Financial Crisis and the Culture of Risk

In the Josiah Stamp Memorial Lecture
which he delivered on January
13, 2009, at the London School of
Economics, Ben Bernanke, Chairman
of the Federal Reser ve System, listed
the causes of the credit boom that led
to the current financial breakdown:
“widespread declines in under writing
standards, breakdowns in lending
oversight by investors and rating agencies,
increased reliance on complex and
opaque credit instruments that proved
fragile under stress, and unusually low
compensation for risk-taking.”

This is not moral language but the
language of the scientific economist
looking for explanations rather than
making judgments. What Bernanke described
was the behavior of many important
actors in the financial system.
Yet that behavior had a moral dimension,
and it can only be described as
irresponsible at best. Sir Josiah recognized
as much in his 1938 book Christianity
and Economics, when he talked
about “the reign of law, decency, honour,
industry and thrift in which alone
a complex industrial system can work”
(p. 189). Justified as passing judgment
is, however, to understand the roots of
our financial crisis we must examine
how risk changed from being a morally
fraught but unavoidable problem of human
existence to being a commodity
traded on markets like wheat or copper.
The neglect of the moral reality of risk
is a recent phenomenon that lies at the
bottom of our problems.

The Christian church and the western
cultural heritage traditionally considered
risk to be a problem that was
a consequence of sin in the world. In a
sinful world, things can and often do
go wrong, but the Christian trusts that
God will make sure that ever ything
works out for good. The Christian would
not take unnecessary risks because
that would be to tempt God. The Christian
would not try to lay risk off onto
other people because that would be to
shirk moral responsibility for one’s own
decisions and cause problems for others
for whom we are supposed to show love.
The biblical prohibition of usury can be
understood in this light: borrowing at
fixed interest lays the borrower’s risk of
failure off on the lender. Better to form
partnerships where all parties share in
decision-making and risk. Christians
long viewed insurance with suspicion,
especially life insurance, and instead
formed “burial societies” in which
church members for a small subscription
would share the burden of funeral
costs. Widows would be supported by
church benevolence funds. Christians
especially opposed gambling in all its
forms as the unnecessary taking of
risks with no possible benefits for family
or community, and in most Christian
countries gambling was forbidden
or strictly regulated. Though the usury prohibition was not observed after the
Reformation, many of these attitudes
and practices sur vived well into the
twentieth century and were reinforced
for many by the experience of the Depression.

Practices in the world of banking
and finance also reflected this cautious
attitude towards risk. Most lending
was done through the banking system
(rather than through investment
banks or the bond market), and bankers
practiced “relationship banking.”
 
The neglect of the moral reality of risk
is a recent phenomenon that lies at
the bottom of our current economic
problems.
 
They took a lot of trouble to know who
their borrowers were and did a lot of
business with regular customers over
a long period of time so that they understood
a business, and the character
and practices of its managers, very
well. Regulatory limits on branching
in the United States meant that banking
was always a local affair. Bankers
stayed away from making loans in industries
they did not understand, even
if these were the fashionable,
new, high-tech, “hot” areas of
the economy.

In the 1950s and 1960s
all of this began to change.
The development of Las Vegas
as a successful resort city
based on a combination of
casino gambling and glamorous
entertainment led cities and states
all across the country to rethink their
opposition to recreational gambling.
Virtually all the states began to allow
limited casino development, and Native
American tribes looked to casinos as an
important source of revenue. State governments
found a new source of revenue
in state-sponsored lotteries, supported
by heavy advertising. Compulsive gambling
was treated as a problem limited
to a few people, in the same category
as alcoholism, and not a reason to prohibit
gambling. Gambling became just
another form of entertainment, with no
particular moral baggage.

At the same time economists were
developing the modern theory of finance.
One major result of this research
was the finding that the riskiness of a
portfolio of loans or securities could be
reduced (to a point) by diversification;
this finding gave a real boost to the mutual
fund industry. The stock market
did very well in this period as more ordinary people put part of their savings
into stocks, confident that the mutual
fund portfolios they held had diversified
away any systematic risk. As economists
began to understand risk better,
they developed mathematical models
that allowed the calculation of an “efficient”
or “rational” price for risky assets
of all descriptions, as long as the
probability distribution of possible outcomes
was known. Since risk could be
priced rationally, it could be packaged,
marketed, and sold in an infinite variety
of forms, especially after the coming
of cheap computers made complex
calculations easy. People were seduced
into assuming things about risky assets
that they didn’t really know. Even
if they knew nothing about the borrower
or the market, they bought financial
instruments in the confidence that the
assets had been priced appropriately
by a competent computer program.

With the coming of the Reagan
administration, there also developed
a popular ideology that idealized the
risk-taking entrepreneur. This way
of thinking suggested that the main
source of economic growth and new
jobs was risk-taking by small entrepreneurs
which created new businesses
based on new technology–or at least
on new insight into the wants of consumers.
 
Lending money is not a game we play
for thrills, nor is it simply an easy way
to make money without working; it is a
serious expression of our responsibility
before God.
 
Big corporations could also
create new jobs to the extent that they
cultivated this entrepreneurial spirit,
or at least imitated the more successful
new businesses. Therefore to encourage
growth, the returns to risk-taking had
to be increased, preferably by reducing
the taxation of income from capital to
zero. Reagan sharply reduced income
tax rates for high-income people and reduced capital gains taxes. This period
also saw the introduction of the
“Roth Individual Retirement Account”
and the Section 529 education savings
account, both of which exempted dividends,
interest, and capital gains from
any taxation. President George W. Bush
took this further, exempting most stock
dividends from taxation and sharply reducing
the estate (inheritance) tax. Of
course, this ideology stands the Christian
tradition on its head. Where the
usury principle favored income from
work and was suspicious of income
from capital, the new ideology favored
capital income and tried to shift the
bulk of the tax burden onto wages and
salaries.

The policy environment produced by
the new ideology increased the degree
of inequality in income distribution.
As high net-worth families saw their
standard of living increase, middle- and
lower-income families saw their
living standards fail to keep up with
what they were assured was a growing
economy. To make up for this shortfall,
many families reduced their saving and
made greater use of debt that was made
available to them with very few questions
asked. This pile-up of household
debt reduced the stability of the system
in the face of a shock to asset prices,
especially the prices of households’ biggest
assets, their homes.

The new theory of efficient capital
markets and the new ideology of job
creation led American and other developed-
country policymakers to advocate
an integrated global capital market.
This was part of what came to be called
the “Washington Consensus” on globalization.
By allocating capital to the
most promising opportunities for job creation
and growth around the world,
and by further diversifying risk, the
Consensus held, such a market would
lead to global growth, the reduction of
poverty in the global South, and generous
profits for the providers of capital
in the global North. It was only required
that all countries should adopt institutions
and business practices modeled
after those in the successful
developed countries, most
notably the United States,
so that the new global market
would have a “level playing
field.”

The new technology for
marketing risk led to a separation
between the underwriting
and pricing of risk
and the actual assumption of risk by
the lender. This was the major problem
with “subprime” and “Alt-A” mortgages
but it became a problem with other kinds
of loans as well. Lenders relied on loan
originators, servicers, and packagers to
assess the risk, service the loans, put
together a diversified package of risky
assets, and price it appropriately. For
this, the servicer received a fee. The
risk was borne by the lender, who had
done no investigation or “due diligence”
and did not really understand the risk.
 
If the church can stand resolute for honest
and prudent behavior, consistent with God’s
will for society, maybe we can avoid such
problems for a long time to come.
 
This kind of behavior by lenders is imprudent
at best, but the gambling culture
that has grown in American society
leads lenders to view it as a game,
not a serious enterprise. The new ta x
structure encouraged it. The investment
banks and mortgage companies that
under wrote and priced these financial
instruments, and the agencies that rated
them, presumably had some interest
in protecting their reputations, but
since they bore little risk themselves,
there was an over whelming temptation
to make as many loans as possible and
sell them on as quickly as possible with
little attention to controlling risk. This
was also imprudent and irresponsible,
but nevertheless was a very profitable
business until the most recent financial
collapse.

The collapse brought to the surface
the systemic risk inherent in these
practices. Once an unexpectedly large
number of loans began to default, it became obvious that many of these loans
were riskier than they appeared, and
were inappropriately priced because
optimistic assumptions had been made
about the distribution of outcomes.
Calculations of efficient prices tend to
be based on the assumption that financial
crises almost never happen, even
though we have now had four such crises
in the last twenty-five years. With
a crisis, uncertainty enters the picture.
Uncertainty is different from risk. Uncertainty
is the situation in which the
parties to the contract do not know
the probability distribution of the outcomes.
Under uncertainty, an efficient
price for the loan cannot be determined.
Investors hate uncertainty and f lee it at
any opportunity. Once investors believe
that they cannot know the risk involved
in any loan or determine its appropriate
price, they refuse to make loans or
buy risky financial assets at all. This
leads to a collapse in the prices of risky
financial instruments and lending activity
freezes up. The consequence for
the real economy is that purchases by
businesses and consumers cannot be
financed, and so economic activity collapses.

Fundamentally this is a moral issue.
I don’t mean this only to say that
clearly dishonest and fraudulent activity
took place, although it surely did.
Bernard Madoff and people like him
took advantage of the atmosphere of
optimism and trust
to cheat people out
of billions of dollars.
Mortgage originators
conspired
with clients to falsify
loan applications
and connived
with appraisers to
inf late house values. Ratings agencies
paid too much attention to the wishes
of their clients and too little to their
public duties. Investment banks and
other businesses hid liabilities in offbalance-
sheet entities to conceal from
the investing public the degree of leverage
they had taken on. Hedge funds
refused to reveal anything about their
investment strategies on the grounds
that they were private entities open
only to the super-rich, but then marketed
themselves to the public through
“funds of funds.” There must and will
be legal consequences for those involved
in these activities, as well as new regulations
designed to reduce the amount
of risk in the system.

But besides such straightforwardly
illegal activity, there was a lack of the
kind of prudent attention that is called
for by the biblical idea of stewardship.
The managers of financial institutions,
investment advisors, and ordinary individuals
failed to take the most basic
steps. Questions about borrowers
and risk were not asked. Ratings were
taken at face value, so independent
risk assessment was not done. Investment
banks, insurance companies, and
hedge funds ran up too much leverage,
and households borrowed too much
money. A premium was placed on innovation,
so new, risky derivative instruments
were invented that had no
real business purpose. Brokers were so
concerned about selling products that
they forgot about their fiduciary duties
to their clients.

As we have seen, taking risks with
our money, which is really God’s money,
is not generally a good thing to do,
whether it involves borrowing for a
risky venture, investing in risky financial
assets, or buying too little (or too
much) insurance. It calls into question
our willingness to be responsible for
our own behavior, our concern about
the welfare of others, and our faith in
God’s providence. It is acceptable to
take risks if it is likely that the community
as a whole will benefit, so taking
good business risks is acceptable.
Since the Reformation, Christians have
accepted that lending money at interest
is a business practice that can be useful and beneficial to all people. But
there must be prudence. There must be
due diligence. Lending money is not a
game we play for thrills, nor is it simply
an easy way to make money without
working; it is a serious expression
of our responsibility before God. Our
problem is that we have not taken it seriously
enough.

The church needs to reassert moral
leadership on the topic of risk. We
need to stop caving in to the prevailing
cultural pressures and assert what
the Bible, our moral tradition, and our
experience teach us to be true. First,
we must begin to preach against gambling
again, not only describing it as
sin but explaining to people why it is
inconsistent with God’s will. We also
need to bring back the moral tradition
that excessive debt is not a healthy
thing for households or for businesses.
Yes, there are good reasons to take on a
prudent amount of debt to buy a house
or expand a business, but debt is not a
game and it is not right to take on debt
just to look for a ta x break or to fend
off a corporate takeover. Nor should we
be financing ever yday expenditures by
borrowing.

The church needs to emphasize that
in lending or investing, there need to be
prudence, due diligence, and a full regard
for the effect our actions will have
on the larger community. It is not just
bad business to take on risks that we
don’t understand; it is immoral. It puts
our whole economy at risk for our lack
of prudence. In our age of instant information
about ever ything on the Internet,
there is also no excuse for not investigating
where our money is going. If
the people soliciting your money can’t
answer all your questions, don’t invest
with them.

The church also has a witness in
the area of public policy. We need to
point out the dangers inherent in financial
globalization. Crises spread easily
from one country to another in a world
of closely linked markets. Investing at
a distance makes it harder to do due
diligence and makes investors more inclined
to judge projects by quick summary measures, like profits, and not look into the effects on communities.
We Americans also end up imposing
our business practices on people whose
cultures, religions, and values we don’t
always understand very well. This creates
resentment of our power.

There are also dangers in public
policies that increase income inequality
and disadvantage work. Let income
from work and income from capital be
ta xed at the same rates. This is just.
Let the benefits of economic growth
bless both workers and investors because
both contribute to that growth
and both bear the risks of change in a
dynamic economy.

Many people thought that after the
lessons learned in, the financial crisis
of the 1930s, no such disaster could
ever happen again. Now the disaster
has happened again. There is no guarantee
that once the current crisis is
over, we will be done with financial catastrophe
forever. But if the church can
stand resolute for honest and prudent
behavior, consistent with God’s will for
society, maybe we can avoid such problems
for a long time to come.