FIN800 EXAM REVIEW
FE, Chapter 1 – Introduction – Paragraphs 2 and 3, (pages 3-4), and then the rest of the chapter
except the section on Finance Theory
Finance: The generation, allocation, exchange, and management of monetary resources.
[Personal, corporate, and public finance]
Finance Ethics divided into 4 parts:
1. Financial Theory (don’t have to read this part)
2. Financial Markets
3. Financial Services
4. Financial Management
- Ethics is a pervasive subject in finance, without being recognized as such.
- fundamental ethical requirement: fairness
fairness can be analyzed by identifying instances of unfairness
unfair trading practices (manipulation/fraud), unfair conditions (unlevel playing field), unfair
contracts (one party has taken morally impersmissible advantage of another)
- thus a prospectus may be required for issuance of a security, thereby correcting an information
asymmetry, because investors are judged to have the right to make an informed decision.
- fairness may be defined either substansively (when a security is accurately priced) or procedurally
(when a security is sold with full disclosure so that the buyer can assess its value)
- blue-sky laws: require expert evaluation of securities offered for sale, aim at substansive fairness
- regulations that merely require disclosure of relevant info aim at procedural fairness
- derivative contracts (futures, options, and swaps) – described by Warren Buffet as “financial
weapons of mass destruction”
- many of the ethical issues in the recent financial crisis were the result of investment banks’
activities in originating and securitizing loans and selling them as collaterized debt obligations
(CDOs) to others, as well as in buying and selling credit default swaps (CDs).
Hedge funds: lightly regulated pools of capital, usually from wealthy individuals and large
institutional investors – including pension funds and university endowments – which seek above-
market rates of return (alpha) by exploiting diverse markets with innovative (and ususally
proprietary) investing strategies.
- due to their size and heavy use of leverage, they pose some risk to capital markets
- they raise ethical issues about their fee structures – the usual “2 and 20” (2% mngmt fee 20% of the
returns) and about the tax treatment of returns.
- returns are classified as carried interest –thus taxed at capital gains rates rather than the higher
personal income tax rate. - main ethical issue is opaqueness (lack of transparency), which is defended as essential to the fund’s
Sovereign wealth funds (SWFs):
- investment funds owned and controlled by nation states, usually funded by trade surpluses, rasie
many fears about their impact on financial markets, due to their size and their control by a foreign
- concern that decisions by SWFs may be influenced less by standard financial market considerations
and more by national interests.
- corruption – of national security, of market processes, of info integrity, of rule of law, and of
domestic industry competitiveness.
- like hedge funds, they do not appear to have played a disruptive role in the current financial crisis,
and may have played a constructive role by providing American banks with much-needed capital
- Acting as intermediaries, financial services firms become agents/fiduciaries
- formation of contracts
- 3 areas that are subject to greatest controversy: home mortgages, credit cards, and payday loans
- most financial codes of ethics consist of 7 basic principles: integrity, objectivity, competence,
fairness, confidentiality, professionalism, diligence
- BANK ethical challenges to banks are grouped under: integrity, responsibility, and affinity.
- MUTUAL FUND ethical issues in two forms of mutual funds brokerage commission rebates: soft
dollars, and directed brokerage.
- soft dollars: credits that a brokerage firm provides to mutual fund to pay for research and other
- directed brokerage: commitment by a brokerage to market the fund’s shares.
- INSURANCE: “a question of economic justice”
- SRI: socially responsible investing. – a product and a practice.
- stands in opposition to modern portfolio theory.
- Sarbanes-OxleyAct assigns the CFO a responsibility to attest to accuracy of financial statements
and requires corporations have a code of ethics for their top financial managers.
1. Ethical obligations/duties of financial managers of a corporation
2. Ethical justification for organizing a corporation with shareholder control and the objective of
shareholder wealth maximization
- Sarbanes Oxley Act passed in 2002, in response to the collapse of Enron
- addresses the composition and operation of boards, including requirement that there by a majority
of independent directors (i.e. managers cannot be on the board)…follows AGENCY THEORY FE, Chapter 2 – Key Assumptions in Finance (pages 24-26). Note: The rest of the chapter, while
not required reading, is a good review on “What is Finance”
KEYASSUMPTIONS IN FINANCE
1. Rationality and Self-Interest
- rational person is someone who takes effective means to secure a given end.
2. Financial Theory of the Firm
- managers are the agents of shareholders, who are the principals
- the firm faces a constrained optimization problem: maximize the value of shareholder wealth,
subject to a variety of constraints.
- John Stuart Mill provided the classic statement of utilitarianism – economist.
FE, Chapter 9 – (pages 163-167)
FAIRNESS IN FINANCIAL MARKETS
- concept of fairness may be invoked to consider thee foundational framework of markets as well
as the rules and regulations of ongoing exchanges – the practices of business firms or the conduct
of professionals and clients.
- must be recalled that the idea of profit maximization is a postulate of theoretical models
MARKETSAND FINANCIAL MARKETS
- one of the virtues of markets is that they generate wealth.
- it is not expected for the wealth of markets to accrue equally to all persons
- individuals act within the foundational rules that allow for production and trade
FAIRNESS: FORMALAND SUBSTANTIVE
- in being fair, one does not fulfull all of the aims of ethical conduct
- justice and fairness may diverge; some demands of fairness could require a violation of the
constraints of justice.
- it is at a substantive level that fairness becomes more contestable morally and politically.
it is one thing to assert that a rule, agreement, or expectation generates a claim on behalf of
those whom it applies (procedural fairness); it is a more fraught question to consider whether we
owe something to individuals, or to identify the claims that individuals may have, simply as
procedural fairness: fairness in relation to a rule.Agreement, or recognized expectation
The Goal of the Firm
The Equity/Efficiency Trade-Off
Agency Costs – What are they, why do they occur, and how they can be minimized What is the
Finance, and what does it have to do with Ethics An Introduction to Financial Regulation
New Orleans Saints Scandal
The facts of this scandal are roughly as follows: players on the team, along
with one assistant coach, maintained a ‘bounty pool’ amounting to tens of
thousands of dollars, from which bounties were paid to players who inflicted
serious injuries on players from opposing teams. This violates the NFL’s
“bounty rule,” which specifically forbids teams from paying players for specific
achievements within the game, including things like hurting other players.
-The limits on competitive behaviour in business, however poorly-defined,
must be precisely those limits that keep the ‘game’ socially beneficial.
Hockey’s Ken Dryden on Business Ethics
- recent editorial, “The anatomy of three hits”, technically wasn’t about business ethics,
but about the ethics of that business known as “hockey.”
- What’s essential, then, both in hockey and in business, is that the players understand,
and internalize, a basic respect for each other, and for the game
- he hockey player, you see, is, like the business executive, subject to a strong duty of
loyalty. The hockey player has a duty of loyalty to his team. The executive has a duty of
loyalty to the corporation. But in both cases loyalty has its limits. Even the toughest of
hockey’s tough guys know that.
1. FE, Chapter 2, (page 27 to the end of the chapter)
Time Value of Money
- The time value of money relates directly to the concept of usury, the unethical demanding
of interest on a loan.
- in a strict finance view, usury is meaningless…interest rates are devoid of moral
significance, and any interest rate that emerges from the interplay of supply and demand
in markets free of deception and coercion is entirely unproblematic.
- however many finance academics and practitioners would concede that some practices
of charging interest can be excessive and abusive, especially when borrower is
Risk, Risk Aversion, and Expected Return
- Firms charge more interest to riskier borrowers who are poor/have higher chance of
The Price of Risk-Bearing Services
- Non-systematic risk = diversifiable risk
- Systematic risk = nondiversifiable risk
- By holding a fully diversified portfolio, all of the diversifiable risk of all of the
securities is eliminated, and the remaining risk of the portfolio is simply systematic
or nondiversifiable risk. Net Present Value and Corporate Financial Management
- The firm should undertake projects that have a net positive NPV
- Anything that lies below the SML should be rejected
Finance, Corporate Governance, and the Goal of the Firm
- goal of everything is to maximize shareholder wealth
- anything even slightly below the RRR will be rejected, even if it benefits society
The Efficient Markets Hypothesis
- a market can be efficient in either an operational or an informational sense
- operationally efficient market: functions smoothly, rapidly, accurately, by conveying
orders to the market executing them quickly at the best price available, and reporting the
results of the transaction in a timely manner
- informationally efficient market: prices in a market fully reflect a particular body of
Efficient market hypothesis (EMH): theory that pertains to informational efficiency in
financial markets, such as the market for labour, homes, and other services or real assets
(a market is efficient with respect to a given information set if prices in that market at all
times fully reflect that information)
weak (security prices fully reflect all historical price data)
semi-strong (all publicly available info, including earning announcements, news articles,
govt. statistics, etc.)
strong (markets fully reflect all info, whether public or private)
- EMH pertains only to security markets, not to real investment opportunities such as
developing new cars or discovering pharmaceuticals – even if the EMH is literally and
exactly true, real investment can still earn economic rents
Option Pricing Theory
- One of the simplest options is a plain vanilla option (put/call) – zero-sum game.
- Option pricing theory – value of an option is function of 5 factors:
1. Stock price 2. Exercise price 3.Time until Expiration 4. Risk-free Interest rate
5. Riskiness of the stock (value of stock increases w. riskiness of the stock)
- shareholder/bondholder example, where firm starts of with low-risk (deceiving
bondholder) and then all of a sudden increases risk, thus decreasing bondholder value
and transferring it to the shareholders.
- Mortgagee/mortgagor example, borrower has option to default, ignoring promise of
- Finance is an infant intellectual discipline, tracing origins only to the 1950s
- In the classical view of finance, securities are prices according to CAPM and investors
need only consider the systematic risk of securities, so the nonsystematic risk that results
from corporate decision making need not be considered…one implication from this is
that a firm has no need to avoid the risks of bankruptcy and the possibility of dissolution
because well-diversified investors can insulate themselves effectively form demise of a
- Nonetheless, firms invest in risk management…challenges classical view of finance
- One of the explicit assumptions in CAPM is assumption that there are no transaction
costs…this is clearly false in actual markets and firms
Behavioural Finance - The attack on the EMH – ppl actually use morals not just profit maximization
- The importance of Fairness
- An adequate financial theory must expand its conception of rationality to correspond
more accurately with human nature and adjust its prescriptions for financial management
to model more true human behavior
- i.e. if you treat someone unfairly, they will want to punish you
2. FE, Chapter 10, (pages 179-180)
- Defective risk management practices were to blame for the spate of firm failures
- Regulators with ample authority to constrain financial institutions from taking excessive risks
did not do so.
- Agencies have 2 means of bringing the law to bear on financial institutions: regulation and
- The notion the deregulation caused financial crisis is a MYTH
IOU, Chapter 2
Banking should be simple: banks take in money, which they lend out at interest. The bank must
reduce risk by lending only to reputable customers. However, during the 20th century, banking
became modern, which means that it became self-referential, abstract, and separated from
common sense. The arrival of modernism in finance was the management of chance and risk.
Lanchester illustrates by explaining the financial instruments called derivatives. Say a farmer
agrees to sell his or her crop ahead of harvest for an agreed upon price. That contract can then
be bought and sold; it is a derivative because its value derives from the crop. The simplest
derivatives are options
and futures. An option is the right, but not the obligation, to buy or sell something in the future
for a specified price. A future carries the obligation and is therefore riskier. Lanchester explains
that someone might spend $500 on an option to buy a sports car for $50,000 in a year’s time. If
the price goes up, the option has gained value and is a good investment. If the market value of
that car drops, then the option was not a good investment and the buyer can decide not to buy
the car. He or she loses the $500 option, or “premium.”
The derivative market opened when when Fischer Black and Myron Scholes worked out how to
price derivatives. Lanchester explains that the value of the total market in derivatives is thought
to exceed the world’s economic output by about $66 trillion, or by roughly tenfold. Lanchester
explains that in an ideal world, derivatives would be used to reduce risk. An investor can choose
to buy wheat but can also buy options that allow him or her to sell it at a fixed price. This is
“hedging.” However, confident financial experts often buy options—or better yet, futures, since
although these carry greater risk they also carry greater reward—that align with their primary
investments. This magnifies risk.
Credit default swaps are the most destructive derivatives of all. In a “swap,” businesses can
agree to swap financial assets without swapping businesses. These are known as “synthetic”
swaps. J.P. Morgan built on this strategy and began to swap the risk of a loan default, and
therefore their bank’s risk, to offshore shell companies, or “special purpose vehicles.” This
allowed them to, in theory, give loans without taking on risk because the loans were not on their
books. It meant that banks could give out multiple loans based on their assets since they were
taking on no risk, and so the banks were soon overleveraged. J.P. Morgan’s next innovation was “securitization,” where loans were bundled together. Before long, these securitized bundles of
credit default swaps were grouped, or “tranched,” according to levels of risk and were sold
accordingly. The market came to call these “synthetic collateralized debt obligations.” Although
these financial instruments were clever, Lanchester maintains that they broke banking. AIG was
a gigantic insurance company worth $200 million—too big to fail. When the subprime mortgages
collapsed in 2008 and made the investment bank Lehman Brothers insolvent, investors looked
at the market to see who was carrying similar risks, and they found AIG, which had participated
heavily in credit default swaps and collateralized debt obligations. The value of their swaps
quickly dropped and they discovered that they could not remain solvent. When the American
government saw that AIG was big enough—and its agreements with other banks global enough
—to collapse the global economy, it began to funnel cash into the company, which spread to
banks around the world. The companies walked away solvent, while the American taxpayer took
on billions of dollars of debt. If derivatives were the moment when finance entered the modern
era, 2008 may have been the moment that it became postmodern.
3. CFA: Modules 1, 6, and 7
Finance, Ethics, and Faith
Finance in Other Venues
1. A Primer on Islamic Finance, Chapter 1, Chapter 2 (pages 18-22), Chapter 3 (pages 31-
35 and 37-38), Chapter 5, page 64, Chapter 7, page 81, and chapter 8 (pages 96-97), on
Primer on Islamic Finance
- financing should not involve an activity prohibited by Shari’a (Islamic Law)
- financing should not include riba (the giving or receiving of interest)
- should avoid gharar (uncertainty, risk, speculation)
- Objective of Shari’a is economic justice through equitable dist’n of resources
- Growth of sukuk (Islamic bonds) market..globalization
- Drivers of growth in Islamic Finance: Economic growth and liquidity, Investor appetite for
Shari’a compliant instruments, privatization and FDI, regulatory canges, diversification,
CONTRACTS IN ISLAMIC BANKING
- Contract of exchange (primary type)
- Contract of Usufruct (leasing – 3 types)
- Gratuitous contracts (for benevolent purposes – 3 types)
- Participation contracts (to promote risk-and-reward sharing; encourages wealth creation from
- Supporting contracts
- Mubarah financing has become the backbone of contemporary Islamic banking – commonly
used for financing the purchase of raw materials, machinery, equipment, and consumer
durables…profit margin mutually agreed upon between client and bank. (loan) - Ijarah financing: to give something on rent. Bank purchases a tangible asset based on
client’s specifications and leases it to the client. Used for high-cost assets w long life spans
- Al-ijarah thumma al-bai (AITAB) financing: a leasing contract combined with purchase
contract. An ijarah contract ending with a purchase
- Musyarakah financing: partnership financing in which one of the partners is an Islamic bank
- Profits and losses shared among the partners according to a predetermined formula. Regarded
as the purest form of Islamic finance *** considered highly risky by many banks
- Istisna financing: involves a contract of exchange providing for deferred delivery of the
good or the asset that is being financed. A commodity is purchased or sold before it comes
into existence, which is an exception to sharia principle which requires asset be in existence
in order for financial transaction to take place
- Bai’inah financing: sale-and-buyback transaction that involves two back-to-back
agreements. Designed to provide customer with a cash sum.
- Mudharabah financing: “trust financing” based on principle of profit sharing. It Is a
commercial activity in which an Islamic bank entrusts funds to an entrepreneur – enables
entrepreneur to carry out business projects.
- Bai’salam financing: a forward financing transaction frequently used in the agriculture
industry. Bank purchases specified assets in advance of predetermined delivery date.
Takaful: Islamic Insurance
- Conventional western insurance is seen as violating sharia through uncertainty/gambling.
- Risk s shared among takaful participants whose contributions provide means to cover
losses or damages incurred by themselves or others
- definition: “guaranteeing each other” / “joint guarantee”
- Based on concept of social solidarity, cooperaton, mutual indemnification losses
CORPORATE GOVERNANCE FOR ISLAMIC FINANCIALINSTITUTIONS
- Has two components: self-governance and statutory governance
GROWTH OF ISLAMIC FINANCE
- takaful sectors one of the fastest growing in the next few years..will quadruple by 2013
- now represent almost 10% of the 28- insurance companies in the region
- AAOIFI and IFSB are on a mission to promote better transparency in Islamic banking
and to provide regulatory guidance across the global Islamic financial landscape.
- There is a need for greater standardization within product lines and for better and more
consistent regulation and governance if the industry is to flourish and be competitive.
2. FE, Chapter 15 (Payday Loans, pages 287-291)
- $100 billion industry…more payday outlets than McDonalds’ - Ethical issues: 1. Info borrowers have about terms of loan 2. Pricing of loans 3. Groups to
which they are marketed 4. Issues of mistrust of traditional financial institutions
- Payday lenders draw approx. 90% of their revenue from borrowers who cannot pay off their
loans when due rather tan from one-time users dealing with short-term financial emergencies.
- Some 28 million americans have no bank account, 50 mill have no credit score, which means
no access to mainstream credit
- People go to payday lenders because it is cheaper than having a bank account and paying
- These lenders position themselves as part of the community
- Payday lending can end only if banking sector aggressively seeks to
Finance, Debt, and Ethics
Finance and the World (Post World War II to the Present)
The Financial Meltdown, using the Housing Mess as an example of the issues in play then (and
IOU, Chapters 1,3, and 4
John Lanchester begins I.O.U.: Why Everyone Owes Everyone and No One Can Pay by admitting that as a child he was scared of
ATM machines. Looking back, he now realizes, he may have been on to something. He explains that the frictionless way money
moves around the world can be frightening. Few people can really conceptualize the numbers involved in the global economy.
What is the difference between a million seconds and a billion seconds? It is the difference between roughly twelve days and
thirty-two years. By the end of 2008, Icelanders went to their ATMs and discovered that the frictionless withdrawal of money was
no longer frictionless. Their banks, which had twelve times as many assets as their national economy, had failed. Lanchester
seeks to explain how the “Reykjavíkization of the world economy” came about.
Lanchester tracks the process back to the fall of the Berlin Wall. Until that point, Western liberal democracies had an ideological
counterpoint, and though Lanchester maintains that the Western liberal democracies are the most admirable societies humanity
has ever seen, they are admirable in part because they sought to show that they provided citizens with a better standard of living
than their Communist adversaries. Therefore, the “jet engine” of capitalism remained hitched to the “oxcart” of equality and
fairness. With the defeat of the Soviets, the capitalists were under less pressure to provide equality and fairness. Consequently,
previous bans on torture were lifted, the income for the middle class remained stagnant, and the income gap between the super
rich and everyone else grew. Amystical faith in capitalism became normal, and the financial sector’s wealth skyrocketed.
Unfortunately, notes Lanchester, the victory party following the fall of the Berlin Wall was neither fair nor sustainable.
Oddly, few people are able to explain how the financial sector works, even though banks are essential to the system everyone
lives in. Banks are machines for making money. They take in money, lend some of it at interest, and when they collect their
money, they have more money, which means that they can lend more. Lanchester explains that a bank’s balance sheet differs
from other balance sheets because a bank increases its assets by lending credit to others. During the 1990s and 2000s, bankers
began to lend credit to anyone, increasing the banks assets and the bankers’bonuses.Additionally, many banks began to over-
leverage their assets. When it turned out that many of those assets would not be recovered (known as toxic assets), the banks
suddenly became insolvent and were bailed out by taxpayers.
Lanchester explains that now no one knows which banks are actually solvent. They do not lend credit because they are waiting
for their toxic assets to regain value. However, a bank that cannot lend credit is useless. It becomes a “zombie bank.”An
economy with zombie banks will grind to a halt because there is no machine for making money.
Lanchester turns his attention to the housing market. He begins by discussing interest rates and mortgages. Because America and
the U.K. promote policies that will allow people to buy houses, the laws allow banks to give credit with few restrictions. In
Germany, a person can only borrow up to 60% of a property’s value, and in France people can only borrow up to a third of their
monthly pay. This means that in America and the United Kingdom, people are often in debt well beyond their income.America
and the U.K. may share the prioritization of the citizen owning property, but there are differences. In the U.K., a mortgage’s
interest rate shifts, and it is the mortgager that takes on the risk that interest rates will go up. In America, banks tend to offer fixed interest mortgages, which means that the bank takes on the risk that interest rates will go up. In America, the banks that were
designed to carry these risks were Fannie Mae and Freddie Mac. The costs of these risks swamped both banks.
The push for everyone to own property led to policies that encouraged banks to lend money to people that
could not pay back their loans. The Depository Institutions Deregulation and Monetary ControlAct, for
example, allowed banks to charge higher rates and fees to some borrowers—in other words, it legalized
subprime loans. The Alternative Mortgage Transaction ParityAct of 1982 legalized variable interest rates, and it allowed for
“balloon payments” to catch up the unpaid balance at the end of a loan. The Tax Reform Act of 1986 allowed for a tax deduction
of interest on mortgage loans, which increased their attractiveness as a form of debt. The goals of these policies were continued
under Presidents Clinton and Bush, and by 2005, home ownership was nearly 70%. The gap between ethnic minorities and the
white population had also narrowed.
Normally, a bubble bursts of its own accord due to inflation and interest rates. To explain this, Lanchester turns his attention to
bonds. The biggest influence on the bond prices is the interest rate, which is determined by the government. It determines the rate
at which banks lend money. If the interest rate is high, this means that the price of money is high, but it also means that economic
growth will tend to slow. Alower interest rate means that the price of money goes down, which can lead to investment and
growth but at the risk of inflation. The two forces tend to bring balance.
At the beginning of the twenty-first century, something strange was happening in stock and bond markets. The dot-com bust had
just happened, drastically affecting the stock market. Investors did not turn to bonds because interest rates in the bond market
were also very low. It was cheap for businesses to raise money and for people to borrow money, but the price should have begun
to rise. Why didn’t it? Lanchester explains that China had begun to earn a great deal of money, and it started buying U.S.
Treasury bills, which kept the interest rates low. With cheap credit at hand, with low interest rates making the bond market
unattractive, and with decades of policies making it easier for people to take out mortgages, investors turned to the housing
market. This caused the price of houses to go up, but credit was cheap. People thus kept borrowing.
Mortgages were attractive to investors at the start of the twenty-first century. Stocks and bonds were
unattractive, but property prices were rising quickly. Homeowners pay higher interest rates than governments and companies,
which means that mortgages would offer more money. Further, many people were waiting to buy property. Given that J.P.
Morgan had already worked out a way to engineer risk out of their balance sheets through collateralized debt obligations (CDOs)
with respect to bonds, the lenders felt that they were taking on no risk when they lent money.
At first, mortgage-backed CDOs were only used with “conforming” mortgages. These were mortgages that conformed to the
rules of Freddie Mac and Fannie Mae: Freddie Mac and Fannie Mae lend to financial institutions that own the mortgages rather
than to the general public. “Nonconforming” mortgages had been carefully extended to what the ClintonAdministration had
called the “underserved” communities—lower income and higher risk groups—and the policy had appeared successful. The
number of these “nonconforming” mortgages quickly grew. They were also known as “subprime mortgages.” These subprime
mortgages may have been riskier, but this higher risk meant they were potentially more lucrative. Still, as yet, no one had worked
out a way to design CDOs based on subprime mortgages.
Most mortgages that are made with reliable borrowers are easy to model. However, because the market for subprime mortgages
was new, there was no data from which lenders could model and predict risk. David X. Li came up with a way to use a Gaussian
copula function to create subprime mortgage CDOs. CDO and CDS (credit default swap) markets skyrocketed. The lender now
had no need to bother about whether the borrower could pay. The banks went on to create pools of structured debt that were
tranched for investors. The banks then created structured investment vehicles, part-independent subsidiaries of the banks that kept
assets off of the banks’balance sheets. This allowed the banks to avoid the Basel restrictions on capital reserves. Although J.P.
Morgan had created the CDS industry, they did not buy join invest in the mortgage-backed CDOs. Unfortunately, many other
Lanchester explains that the “circuit breaker of risk assessment” was no longer in place at this point.Anyone could take out a
mortgage, regardless of their credit history. Their debt would be bundled and sold. It led to an epidemic of “predatory lending,”
overwhelmingly in the United States. The lending system became chronically prone to abuse, though many of these abuses were
perfectly legal.Atrocious scams became commonplace. These banks had no stake in whether or not the borrowers could repay
their loans, and so they adopted a “buyer beware” stance while many borrowers lied about their credit and income.
FE, Chapter 10, other thanAppendix A
REGULATION - 2 claims defended:
1. Defective risk management practices were to blame for the spate of firm failures
2. Regulators with ample authority to constrain financial instiitutions from taking excessive risks did
not do so.
- financial services industry was NOT deregulated
- Risk management failure was not b/c of the laws but because of individual firms
THE REGULATORY FRAMEWORK
- three govt agencies have primary responsibility for the safety and soundness of nationally chartered
banks and thrifts: The Board of Governers of the Federal Reserve System (Fed), Office of Thrift
Supervision (OTS), Office of the Controller of the Currency (OCC), Securities and Exchange
- the success or failure of the regulatory project turnssupervision.
- Supervision is a rational response to the huge obstacles to achieving legislative objectives
- The Glass-SeagallAct introduced safeguards that were intended to restore the integrity of
a very battered banking system…reasonable to believe that eliminating those safeguards
would weaken the regulatory system….theAct was dismantled in stages.
ADEQUACY OF REGULATORYAUTHORITY
- risk management failures, by regulatory authorities failing to constrain risk-taking activities
- Lack of proper supervision
REGULATING ROOT CAUSES
- effectiveness of risk management is not a function of the sophistication of the systems or the
rigor of the regulatory oversight alone. It turns on the culture in which those systems are
- relationship b/t formal controls, organization culture, and performance is well supported by
scholarly research….culture trumps controls in terms of how people behave.
- culture is not a priority for the agencies who assess firms...absence of a protocol assessing it
- Bank failures perception of failure from external factors is wrong, most that fail are the
result of poor management and other internal problems.
- Unlike the CSB, financial regulators have the ability to act before disaster strikes – they
can periodically assess risk cultures and provide advance warnings
Bribery and Corruption
What is bribery, why does it occur, is it defensible, is it preventable, is it manageable
The Financial Meltdown explained without Ethics, then and now
1. “To Bribe or Not to Bribe” (on Blackboard)
IOU, Chapter 5
Lanchester argues that the central mistake was how bankers calculated risk. In general, people are not good with risk. People do
not tend to act rationally. Daniel Kahneman andAmos Tversky, two economists who studied heuristics, or the patterns of
thinking that people use to interpret data, concluded that people’s heuristics are often wrong. Economists are unduly preoccupied
with developing “pseudomathematical formulae” that predict behavior and decision-making. Traditionally, people tried to avoid risk through diversification, but today the industry relies on mathematical models like VAR, or “value at risk.”
VAR is a statistical technique that arose in response to Black Monday, the 1987 stock crash. Dennis
Weatherstone, the CEO of J.P. Morgan, initially adopted it, and he would receive a VAR report every day at 4:15. VAR’s job was
to summarize the risk the bank took that day. VAR is made up of three parts: a time frame, a number stating the amount of money
at risk, and a fixed probability expressing the chance that money will be lost. For example, a bank might have a 5% risk of losing
$1 million over the next 24 hours. Lanchester notes that VAR explains the risk only within a given range of probabilities. Where
does that range of probabilities come from? The data that VAR relied upon tended to perform well in response to “normal”
market activity. However, it was a horrible predictor of catastrophe, or events that occur outside of the given range of
probabilities plugged into the model.
Lanchester explains that bankers came to recklessly rely on VAR. The number became an industry standard, though it was never
without detractors. When David X. Li released his Gaussian copula function to CDOs was adopted, it allowed the mortgage-
backed CDOs market to be reduced to a number. Because there was no national housing market at that time, because there had
never been a national downturn in the housing market, and because there was little data on subprime mortgages, Li’s formula
ignored the absence of historical data and instead represented correlation based on the price of credit default swaps.
Unfortunately, the data was rubbish.
The models tended to assign market crashes astoundingly low probabilities of occurring. Lanchester points out that common
sense dictates that market crashes do happen, but according to the math, the Black Monday crash of 1987 was a 10 sigma event,
which means that it was all but impossible. Common sense would tell someone that giving loans to people with lousy credit
histories is doomed to fail. However, the mathematical calculation of risk that bankers relied on was suggesting that the mortgage
market was as likely to crash as a person was to win the U.K. national lottery, consecutively, twenty-one times. Consequently, the
bankers failed as “utterly and completely as it is possible to fail...They were exposed as doing something which was contr