Frenchman Jérôme Kerviel offered a particularly enlightening commentary on the steadily worsening crisis in the financial markets. Just as a reminder, Kerviel is one of the young traders whose unauthorized trades resulted in the stunning loss of €4.9 billion ($7.66 billion) for his employer, French bank Société Générale. When questioned by prosecutors, Kerviel offered this logical explanation for his actions: "Working in this profession, you lose your sense for sums." Then he added: "You get a little carried away."
The sad and, for many contemporaries, extremely costly truth is that the entire financial sector has apparently lost its sense for sums in recent years. We are all in the hands of tens of thousands of men and women like Kerviel, who pursue their business deals in banks around the globe.
Billions (yes, billions, not paltry millions) have been at play for months. No part of the money business seems truly clean today. After the debacles of investment banks like Merrill Lynch and Bear Stearns, problems are beginning to pop up among hedge funds, and there are already rumors of difficulties at credit card companies in the United States.
Is this crisis simply part of the regular ebb and flow of doing business in a capitalist system? Minimizing the problem in this way, one year after the eruption of the subprime debacle, is no longer appropriate. Bankers, who like to see themselves as the true masters of the global economy, have driven the global economy into a calamity that is spreading to become a fundamental crisis for the entire financial system.
No matter how it ends, we must learn our lessons from this tremor as quickly as possible. Perhaps the most important lesson is that the financial sector is far too important to be left almost entirely in the hands of nimble financial traders in Frankfurt, London and New York.
As it happens, the financial industry plays a special role in a market economy. A crisis in the auto or chemical industry can be contained. But a blow to the banking system affects everyone and can even lead to the collapse of political structures, as the crash of 1929 and its consequences have shown.
Where Were the Well-Paid Accountants?
The history of modern capitalism is, among other things, the history of an economic order that has learned its lessons from shocks and distortions since its beginnings in the 19th century. Although the right conclusions were not always drawn from these experiences, they were drawn often enough to facilitate the eventual triumph of the free market economy.
We have learned that unbridled markets tend to facilitate the formation of monopolies. To prevent this from happening, we created antitrust laws. We also knew long ago that banks needed a legal framework and government supervision. To quote the German Federal Financial Services Authority (BaFin), the country's financial industry regulator, the purpose of banking regulation is "to avert undesirable developments that could impede the functioning of the banking system."
We have drawn comfort from the certainty that we will be spared an economic shock capable of tearing apart the finely woven network of the global economy, the sort of shock that culminated in the world economic crisis. Could this expectation have been too naïve? Have we been too gullible?
Our confidence that the major risks of the market economic system could be kept in check has faded, especially with daily reports in the media of bankers for whom the world is apparently nothing but a gambling casino. We would never have thought it possible that a small financial institution like the German state-owned bank Sachsen LB could conceal credit risks amounting to a staggering €20 billion in a Dublin subsidiary -- an amount several times larger than the bank's equity, but for which the Dresden-based institution was nevertheless fully liable.
We are forced to acknowledge, with great astonishment, what a giant wheel some of the most respected institutions in the banking industry have turned with hedge funds. A fund run by the operating company Carlisle Capital, for example, used $670 million (€428 million) of its own money to buy mortgage-backed securities worth close to $22 billion (€14 billion). For each dollar of equity, the company borrowed $31. Commercial banks were only too willing to approve the loans.
But what truly robs us of our faith in the banking profession is the fact that the gentlemen have nonchalantly invalidated all of the basic rules of the banking business. One such rule is the principle that high yields can only be achieved by accepting high risk. As it turns out, no one in the industry bothered to cry foul and make the rest of us aware that the emperor was in fact wearing no clothing.
Where were the well-paid accountants who were supposed to be auditing the balance sheets of these banks? Where was BaFin's self-confident president, Jochen Sanio? What were the omnipotent ratings agencies doing? What happened to the banks' normally so judicious supervisory boards, which consisted of both the politicians serving on the boards of the state-owned banks and such respected executives as Ulrich Hartmann, the former CEO of German energy conglomerate E.on and chairman of the supervisory board of the troubled IKB Bank, or Michael Diekmann, the CEO of insurance giant Allianz and head of the supervisory board of Dresdner Bank?
Disempower the Bankers!
What is to be done, aside from the current bailout activities, which are primarily the responsibility of central banks? As difficult as it is for a liberal economist to say this, the only real solution is to disempower the bankers. We must impose tighter restrictions on our money traders' freedom of action. After years of deregulation, what we need now is re-regulation.
One can say, completely without irony, that the financial industry is blessed with a truly remarkable level of resourcefulness. It has constantly created new instruments, especially within the last decade. The only problem was that these grandiose innovations came with a cosmetic defect: They were increasingly removed from the fundamental purpose of the banking business, which is to collect money from investors and lend money to borrowers. The sheer variety of debt securitization, derivatives and hedges has even become confusing to senior members of the banks' executive boards, not to mention government regulators.
This wildly overgrown system must be trimmed back. Of course, as German Finance Minister Peer Steinbrück rightly emphasizes, this would only be feasible in a global, or at least European, accord. The authority of banking regulators must be strengthened, and internationally binding accounting rules, like the Basel II banking standards, must be effectively tightened.
Not least, the financial institutions must effectively reform their own compensation systems. Everything in banks is currently geared toward taking advantage of the greed of individual bank employees, from senior executives to clerical workers, to maximum overall profits. Greed is treated as the supreme and sacred business principle. "This rat race for greater and greater profits can literally rock the system," Steinbrück aptly said in a SPIEGEL interview.
This rat race is now internally institutionalized: through profit centers with extreme profit objectives, and through bonus systems in which, in many cases, only a small portion of income is salary-based, while the overwhelming share of compensation is based on employee performance. Such structures amplify the tendency to take enormous risks and to ignore safety rules. They cannot endure in their current, extreme form.
Perhaps it would be useful if bonus payments and profit sharing were made dependent on the sustainability of the underlying transactions. In other words, if deals that have provided handsome profits and fat bonuses for the relevant employees were to fall apart down the road, the employer would be entitled to demand repayment of the incentive compensation.
In the case of Dusseldorf-based IKB Bank, former CEO Stefan Ortseifen can now look forward to a bonus running into the millions, despite the fact that the bank almost went under and he was let go. Nevertheless, under his contract he was owed the bonus for 2006, which was a successful year for IKB. At the time, the securities that would drag the bank into near-failure only a year later were still producing excellent returns.
A bit of thought in the category of sustainability, now wouldn't that be an unusual innovation for bank executives and their employees? To return to Monsieur Kerviel, it would undoubtedly sharpen their sense for large sums.