View - Lahore University of Management Sciences

The failure of the FIs, in my opinion, is attributable to two
main causes: greed and unruliness at the FI level, and incompetence
and tardy attitude at the regulatory level. While the
FIs created structures, instruments and strategies which they
themselves at times did not fully understand (cutting edge innovation
as they called it) the regulators felt shy of asking too
many questions fearing exposing their ignorance. Why spoil
the party when everyone’s having such a great time and
everything seems OK.
Global FI industry is ripe for change, an alternative FI framework
that is stronger, more robust and dependable needs to
be built. Greed will continue to drive us, speed will continue
to thrill us, fear will continue to hold us, and love will continue
to be a distant third at best (I know a few will disagree
with me regarding the latter). It is unclear when we will be
able to respond differently to greed, speed, fear and love. Until
the scientists figure that one out, we need to clear the fog off
the roads, built safer vehicles, ensure that drivers stick to the
speed limit and the cops don’t take catnaps. If you arrived at
your destination way ahead of others, then you were either
speeding or used an alternative transportation mechanism.
The alternative is simple. All transactions with the semblance
of gambling must be forbidden (did I hear you say boring?),
each transaction must be backed with a real asset trade (did I
hear you say boring again?). This means no derivatives, no
shorts, no implied rating or similar fancy stuff (now you are
asking yourself why did you go to business school, this guy
must be nuts). Investment philosophy must be real value creation
by delivering either a service or asset; it cannot and
must not be a phantom product based on ifs, buts and
maybes. The simple rule is, if the product needs fine print, it’s
too fine to pass. FIs must disclose, upfront and fully, the assumptions
and what needs to happen for the investors to lose
money. The emphasis must be on sustainable wealth creation
and preservation and not speculative short term gains.
Financing
The availability of financing (debt capital) is essential for any
economic system to work efficiently. Rightly used financing is
a blessing; wrongly used, it’s a curse. Financing can amplify
returns; the reverse is also true if project return falls below
the cost of financing. Financing increases risk and thus, any
prospect of return amplification is not for free; there is no free
lunch. If one's having a free lunch, then surely someone else
is paying for two. Financing, like medicine, must be used
within prescribed limits to avoid the negative side effects
which can be fatal.
The rules are simple; financing will only be available at the
physical asset level, i.e. car, home, plant, machinery, infrastructure,
merchandise etc. and to a level appropriate for each
particular asset. High risk vestures will only be equity funded
(sounds like the future Basel, doesn’t it?). Financing will not be
available for investing in investment products, margin trading,
etc. If you don’t have the money (equity), don’t do it; gambling
with borrowed money is insane.
Stability of the global financial system (risk in the system) depends
on its level of gearing at any given time. The alternative
FI framework must be equity dominated; this will keep the
system stable and prevent tipping.
Risk Identification and Management
Risk identification and management is core to the change, I
propose. The principal role of the future FI’s must be risk identification
and management. No FI employee or owner should
be allowed to take on a decision making position without the
requisite understanding and experience of risk.
Trust me, risk is not easy. It’s an art and a science and at the
best of times, difficult to identify. If risk is not identified,
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