Wednesday, April 8, 2009

Global Economic Downturn - Part 2: Who is to blame?

In the last 18 months we have witnessed increase in number of company closures and rise in redundancy. Analyst and experts have predicted a longest recession in living memory, and confidence in the markets around the world is at the all time low. Everyone including the politicians do not want to take blame for this crisis. This crisis is really not a political problem as it turns out to be, as governments are bailing out big corporations from total collapse. At times like this, finger pointing, name calling, scapegoat are order of the moment. But who should we really blame for this crisis? Some argued that the CEO’s and the management of near-collapse banks should be responsible. Others said that the government should be blamed for lack of regulations. I think there is a fair legitimate argument from both sides.

In this article, I will take each argument in turns: Last week we witnessed thousands of demonstrators plotting a series of protests to exploit the disenchantment with City financiers blamed for dragging the economy into recession. The protesters aim was to show their concerns to world leaders at G20 summit in London that weekend. Their main concern is the excessive performance based bonus/incentive culture of the banking industry, which they argued was the main catalyst that leads traders to be reckless and “gamble” with investors monies. The have taken position in a rather complex financial instrument. These instruments are very difficult to account and report and sometimes do not appear on company’s balance sheet but revenue from these transactions appear on company’s book. It is these transactions that now threaten the entire Western economies and it’s spreading like a plague around the globe.

But why should we make traders a scapegoat in all of this? The executives of these companies are far worse when you look at the average remuneration package of CEO’s of investment banks. An average salary of a trader in the city is around £60,000 to £90,000 but their annual bonus ranges from a quarter to 1 million pounds depending on revenue generated. So you can see why these traders would be motivated to take risk or try to make profit at all costs leaving investors at huge risk. The same argument goes with their executives who received stock options. With stock options to be exercise when top management are leaving the company, there is an incentive for these executives to want to increase the value of the stocks to receive maximum payout when their time in office is over. In 2008, an investment banker Andrea Orcel at Merrill Lynch was paid $38.8 million in cash and stock option.

In the mortgage sector, brokers whose salary depend on the number of property he/she sells also became reckless. They ignore the basic principle of risk management. Mortgage loan were offered to families with no secure job at 3 times their annual salaries. No one seems to care as economy booms, house prices rocketed. Average family in the UK and US has 3-4 credit cards on top of their mortgage loan. Our bank executives for their own greed encourage masses to be indebted.

So why government should be blamed for those actions described above? After all, it all happened in the private sector and we operate in free economy. Let me answer this in its simplest form. The governments are the ultimate beneficial of these malpractices. The economy enjoys the boom period and politicians were given praise for good policy. In the UK under Tony Blair, the financial system was deregulated. Banks became autonomous, the result of this independence we can see clearly today. In some quarters, some argued that government should have clamped down on executive pay and bonus and incentive culture.

From both set of arguments above, it is interesting to see where this debacle will lead us. Some of even suggesting it might be the end of capitalism and free market enterprise. I strongly believe that those who have been charged should look into their closet and decide where to mend what I will call reckless greed of the executives. On the other hand, our governments should also be proactive and vigilant in reading red flags. After all, they the one who have being left to clear the mess with taxpayer’s money.

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