Year: 2008

Investors are looking for scalps and insurers have warned that companies worldwide – not just in the US, where shareholder actions are more common – face potentially ruinous litigation claims for losses caused either as a direct result of their own actions and failure to manage risks effectively, or through their exposure to those companies that followed high-risk strategies. Insurance market Lloyd’s of London has warned that businesses could be facing a future liability crisis if they do not face up to growing litigation issues. In its report called “Directors in the Dock – is business facing a liability crisis?” published in May, Lloyd’s urges businesses to anticipate and prepare for future liability risks potentially arising from the credit crunch.

Lloyd’s research has shown that boards everywhere are feeling increasingly challenged by litigation and are spending more time and money addressing these issues. Key findings include the fact that two-thirds of European business leaders expect to spend more time on litigation-related issues over the next three years, and that two in three business leaders believe that the scale of liability claims arising from the credit crunch will exceed those arising from the dotcom crash.

By the end of 2007, the credit crunch had sparked a 58 percent rise in the number of class-action lawsuits filed by US shareholders against companies and their directors. Research has found that lawyers filed 207 class-action cases last year, up from 131 in 2006. The average settlement also soared to $32.2m, up nearly 50 percent on 2006. The median pay-out also hit a high of $10m, according to NERA Economic Consulting, an international firm of economists. So-called mega-settlements, worth $100m or more, accounted for nearly one in 12 of all settlements. Before 2000 they accounted for, at most, two percent of payouts.

The first of the sub-prime related securities class action lawsuits were filed in February 2007, just as the problems in the sub-prime marketplace began to surface. Since then, as the sub-prime-related problems developed into a more generalised credit crisis, the associated litigation has also grown. As of October 1, 2008, there have been 120 sub-prime and credit crisis-related securities class action lawsuits filed, in addition to 23 derivative lawsuits and 15 ERISA lawsuits.

Breaching fiduciary
As might have been predicted, shareholder lawsuits have already been filed against the directors and officers of some of the most prominent companies caught up in the events of Black September 2008. For example, on September 15, 2008, Merrill Lynch shareholders filed a complaint in New York state court against the company, as nominal defendant, and a certain number of directors and officers. The complaint alleges that the company’s planned merger with Bank of America is the result of a “flawed process and unconscionable agreement” and that the defendants had breached their fiduciary duty.

Similarly, on September 18, 2008, AIG shareholders filed a Delaware Chancery Court lawsuit against certain current and former directors and officers of AIG. The lawsuit blames the defendants for the company’s “exposure to and grossly imprudent risk taking in the sub-prime lending market and derivative instruments.” The lawsuit seeks the return to AIG of all compensation paid to AIG’s CEO and to its directors, among other things.

In addition, on September 24, 2008 plaintiffs’ lawyers initiated a securities class action lawsuit in the Southern District of New York against certain directors and officers of Lehman Brothers, on behalf of persons who purchased shares in the company’s February 5, 2008 offering of preferred securities. The complaint also names the offering underwriters as defendants. The complaint alleges, among other things, that the offering documents did not accurately reflect the company’s true financial condition, because the defendants had failed to appropriately write-down both the company’s sub-prime mortgage portfolio and its portfolio of commercial and residential real estate assets.

So far, directors in the UK have managed to avoid litigation for their part in the downfall of their firms. In October nationalised lender Northern Rock said it would not take legal action for negligence against the executives in charge of the bank before its collapse. Management said a review by lawyers and accountants into the management led by Chief Executive Adam Applegarth found “insufficient grounds” to proceed. The probe also concluded that the firm’s auditors should also avoid any action.

But UK lawyers do not discount the possibility that directors of other organisations severely impacted by the credit crisis will not be treated so favourably. “There’s only so long before someone in the UK realises that the courts are the only real recourse he has to get justice for his pension fund being depleted and the shares in the bank he invested in being worthless. Once that happens, directors will need to be very aware of the consequences of their actions and the risks their organisations are taking,” says one UK corporate lawyer.

Pressure cooker
Experts also agree that as companies are under increased pressure to show shareholders that they can still perform well in a depressed economic climate, it is increasingly likely that company directors will need to make sure that risks facing the business are properly assessed, mitigated and controlled and that corners are not cut simply to reduce costs.

The UK’s Companies Act (2006), which came into effect in 2007, states that the duty of directors is to act in a way which they consider most likely to promote the success of the company for the benefit of its shareholders as a whole and that, in doing so, they will need to have regard “where appropriate” to long term factors, the interests of other stakeholders and the community, and the company’s reputation. As a result, risks need to be identified and managed properly. And in an economic downturn, there are arguably more risks to consider.

One of these key risks is whether the directors are keeping a tight rein on the organisation’s operations and ensuring that while the business may be taking an “aggressive” strategy to stay competitive in the current climate of economic turmoil, it is not acting illegally or outside the bounds of corporate governance best practice. If it is, then the directors could well be in the firing line for regulatory action and/or investor lawsuits. 

And it is not just full-time executive directors that can be targeted. Some recent scandals have shown that non-executive directors can be at the centre of colossal fraud trials and damages claims. Recent examples include Lord Wakeham, formerly a non-executive director at disgraced US energy company Enron, who suddenly found himself being summoned to the US to provide testimony in the world’s most notorious corporate fraud trial.

Under UK law, all directors have a legal duty to display not only a reasonable level of skill, care and diligence in the discharge of their functions, but also to bring to bear such knowledge, skill and experience as they have. Furthermore, UK company law does not distinguish between executive and non-executive directors and thus both sets of directors share the same duties and responsibilities to shareholders, regulators and other stakeholders. The dismissive remark once given by executive ITV Chairman Michael Grade about likening non-executives to bidets (“you’re not sure what they’re for, but they add a touch of class”) – which perhaps once captured the passive nature of the role – no longer holds true. Non-executives are equally as culpable as executives.

Risk management
In the case of UK life insurance firm Equitable Life which came close to collapsing in 2000, the troubled insurer’s non-executives were forced – following a regime change at the company’s board – to enter the witness box in the context of a £2bn claim against them to defend their actions. One of the main planks of their defence was to the effect that the risks surrounding guaranteed annuity rates were a highly technical matter on which they had to rely on the good judgement of the actuaries, the other professionals and the executive, and therefore they should not be held equally culpable.

But the UK’s financial services regulator has made it clear that such an attitude is no longer tenable. Shelia Nicoll, director of the FSA retail firms division, has warned that the regulator now plans to interview “more of those applying to hold significant influence functions at the largest firms”. 

In a speech on September 17, Ms Nicholl said: “We certainly expect that those we interview will go on to be approved – those invited to interview as part of our scrutiny process should not feel that they have been singled out for attention. We have run pilots and we expect and hope that those we interview will take up their new roles more conscious of their regulatory responsibilities. You should, however, be clear that FSA approval of significant influence functions is not a ‘tick box’ exercise.”

Ms Nicholl said that while the FSA appreciates that it cannot expect non-executive directors to have the same grasp of detail as executives who work full time for a group, she added that “we expect them to ask the challenging questions, to understand the business models and sources of profit in the firm, along with the risks which those entail. So, if you agree to be a non-executive director of a regulated firm or a group containing regulated firms, you must expect us to assess your competence and to hold you to account if you have not conducted yourself in a way which falls below the standards we reasonably expect of non-executive directors.”

“Boards which are mere paper tigers can be worse than useless because they give false reassurance of high standards – of checks and balances – where none exist,” said Ms Nicholl. “We aren’t ignorant of the difficulties which medium-sized firms have in getting hold of good directors, but my personal view is that a firm is better served by having a smaller number of hard working, well paid non-executive directors than a larger number of token ones.”

Lawyers also believe that the current financial climate may compel directors to take greater credit risks. Danny Davis, partner in the insolvency practice at law firm Mishcon de Reya, points out that while the UK is heading for recession, there is going to be increased pressure on companies to push back payment deadlines with suppliers while trying to get customers to pay more rapidly. As a consequence, he says, there are going to be more instances of companies trading while heading for insolvency.

“The credit crunch is going to make some directors take bigger risks with regards to how they try to manage their cashflow,” says Mr Davis. “It is increasingly likely that more companies will be heading for insolvency in the coming months, and directors need to make sure that their companies do not trade while insolvent – or are about to go insolvent – in an attempt to keep the business running.”

Mr Davis adds that directors should also not make the mistake of thinking that the company’s tax payments are not as important as payments to suppliers. “Time and again we see court cases where companies are filing for insolvency and they haven’t paid the taxman because they mistakenly thought HM Revenue and Customs was the least important creditor. Companies in difficulty often believe that their tax payment can simply be made at a later date – often without telling HMRC why – so that funds can be used ‘constructively’ to pay staff, suppliers, stockholders, utilities, lease holders and so on first. This is nonsense and is not favourably looked upon by the courts.”

This is, by general consensus, about the worst time to be a broker since 1929 – and possibly since 1914 and the start of the First World War. Both retail brokerage and prime brokerage firms have been kicked around by the crisis of the past few months, and both will emerge changed, even ignoring the way some firms have simply disappeared off the map. There is going to be a much more risk-averse culture from clients and among the owners of brokers, there is going to be greater pressure on analysts (who might find their remuneration changes to “payment for accurate prediction”), and there is almost certainly going to be regulation to ensure firms have to measure risk better, and show that they are measuring risk better.

After all, if even Alan Greenspan, Chairman of the Federal Reserve Bank for 18 years until 2006, confesses himself “in a state of shocked disbelief” over the global financial crisis, then one can be safe in drawing the conclusion that the system did not work the way it was meant to. Mr Greenspan said as much himself, on October 23, when he told a congressional committee in Washington that he regretted opposing regulatory curbs on the types of financial derivatives that led to banks in the US, the City of London and elsewhere with billions upon billions of dollars of liabilities. “I made a mistake in presuming that the self-interests of organisations, specifically banks and others were such that they were best capable of protecting their own shareholders and their equity in the firms,” Mr Greenspan told Congressmen on the House oversight committee.

The problem, as Mr Greenspan now seems to be realising, is that you can only assess risk, and protect your company and your shareholders against too much risk, if you understand the game that is being played. Those at the top of banks knew too little about what their subordinates were doing in bundling up all sorts of derivatives and trading them on.

They believed what they were told about the risk, or lack of it, in these new sorts of financial instruments. They did not understand how what was being bought and sold in their companies’ names really worked, and so they were unable to make a judgment on their real safety. Nor did they have in place systems to properly evaluate and report on the risks these instruments really posed. Instead, they saw the large profits being made, and ignored any qualms they may have felt, until suddenly too much of what was being passed as prime assets turned out to have the solidity of dry sand. Trust collapsed, as banks realised they could not believe their fellows’ balance sheets and could not be certain to get any loans back, and credit – which relies on trust – dried up.

If and when the dust settles
With so powerful a free-market flagwaver as Mr Greenspan giving the nod towards greater regulation in a post-credit crunch world, there seems little doubt that financial institutions are going to be working in a very different regulatory environment once the dust finally settles after the collapse of such former banking giants as Lehman Brothers, with debts of more than $613bn.

On the other hand, as Mr Greenspan also told the congressional committee, in words rather less widely reported than his comment about “shocked disbelief”, self-interest, properly applied, is still more powerful than regulation: “Whatever regulatory changes are made,” he said, “they will pale in comparison to the change already evident in today’s markets. Those markets, for an indefinite future, will be far more restrained than would any currently contemplated new regulatory regime.” Clients are going to remain risk-averse for a long time, and the leaders of financial institutions are going to be ensuring their own organisations are pursuing risk-averse policies for a long time: even without legislative compulsion to do so, out of protective self-interest banks and other financial institutions are going to set up internal systems to review risk much more thoroughly than they have been doing.

That is unlikely to be enough for politicians. Already some are fearing a knee-jerk rush by governments and legislators to, effectively, punish the global financial services industry with new regulations as a payback for the pain the perceived excesses of the banks and financial institutions are causing the world economy right now. One US politician, the Republican Congressman Chris Shays, spoke for many when he told the House Financial Services Committee on regulatory reform at the end of October: “No one has the right to juggle knives on a public bus.” Attacking the highly leveraged share dealing practised by hedge funds and backed by prime brokers such as Lehman Brothers, Mr Shays said that “high-risk ventures that threaten systemic integrity need to be fully capitalised by their private sponsors or prohibited altogether.”

Despite bankers’ natural aversion to regulation, there is unlikely to be too much fuss made about new regulatory oversight of risk and risk management. The financial world is so interlinked that, just like in the child’s game Ker Plunk, pulling out one vital stick can suddenly make the whole thing collapse. Banks are likely to say: “We know we’re all right, but we want new regulations to prevent our rivals from putting themselves, and us, in danger.” Tim Ryan, Chief Executive of the US Securities Industry and Financial Markets Association, one of a number of trade groups representing brokers, banks and insurers. Who gave evidence to the House Financial Services Committee on regulatory reform, called for “a financial-market-stability regulator that has access to information about financial institutions of all kinds that may be systemically important, including banks, broker-dealers, insurance companies, hedge funds, private-equity funds and others.”

Suspicious minds
Advocates of the idea of a new “systemic regulator” disagree whether or not there should be a “market stability regulator” separate from a body focused on business conduct; and indeed whether there ought to be two separate stability regulators, one for banks, broker-dealers, hedge funds and other securities industry participants, and another for “systemically important institutions”, which would include larger hedge funds and other financial entities that “could not be allowed to fail”. How you define “too important to be allowed to fail”, though, will always be a political rather than a financial choice: it looks as if Lehman’s was allowed to fail because it happened to be the first (or at least the first far enough after Bear Stearns): other banks were shored up, not because they were more important than Lehman’s but because their collapse right after Lehman’s would have brought a general run on the entire financial system.

Speaking to the same congressional committee as Mr Greenspan, Christopher Cox, Chairman of the US Securities and Exchange Commission, declared: “We have learned that voluntary regulation does not work.” Regulation on broker-dealers and their investment bank holding companies “must be mandatory, and it must be backed by statutory authority,” he said. The holding company in the case of Lehman Brothers, for example, Mr Cox said, consisted of more than 200 subsidiaries, including over-the-counter derivatives businesses, trust companies, mortgage companies, offshore banks, broker-dealers, and reinsurance companies. The SEC was not the statutory regulator for 193 of them. The current regulatory system is “a hodge-podge of divided responsibility and regulatory seams” where coordination among regulators is difficult, and a new scheme is necessary, he said. Mr Cox wants to abolish “outdated” laws that treat broker-dealers “dramatically differently” from investment advisers.

Paradoxically, part of the blame for the current crisis is being put on a complicated piece of regulation introduced by the Federal Accounting Standards Board in the US and enforced by the SEC, supposedly in the name of transparency, covering “marking to market”, which regulates, among other things, how banks value every day the assets they hold and how brokers value assets and make margin calls on accounts. Critics, such as William Isaac, former chairman of the Federal Deposit Insurance Corporation in the US, which guarantees bank deposits, claimed that the Securities and Exchange Commission’s “senseless” insistence on firms “marking to market” assets for which there was no proper market to assess value by that has destroyed $5trn of bank lending. Mr Issac said: “That’s a major issue in the credit crunch right now. The banks just don’t have the capital to start lending, because of these horrendous markdowns that the SEC’s approach required.” The problems with regulating the proper valuation of assets whose real value can’t be known until they are sold at some time in the future by marking to an effectively imaginary market, whether or not those regulations added to the credit crisis, certainly show that framing regulations without running into the Law of Unintended Consequences is not easy.

Jenga
There is certainly going to be a new take on risk from all sides of the financial world. Hedge funds, who might have been expected to know more about risk than anybody – after all, it is meant to be how they make their money, evaluating risk more accurately than the market as a whole – found themselves badly hammered when a risk they never expected, the bankruptcy of Lehman Brothers, the biggest in the world reared. Many hedge funds used Lehman’s as their prime broker, and found their assets stranded when the bank went down – assets of up to $1.5bn for a single fund, in some cases. At least one hedge fund is said to be closing, because of Lehman brothers’ bankruptcy. Since the rule now has to be “if it can happen to Lehman’s, it can happen to anybody”, clients who use banks for prime brokerage operations in future are going to be putting pressure on those banks for greater transparency, and better safeguarding of their funds.

The prime brokerage market was previously dominated by three big American players, Goldman Sachs, Morgan Stanley and Bear Stearns (sold to JP Morgan Chase in March this year for $10 a share, down from $93 a share only a month earlier, after investors’ confidence evaporated in the face of the sub-prime mortgages crisis). Going forward, the industry looks likely to be divided up more evenly between six key players, with hedge funds spreading their own assets around these six firms rather than having a single main prime broker.

Retail brokers have been surprisingly busy so far this year, with volumes high even as prices plunged. Many brokers derive a high proportion of their revenue from trading fees, so that prices are of less concern than they might at first appear. But with the storm that has taken place in September and October likely to lead to a reduction in retail trading, brokers could see fee income fall, at the same time as lower interest rates hit the amount they can charge for leveraging loans.

If clients prefer to sit on their assets, or seek safety outside stock markets, then the retail brokerage industry round the world is going to see a wave of closures and mergers. There are certainly not going to be too many company flotations to keep brokers busy over the next few months.

Not everybody agrees that more regulation is the way forward. The FSA in the UK stepped in quickly to ban short-selling during the crisis, but Hector Sants, head of the organisation told the Hedge 2008 conference in London at the end of October that increased regulation is not needed. “There is pressure for more regulation in a rather general way,” he said. “I don’t particularly think more regulation is needed, but I do think more effective regulation is needed.” What exactly the difference between “more” and “more effective” was, Mr Sants did not say. But he stressed the need for tighter control and increased vigilance by risk managers in the affairs of  banks and broker-dealers, However, with the Bank of England announcing that it will be asking for more powers from the government to intervene directly in markets, it looks as if, in the UK at least, there is going to be a clash between the still laissez-faire FSA and the interventionists in Threadneedle Street.

For a brief moment in October it seemed as if the world’s financial systems were about to implode. What was once unthinkable, and if we are to believe many financial models, unimaginable, was actually happening. Rock solid corporations were crumbling, governments that had long espoused free market capitalism were rushing to bail out banks, in many cases through part or complete nationalisation.

As is always the case, along with the woe, there was plenty of finger wagging. A once in a lifetime financial crisis is bound to be accompanied by some serious recrimination. And so it has proved.

In the frame are a number of people and practises associated with the crisis. But perhaps three are mentioned more than most as the principle offenders: banking bonuses; light touch regulation; and financial innovation. All three have been identified as culprits at the heart of the current debacle. But how culpable are they?

Executive compensation and the bonus system
The accusation: The compensation system for many employees in the financial services industry is rigged in a way that encourages and rewards excessive risk taking.
When those risks pay off, profits are privatised in the form of huge salaries and bonuses for senior executives, traders and other employees. Yet when the risks prove a bridge too far, resulting in staggering losses, and, in some cases, destroying companies and billions of dollars in value, the losses are socialised. Banks are recapitalised. Ordinary shareholders and taxpayers lose out.

Plus golden parachute deals, and other aspects of executive compensation, mean that senior executives can still receive significant payoffs when they step down (or are removed), despite presiding over, and presumably approving, the risky, often highly leveraged activities that underpin the slump in the value of many financial stocks.

In defence: If you don’t pay the market rate, the best talent will go elsewhere, whether it is another firm, or another industry. Moreover, financial service firms operate in a global market. So the level of compensation must match the best available globally.

And only a small number of people have the experience and skills required to operate as senior executives, or in various specialist jobs, at firms like commercial or investment banks. Therefore these people can justify what might appear extravagant compensation deals, including golden handcuffs and parachutes. Also, employees need incentives to perform well; the greater the incentive, the better the performance. The prospect of significant profit related bonuses as a major percentage of a compensation plan, drives performance.

The verdict: It is true that in competitive markets, firms must pay attractive rates to attract talent. This needs addressing. If people are rewarded according to performance, then some will be tempted to focus on hitting short-term targets to trigger maximum rewards rather than concentrating on the long-term consequences of the business they are doing.

One suggestion is to introduce some kind of time and performance linked provision with bonuses, such as placing them in escrow, thus allowing claw back in the case of poor performance. As for the global market for talent argument, that is not persuasive. The compensation differential may need to be fairly significant to get people to uproot their lives and relocate to another country. And it should not be assumed that experience gained in one country or market will translate to another.

Light touch regulation
The accusation: That the financial services industry failed to appreciate lessons learnt following US stock market crashes in 1907 and 1929. After the 1907 crash, betting on whether shares went up or down without actually owning those stocks was outlawed. After the 1929 Wall Street Crash, the Glass-Steagall Act passed in 1933 separated the operations of commercial and investment banking.

By the 1970s, however, despite decades of relative financial systemic stability, senior executives grew restless for better growth and shareholder returns. The Glass-Steagall Act was finally repealed in 1999. The Commodity Futures Modernisation Act of 2000 removed derivatives from federal oversight, and rendered the bucket shop laws obsolete.

It is no coincidence that, as the regulations were relaxed, systemic financial crises mounted up.

In defence: External regulation stifles financial innovation, and the ability of firms to provide the best service for their customers, and the maximum value for shareholders. Compliance with external regulation is often very costly, having an adverse competitive impact on business within a particular jurisdiction, with respect to businesses outside that jurisdiction. While oversight is required, it is best provided by the people who have the most appropriate industry specific experience – in this case the financial services sector itself. This is a free market after all, and supply and demand should be left to fend for themselves.

The verdict: The concept of self regulation has been hugely discredited in the wake of the current crisis. Surely if light touch regulation is effective the global financial system wouldn’t be in this mess. However, with the financial services sector playing a significant role in economic growth, particularly in the US and UK, governments are reluctant to interfere when things appear to be going well. And financial institutions are a powerful lobbying force.

Inadequate regulation has played a fundamental role in the credit crisis. But, despite the obvious regulatory shortcomings, and the expected tightening of the regulatory environment through legislation in the short term, history suggests that after an initial rush to regulate, lobbying by powerful corporations, and the lure of significant returns, will once again lead to deregulation over the longer term.

Financial innovation
The accusation: Warren Buffett is right – derivatives are financial weapons of mass destruction. Brilliant engineers at investment banks used their talents to create exotic financial instruments, which in turn were used, among other things, to move loan default risk away from lenders to other investors, and in ways that make it very difficult to understand the level of risk involved in the underlying investment.

Collateral debt obligations (CDOs), as sub-prime mortgages, bundled together, sliced up, repackaged, credit rated and sold on, were used to create a vehicle for speculation on the repayment of mortgages. Then credit default swaps, a $54trn market, invented ostensibly to be able to hedge the risk of default on the CDOs, were used to bet on the future solvency of companies.

In defence: Financial innovation is essential for economic growth. After all, many aspects of finance that we take for granted, such as credit cards, or mortgages, are the product of financial innovation. Nor is there anything intrinsically wrong with derivatives. They are an important and useful device for reducing risk through hedging strategies.

The verdict: One unfortunate outcome from the existing crisis is that financial innovation has a bad reputation. Yet it must be encouraged, not legislated. Alongside that innovation must be transparency. Derivatives are a $500trn market. Credit default swaps a $50trn market. These products need to be regulated and traded in transparent markets. Financial innovation is a good thing, providing it is used responsibly.

Regulators could ensure that originators of loans, and those parties that sell them on, are required to leave some risk on their own books, rather than offloading to a third party, thus leaving the originators of the loans, and those that securitise them, with no incentive to do due diligence.

Best Investment Services Provider,
Switzerland
Bank Sarasin

Best Online Investment Provider
Europe
IW Bank SpA

Best Brokerage Services Provider,
Middle East
United Securities LLC

Best Trade Finance Bank,
Turkey
Yapi Kredi

Best Corporate Lending Bank,
Russia
NOMOS-BANK

Best Investment Bank,
Middle East
Riyad Capital

Best FX Bank,
Islamic Finance
Standard Chartered Saadiq

Best Emerging Investment Bank,
Kingdom of Saudi Arabia
FALCOM Financial Services

Best Universal Banking Solutions Provider,
Islamic Finance
International Turnkey Systems

Best Investment Bank
Portugal
Espírito Santo Investment

Best Investment Services Provider,

Cyprus 

Laiki Investments (Financial Services)

Best CSR Bank
Oman
National Bank of Oman

With pain and misgiving, the United States Congress bailed out Wall Street in order to prevent a meltdown of America’s financial system. But the $700 billion to be used may flow into a leaky bucket, and so may the billions provided by governments throughout the world.

The US financial institutions that went bankrupt in 2008 – or that would have gone bankrupt without government help – were in trouble because they lacked equity capital. They did not lack that capital because they never had it, but because they paid out too much of their abundant earnings in previous years to shareholders, leveraging their operations excessively with debt capital. If no measures are taken to increase the minimum equity requirements for banks and other financial institutions, financial crises like the current one could recur.

Anglo-Saxon financial institutions are known for their high dividend-payout ratios. From a European perspective, the hunger for dividends and the emphasis on short-term performance goals that characterize these institutions is both amazing and frightening. Investment banks, in particular, are known for their minimalist equity approach. While normal banks need an equity-asset ratio of at least 7%, investment banks typically operated on a ratio of only 4 percent.

The lack of equity resulted largely from the concept of “limited liability,” which provided an incentive for excessive leveraging. Earnings left inside a financial institution can easily be lost in turbulent times. Only earnings taken out in time can be secured.

Lack of equity capital, in turn, made risk-averse shareholders hire gamblers to manage their limited-liability investment companies. The managers chose overly risky operations, because they knew that the shareholders would not participate symmetrically in the risks.

While upside risks would be turned into dividends, downside risks would be limited to the stock of equity invested. Claims against the personal wealth of shareholders would be blocked by the limited liability constraint. The banks’ creditors or governments ultimately would bear any losses. The mutual interaction between the incentive to minimize equity capital and the incentive to gamble in order to exploit the upside risks caused America’s crisis.

In theory, bank lenders and the government could anticipate the additional risks they encounter when a company chooses a high-leverage strategy. Lenders may charge higher interest rates, and the government may charge higher taxes or fees.

But this theory fails to match reality. Governments do not tax the return on equity less than debt interest, and lenders do not sufficiently honor the benefits of high equity with lower interest rates, owing to a lack of information about the true repayment probability. This is why equity capital held by financial institutions typically is more than twice as expensive as debt capital and why these institutions try to minimize its use.

The provision of limited liability not only turned Wall Street into a casino, but so-called “Main Street” also was induced to gamble, because homeowners enjoyed a limited liability similar to that of the companies. When low-income borrowers took out a loan to buy their homes – often 100% of the purchase price – they typically could use the home as collateral without warranting the repayment with additional wealth or even their income. Thus, they were protected against the downside risk of falling house prices and profited by speculating on the upside risk of appreciation.

Such homeowners knew that with rising prices they would be able to realize a gain by either selling their homes or increasing their debt, while in the case of falling prices they could simply hand over the keys to their banks. Given the uncertainty about future house prices, they could reasonably expect gains, which induced them to pay even more in the first place. Gambling by Main Street caused the sub-prime crisis.

The crisis spread because the banking system was not sufficiently risk-averse – and in some cases even seemed to relish risk. Mortgage banks kept some claims on their books, but sold most of them to investment banks as “mortgage-backed securities.” The investment banks blended these securities into “asset-backed securities” and “collateralized debt obligations” (CDOs) and sold them on to financial institutions throughout the world. These institutions, attracted by the high rates of return that were promised, invariably neglected the downside risks.

The buyers of the CDOs were often misguided by rating agencies that performed badly and did not provide reliable information. As private rating agencies live on the fees they collect from rated companies, they cannot easily downgrade important clients or the assets they sell. The big American investment banks received excellent ratings up to the last moment, and so did the CDOs with which they betrayed the world.

All of this explains why the US had such a formidable period of growth in recent years, despite the fact that household savings were close to zero, and why foreigners were willing to finance a record US current-account deficit of more than 5 percent of GDP – higher than it has been since 1929. That period is now over.

The US must carry out fundamental reforms of its financial system to plug the equity leaks and recover investors’ confidence. But even then it will have a hard time continuing to sell financial assets to the rest of the world. American households will need to learn to accumulate wealth by cutting consumption rather than speculating on real estate. A painful decade of stagnation for America lies ahead.

Hans-Werner Sinn is Professor of Economics and Finance, University of Munich, and President of the Ifo Institute.

Copyright: Project Syndicate, 2008

Research recently carried out by Ethical Investment Research Services (EIRIS), a research organisation designed to reflect the investment principles of the group of churches and charities that helped set it up, found that the top listed companies on the London Stock Exchange have made great strides in the past five years to tackle ethical issues head on, spurred on by the demands of “responsible” investors and stakeholders.

According to the research, in the last three years (2005 – 2007) over 80% of company policies and over 70% of management systems with regards to environmental policy are assessed as being “good” or “exceptional”, with a four fold increase in companies assessed as having exceptional environmental policies.

The survey also found that there has been a significant move towards tackling wider corporate responsibilities such as human rights. For example, EIRIS found that 94% of companies operating in countries of concern have some form of human rights policy, and over a third of these (39%) are considered “advanced”.

But some experts query aspects of EIRIS’ research, in particular its focus on the top 100 companies. Mark Chadwick, CEO at environmental management consultancy Carbon Clear, says that there needs to be a much wider review than just to look at the world’s largest 100 companies. “There are thousands of small and medium enterprises out there – just in the UK alone – as well as some other very large companies that aren’t listed on the FTSE that think that ethical and socially responsible behaviour and disclosure do not apply to themselves,” he says.

It is fair to say that the level of investor pressure and regulatory obligation for firms outside of the FTSE100 or listed on other exchanges such as the Alternative Investment Market (AIM) is much lower than for those listed on the main exchange. Consequently, those companies do not feel compelled to constantly improve their ethical behaviour or level of disclosure about corporate governance, meaning that EIRIS’ findings are likely to be more than a little skewed.

According to Chadwick, legislation such as the UK’s Carbon Reduction Commitment is going to force more organisations – and not just the largest in terms of revenue – to take more notice of their environmental and social policies. This is because the legislation, a new mandatory emissions trading scheme which begins in January 2010, will force all organisations whose electricity consumption is over 6000 megawatts per hour to bid for further allowances to cover their emissions. At the end of each year the government will compile performance tables to show which organisations have managed to reduce their carbon emissions the most. The government estimates that the rules will affect over 5,000 UK organisations.

“This kind of legislation, which takes a wider view than just focusing on 100 entities, will ultimately compel the majority of organisations in the UK to take their ethical, environmental and social responsibilities more seriously because it’s enshrined in law. We all know that legal risk is one of the key drivers of changing corporate behaviour,” says Chadwick.

Other business monitoring groups believe that the UK’s largest companies have a responsibility to encourage greater disclosure and compliance with industry best practice in the smaller companies that they deal with, such as suppliers and other contractors. They think that the “clout” that larger companies have to dictate terms will be a key driver in enforcing compliance with ethical codes.

Philippa Foster Back, director of the Institute of Business Ethics (IBE), an organisation that promotes ethical business practices, says that “from our research, around 60%-65% of companies in the FTSE350 have codes of ethics, compared to over 90% in the FTSE100. We believe that the world’s largest companies have the opportunity and responsibility to help smaller companies become more ethical because they now think that smaller companies have the obligation to act more ethically.”

But does such encouragement amount to corporate bullying? Already, some firms – particularly those in the US – are forcing suppliers (especially in developing countries like China and India) to sign contracts which stipulate that any ethical breach stays at a local level – meaning that if the US firm is found at fault for unethical behaviour on the part of a foreign supplier (for example, the supplier uses child labour), then the supplier agrees to take the rap.

On paper it may sound fair enough – why should a company in the US take the blame for practices in its supply chain that it does not carry out in its own workplace – but the reality can be quite different. Regulators and enforcement agencies have already picked up on the idea that these companies may be using their suppliers from the developing world as scapegoats, and so are now more inclined to look more deeply at the ethical guidelines that they are asking such companies to abide by.