Don't leave finance to the financiers

Finance, in the modern world, has become too important to be left to mere accountants, auditors and MBAs, notes Ajit Balakrishnan.

What caused the credit crisis of the summer of 2008 when the world banking system almost collapsed, when storied banks like Morgan Stanley, UBS, Morgan Stanley, Royal Bank of Scotland and others had to be rescued by their governments, and which since then has trapped us all in a long period of stagnation that has come to be known as the Great Recession?

Was it the work of avaricious, scheming, unprincipled bankers as many media commentators have made it out to be?

A new generation of scholars -- this time, sociologists and anthropologists, who hitherto have been busy with researching social practices of primitive tribes and social structures like India’s caste system -- are starting to cast their eyes on the financial sector and the men and women and organisations that inhabit that world to find answers to such and related questions.

Before I describe their work, here is a 30-second primer on the 2008 financial crisis in case you missed it because you were at that time distracted by staple Indian news headlines about cricket match fixing, the antics of Bollywood stars or the many scandals unearthed by the Central Bureau of Investigation or the Comptroller and Auditor General.

American banks started giving housing loans to low-income American households, a move welcomed by socially minded people, because everyone deserves to own a home; by intellectually oriented people, because the new financial instruments devised to do this lending were mathematical innovations; and by people in the financial services industry, as a new source of revenue and profits.

The lending banks took these loan papers (known in the financial trade as asset-backed securities or ABSs) and used them to get themselves re-financed (so that they could make more such housing loans).

Investment banks then made bundles of these loan papers (called collateralised debt obligations or CDOs) and sold them to other banks worldwide.

To protect themselves from unpleasant surprises, the holders of these papers went to insurance companies and got themselves insured.

Credit rating agencies, as is their duty, assigned credit ratings to these instruments.

All of this worked well so long as American property prices were on a continuous increase: the local banks made money on the interest they earned, the investment banks profited from the fees of selling these papers, insurance companies profited from the insurance premiums they received.

But when property prices started declining, the households who borrowed to buy their home started defaulting on their loan payment installments -- and the paper-holding banks, seeing the decline in the value of their holdings, went to the insurance companies with their claims.

All of this happened so fast that, in the wink of an eye, practically all the players were left holding papers that they thought were worth billions of dollars but were essentially worthless.

They were saved, as we have noted before, only by the kindness of their governments.

Again, was this the work of scheming, unprincipled investment bankers that led the world to this catastrophe?

No, says, Donald MacKenzie of the University of Edinburgh.

In an article in the American Journal of Sociology, titled 'The Credit Crisis as a Problem in the Sociology of Knowledge', he says that the process of generating knowledge about the correct value of these CDOs was what caused the catastrophe.

The time-tested way to discover the value of a financial instrument or commodities is by continuous auctions, coordinated either by an exchange or by dealers who act as 'market makers,' and the wide dissemination of the resultant prices and, thus, generate 'public knowledge'.

The CDO tranches discussed here were not, in general, traded in markets.

Also, the banks, insurance companies and credit rating agencies, says Professor MacKenzie, were organised in silos: one part of the organisation had a clear view of the value of the ABS portion and another part of the CDO part, and practically no one had a view of the value of the whole ABS/CDO instrument.

In other words, the way these institutions are organised internally as well as the division of labour across organisations in the financial services industry has become the focus of study and the study is being done by anthropologists, sociologists and political scientists.

Professor MacKenzie’s own book, An Engine, Not a Camera: How Financial Models Shape Markets, describes how financial theories made the trading in derivatives a legitimate activity.

Karen Ho, an anthropologist, went to work in an investment bank much as Margaret Mead in an earlier era did with aborigines and her book Liquidated: An Ethnography of Wall Street is filled with the voices of stressed first-year associates, overworked and alienated analysts and how they get socialised into a world of high risk and high reward.

Mark Blyth, a political economy professor, examines the current austerity policies in fashion in the United States and Europe in his book Austerity: The History of a Dangerous Idea and wonders whether such policies may lead to the rise of fascist forces as it did in the 1930s.

In other words, finance, in the modern world, has become too important to be left to mere accountants, auditors and MBAs.

Photograph: Issei Kato/Reuters.

Ajit Balakrishnan, the founder and CEO of rediff.com, is the author of The Wave Rider: A Chronicle of the Information Age.