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Leverage is no panacea

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Working hard to win back the client’s trust seems to be a common theme for the financial sector, as companies look to rebuild confidence in the system. From the many conversations I have had with top executives in recent weeks, it is obvious clients have made it known they are not happy and they want answers. In bear markets, it is the quality of your communication that is as important as anything else. As J.P.Morgan’s Laurence Bailey says, “People just want to know, even if you can’t give them the complete answer. They want to know you have thought through the problems.”

At the same time, there is still a lot of anger out there. That will not subside until people can see accountability, or as one TV commentator put it, “until people can be clear who are creators of value and who are the fraudsters, confidence will not return. You cannot expect people to engage with a system that is seen to be flawed”.

It is in the nature of our response to this crisis, and all the others that came before, that we have to go backwards before we can go forwards. The risk in the market is much reduced now, but investors only want conservative, low risk investments. The worst of the hedge fund scandals could well be behind us, and the poor managers have been washed away, but the popular view is that more regulation is needed. While a lot of what is going on smacks of shutting the stable door after the horse has bolted, it is a process that we are conditioned to go through. The difference on this occasion is that the system really is flawed. The debt crisis is not a temporary problem, it is a structural one.

While I don’t believe, as Nassim Nicholas Taleb suggests, that complex derivatives need to be banned because nobody understands them, there is reason to impose limits. Equally, Taleb is right that we have learned nothing if we think using leverage to cure the problems of too much leverage is the solution.

The economist Robert Skidelsky was recently critical of Yale’s Robert Shiller for suggesting that new derivative products will soon be able to insure home owners against the risk of house prices going down. For Skidelsky, this was an example of trying to cure a state of inebriation by having another whiskey. “There are two things wrong with it. First, if financial innovation is, in fact, the route to greater market efficiency, the financial system would have been getting more stable in the last 25 years of explosive financial engineering. Instead it has become more volatile. Second, the assumption that, given enough innovation, uncertainty can be reduced to risk, is just wrong. There will never be sufficient knowledge to enable contracts to be made to cover all future contingencies.”

Another line that captured my imagination was ‘teaching people to navigate a world with fewer certainties’ (Taleb again). “Then we will see an economic life closer to our biological environment: smaller companies, richer ecology, no leverage. A world in which entrepreneurs, not bankers, take the risks and companies are born and die every day without making the news.”

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