New dawn fades

A new systemic financial risk management order is born, but looking at examples from the past can be a helpful exercise in preparing for unknown. Knowing the exact context of your risk is a real must, says Enrique Núñez-Escudero


For many, many years central bankers felt a sort of moral obligation to rescue financial institutions, (particularly banks) when they were going under. This situation drastically changed during Barings plc’s turmoil. Barings plc was the most prestigious merchant bank in England at the time. Back in 1873 when Jules Verne wrote his famous Around the world in 80 days, he chose the Barings Bank as the bank where Phileas Fogg had his £20,000 deposited. When Nick Leeson broke the bank down to pieces from the Singapore office, Eddie George had a very tough call to make. Rescue Barings, or let it drown on its own. Certainly, Leeson had put the bank in a very difficult situation. Back in the 19th century the Bank of England had already helped Barings out of trouble from a bad loan in Argentina; why would this situation be any different? This time a billon plus situation would not jeopardise the central bank’s stability. Why would they not help them out this time? Then the governor of the prestigious BOE came with an unusual statement stating that this time the bank would have to fight on its own. Finally Barings’ customers did not have to pay for this ordeal.

The BOE sold that same weekend the bank chosen by Phileas Fogg to the International Netherlands Group, for as little as £1. This became the milestone for a new way to deal with financial institutions disasters. “Let someone else pay for the problem,” were the sentiments emanating from the central bank. The same situation took place when LTCM ended up losing all their marbles and an extra $3.5 billion during the Russia crisis of 1998. At that time the US Federal Reserve pretty much made the top 10 Wall Street investment banks pay for the broken dishes, sending each one a $350 million bill; which they paid. So it was that financial regulators finally had found the key to solving financial disasters. It was, in a way, a new school of systemic financial risk management. For many years, and to this day, having to pay for financial disasters by financial authorities or governments has had but two sources of funding, namely, by spending created money, thus creating inflation, or by taking the money out of other budgets, such as education of social programmes with the correspondent consequences. So this new way of solving the problems seemed to be the right path. Unfortunately the financial crisis of the new millennium that we are now living came with a hefty package of lessons for us all.

Changing times 
Following the new way of dealing with these “uncomfortable situations”, the US authorities at the beginning refused to pay for Lehman’s mistakes in light of new buyers interested in taking charge of them. Unfortunately regulators were not yet aware of the nature of the problem to come. Some say that if Lehman had not been left alone the crisis would have not been as severe. The truth is that with or without the rescue of Lehman at an early stage of the crisis would have not really have made a significant difference.

The real problem lies in the fact that authorities went back to the old way of doing this. This time it appears to be, at least in the case of the US government, that it will take its tow of inflation. Basel II has not been fully implemented yet, and new rules and regulations are breaking into the financial sector. 

The truth is that a real solution for dealing with catastrophes in financial institutions hasn’t been found yet. There is a new wave calling for state intervention into the financial systems, but that is not the solution either. FDIC type institutions have been created across the globe but these types of institutions have not solved the entire problem and appear not to be the ultimate solution as well.

The challenge is not an easy one. Finding the right balance between government interventions and preserving the principle of a free market economy is not an easy task; but quite the opposite. 

What is true is that a new era in systemic financial risk management is being now born, and that we stand before the beginning of a new era in systemic financial risk management. Let’s hope it will all be for the best.

Enrique Núñez-Escudero is chairman at Shirebrook Commodities studies in Economics