per-se is necessarily a solution without other accompanying changes.

After all, banks already have to provide extensive information to both the regulators and the central banks - so (with the exception of the odd criminal deception) the exposures that have led to the current crisis were there for all to see, including the board members of the banks', the regulators, the bank of England, and the banks' shareholders.

Another practical problem is that, within the world of financial engineering there is an extraordinary array of techniques, structures and instruments which can be used to modify and re-arrange exposures, risk profiles and the precise figures which are reported to regulators and others.

These devices often result in greater financial complexity, and less transparency. In our view much of the present crisis has been due to such a lack of transparency. The complexity of the balance sheet of any of the major banks is now such that it is hard to believe that even an 'expert', let alone an average shareholder, would really have a good grip on what really lies beneath the surface. Greater transparency will not be achieved simply by mandating the generation even more reports full of complex financial figures.

The Need For Restructuring And Fundamental Change

In our view, part of the long-term solution might well be a restructuring of the financial system, with a view to achieving both a simplification and greater transparency.

This would partly involve separating out different types of business, so that there is much greater transparency in their financial affairs, and providing simple rules to control any risk inter-dependencies and cross-capitalisation between such entities.

The Role of Non Executive Directors

We also believe that another component of a solution must be to ensure much more effective governance of financial institutions by their directors. In our view these failures have been even more manifest than those of financial regulation.

In risk management terms, one of the most important pitfalls to avoid is 'group think', where a spurious collective view is arrived at. This basic problem appears to have been endemic in the board rooms of many financial institutions.

In particular, we believe that ways need to be found to make the non-executive directors of such institutions much more effective. In their role they are specifically obliged to protect the interests of the shareholders by providing a degree of informed independent oversight - rather than meekly acceding to the will of their chief executive.

In our view, some of these individuals should now be held personally and publicly accountable for their inaction - not as an act of retribution, but to focus the minds of those who hold similar positions in the future on where their responsibilities really lie.