Learning lessons

What have we learnt in the ten years since the crash? An Edinburgh-based library charting the mistakes of the financial services sector is a salutary reminder that we must look to the past to avert future crises
by Martin Flanagan 

It is telling that ten years on from the financial crash, a ‘Library of Mistakes’ on the crisis – and on many centuries of financial history – is thriving. The charitable venture, based in Edinburgh, was founded in 2013 to promote the study of financial history by students, professionals and the general public. Russell Napier, CEO of the Didasko Education Company, set up the library with donations from Edinburgh’s investment community.

The library’s aim is to improve financial understanding “one mistake at a time”. In agreement with Einstein’s famous dictum that the sign of madness is to do the same wrong thing repeatedly and expect a different result, Russell says that “studying financial history may help to reduce financial madness”.

Here are some of the key lessons from the past decade. The interrelated nature of banksThe interconnectedness of the banking world has been identified as a key component of the financial disaster. Chris Higson, LBS’s faculty member overseeing its Masters in Finance programmes, introduced a Purpose of Finance course as a response to the 2008 fallout. 

Chris says: “We knew that one problem was the interrelatedness of financial institutions and the excessive complexity of financial contracts. We explicitly addressed there being too many steps in the supply chain.”
Ring-fencing retail banksAt one of the most tense times in the UK during the financial crisis, savers queued around the block at Northern Rock branches, and Royal Bank of Scotland (RBS) cash machines came within hours of running out of money. In an effort to avert a rerun of this, the legal ‘ring-fencing’ of the core retail banking activities of the UK’s biggest banks from their riskier investment banks is one of the greatest comforts to banking customers. This must be accomplished by 1 January 2019. With the benefit of hindsight, it only seems due to the lengthy period of strong financial performance the banks enjoyed from the end of the 1990–92 recession, that ring-fencing was not adopted before the crash.
Importance of liquidityRussell namechecks the library’s exhibit The big short by Michael Lewis, a book that pinpoints the crux of the sub-prime debacle and the fall of investment banking giants Lehman Brothers and Bear Stearns. “Lewis made clear it was a rerun of Hans Christian Andersen and the king having no clothes. Many bankers knew that at the time, but they had been incentivised not to pay attention,” he says. “It taught us the importance of liquidity in banking. Investors had thought they had liquid assets in mortgage-backed securities and they didn’t. There were no buyers.”
Better capitalised banks A lesson that has been learnt by the sector from the crash is the need for banks to be better capitalised. A key factor in 2007–2008 was their dependence on financial markets as those markets froze. Back then, RBS had a dizzying £2tn balance sheet, with a core tier one capital ratio – the cushion backing its loan book – of just over 4%. The rest is well known – the biggest loss in UK corporate history and a tumble of the lender into taxpayer ownership. By contrast, under pressure from the Prudential Regulation Authority and increasingly severe ‘stress tests’ on their balance-sheet strength in extremely challenging hypothetical economic scenarios, the UK’s major banks have now all but achieved much more robust targeted capital ratios of 13%–14%.
Too good to be true?  The Library of Mistakes points to Mitchell Zuckoff’s book Ponzi’s scheme: the true story of a financial legend. In Ponzi’s case, back in the 1920s, there was no real money in the first place. He could only pay apparently fantastic but illusory returns to investors by using new client money to pay the early investors.

The lesson, says Russell, was that a “vaguely plausible” investment offer – Ponzi was initially in international postage stamp arbitrage – can suck investors in, but that “if it sounds too good to be true, it is”. A warning sign was when newspapers of the time revealed that Ponzi refused to reveal his investment secrets.A call for transparency and less jargonIn July 2018, the FCA had the providers of fast-growing investment platforms in its crosshairs. The financial regulator said these distribution channels for retail investments sometimes had opaque structures and that there were wide variations in charges and penalties for exit, with “significant” barriers to switching providers that “limited the pressure on platforms to provide continued value for money”. A decade on from 2008 and there is a perennial concern that small investors can be placed at a disadvantage in an arcane, jargon-rich sector remains.

The full version of this article appears in the Q4 2018 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.

Once you have read the print edition, keep coming back to the digital edition of The Review, which is updated regularly with news, features and comment about the Institute and the financial services sector.

Seen a blog, news story or discussion online that you think might interest CISI members? Email bethan.rees@wardour.co.uk.
Published: 24 Dec 2018
  • The Review
  • financial crash
  • Library of Mistakes
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