Mi, 13.01.2010

Vortrag von Prof. Dr. Dominique Demougin von der European Business School im Rahmen der „EBS@ISH Lectures on Economics”: Explaining the Crisis

„Trust me,“ said Prof. Dr. Dominique Demougin when he tried to explain his pointof view on the crisis to a group of students last Thursday. Whoever wants togive a speech on this topic in early January of 2010 must have somethingabsolutely stunning and surprising to tell, otherwise he or she would havechosen another title, I supposed. And to put it in a nutshell, Prof.Demougin did have a remarkable theory on who were the ones to blame in terms of the current financial crisis. Triggered by the American housing bubble, as you all know, theworld now finds itself within the deepest recession since 1929. But was itreally because of the greedy financial managers and their lack of ethicalresponsibility? The lecturer from the nearby European Business School claimed something completely different.

To give you a short overview of all the topics we have been discussing during thisoutstanding evening, let’s start straight away with facts, that should soundfamiliar to you: For the shadow banking sector surpassed the traditional bankingby early 2007, US government had to deregulate the limitations of the financial markets. The states began a dangerous race to the bottom, dominated by the competition between Wall Street and the City of London, where deregulations were worst.To look nicely on their balance sheets, from then on, banks were allowed to veilsignificant parts of their transactions. In the meantime, lenders became able tocircumvent capital requirements and increase their leverage. „Let me be French“,Demougin puts it, „imagine the loan as a little river, with a little risk ofdrying out. But what happens to you if it droughts?“ If you now bundle a lot of these little rivers to a big stream, you face an average risk instead of the individual riskof going bankrupt, the clever managers might have thought, being under immense pressure. This diversifies the risk on the one hand and on the other handmakes it easy for the bank to sell a Mortgage Backed Security. MBS. With thesepapers they could increase their liquidity and satisfy all different types ofrisk characteristics, depending on how they bundled them.To make it easier for us to understand this complicated affair, Demougin offeredthe picture of a bottle of champagne. The champagne gets poured over a pyramidof glasses, which symbolize the different types of securities and all differenttypes of financial papers. Typically French you might think now, but it’s cleverand helpful. On the financial market, glasses from different heights in the pyramid got mixed up, put together and were sold as another bottle. Over and over again. Rating agencies, paid by the banks, probably lost the overview and failed to estimate the value of those papers correctly. And because the regulators wanted the banks to hold more liquidity, they were searching for the best project they could work on. By using a pretty complicated mathematical formula, Demougin explained how the process of finding a profitable project means an effort to the bank manager. And as you can mathematically spread risk by bundling loans, the project selection of managers gets worse. Bank managers seemingly had no other choice but maximize their profits and believed they were doing right. So which conclusion could we draw after an interesting evening like this? „The very first step would be to increase capital requirements and regulations again.“

You didn’t get that? Trust me. It’s true.