BOOKS: Bending the regulations

BOOKS: Bending the regulations - INFECTIOUS GREED; By Frank Partnoy; Profile Books; pounds 17.99

by Robert Peston, City editor of the Sunday Telegraph
Last Updated: 31 Aug 2010

INFECTIOUS GREED; By Frank Partnoy; Profile Books; pounds 17.99

This is a breathtaking chronicle of greed and stupidity, yet it leaves Robert Peston more confident that the financial system is robust.

If you ask any investment banker or fund manager about the outlook for interest rates in the US or Europe, you'll be told with utter confidence that they will stay low. And that's a reasonable view - inflation appears to be an obsolete phenomenon in many economies.

These same brainboxes will also tell you that we live in a golden age of controlling the potential losses from investing and lending. We are fortunate, they believe, to have access to the widest, deepest capital market the world has known, with pools of money in the remotest parts of the globe. So the risks of any financial transaction can be spread widely among many providers of capital.

The risks of any individual transaction can be further reduced by tapping into an array of derivative products, which allow borrowers or lenders to hedge against the risk that currencies or interest rates move in a way that they don't expect.

This is not utter baloney. It is remarkable that the integrity of this system has withstood the pricking of the internet and tech bubble in 2000 and the longest and most savage bear market in equities of the modern era.

The underlying reality is, however, slightly different. Financial markets are little more than the sum of the parts of the players operating in them. If they are carrying out vast numbers of transactions to protect themselves against assorted risks, that protection or insurance will extend only so far as the risks that they perceive.

But at some point, something will happen that they simply don't expect. And when everybody firmly believes that interest rates cannot possibly rise in any meaningful way, the big danger is that they do.

If this occurs, a bank or fund management group we all thought was a byword for prudence will suffer huge losses. Our faith in the resilience of our system will be tested.

Here's the 50 trillion dollar question: is this system like an aircraft, where a battering will undermine the functioning of one tiny but vital component and the whole thing will fall from the sky? Or is it a self-repairing machine? Does it have a remarkable ability to discard and replace each distressed cog?

As it happens, I have come away from Infectious Greed, Frank Partnoy's sparkling history of financial markets over the past 15-odd years, with slightly more confidence that systemic disaster can be avoided - which I am not sure is what he intended. In fact, he avoids sweeping conclusions.

He takes for granted that the system is the system and concentrates on how it can be made a little less volatile and also suggests reforms that might reduce the potential for fraud.

His is a breathtaking chronicle of greed and stupidity on an operatic scale. Twenty-something bankers are given billions in capital by famous-name institutions to bet on red - and are then re-employed by other famous names when it comes up black, or they retire on the millions in bonuses they accumulated.

Greedy middle-aged executives of public companies raise billions in capital on the basis of fraudulent accounts and are then given huge payoffs and a mild slap on the wrists when it all goes wrong.

Supine, gullible regulators turn a blind eye to excess in the cause of market efficiency, and then earn their retirement nest-eggs by becoming senior directors of the firms they were supposed to be policing.

Underlying it all for Partnoy are two trends: that regulations are viewed by businessmen and bankers as there to be circumvented in the quest for profit (which augurs ill for Washington's new accounting and governance rules after Enron); and that innovation in financial markets is largely an attempt to disguise risk rather than minimise it, to allow the creators of those products the opportunity to make super-normal profits from ignorant investors.

It's a compelling portrait of corruption on the scale of the last days of Rome. Yet, bizarrely, conflagration does not seem to be imminent.

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