Sub-prime writedowns continue to pile up at some of the world’s biggest banks and the world was stunned by the huge losses at Société Générale. Meanwhile the credit markets remain all but closed. So who is to blame for the crisis in banking and what can be done to prevent future ones?

Are new regulations needed and what form should they take - or should banks reform themselves? Should the bonus system be overhauled, as some suggest? And is the refinancing of the a number of the biggest banks by sovereign wealth funds to be welcomed?

Pete Hahn, at the Cass Business School in the City of London, anwereed your questions live online from 2pm GMT on Friday, February 8. Dr Hahn was a banker for over 20 years, including 9 years at Citigroup, and worked in complex credits, derivatives, securitisations, structured and corporate bonds. He specialises in banking issues and corporate governance, particularly at the world’s largest listed firms.

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The fractional reserve system allows commercial banks to create money and pump it into circulation in order to earn interest. It is clearly to their commercial advantage to create as much money as possible, because the more they create the more interest they earn. Variations in the rate of money creation are the major factor behind modern booms and busts. Instead of confining themselves to the single lever of interest rates, central banks could alter reserve requirements as a tool of monetary policy. For example, higher requirements would restrain new bank lending without inflicting higher interest rates upon existing borrowers. A much more effective way of proceeding, don’t you think?
Tarek El Diwany, London

Pete Hahn: There are various ways that financial regulators could use controls on bank capital to limit ’money or credit’ creation. Until the 1980s in the US, ’reserves’ was the term used that required banks to place some of their available loan funds effectively on deposit at the Fed. Banks saw this as limiting their activity and effectively built in the negative cost they bore, effectively charging customers for these costs and they limited lending. Another example is margin requirements for share purchases: for example banks can only lend only 50% against shares. Raising these percentages limits overall lending. If we relied on banks for all funding these tools can be used as blunt instruments, but banks seeking to pay for their equity would pass on their increased costs. More challenging for regulators is that more and more credit creation has come from outside of the banking system in recent decades and such tools would seem to offer little to control this growth.

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The broker-originate-distribute-restructure model, that could characterise some of the mortgage market and was probably the most toxic, is information-destructive, with each player along the value chain losing information that the previous party knew. Greater transparency is clearly needed to re-assure investors if a disaggregated model is to re-emerge. However does this require more knowledge transfer in order for risk to be correctly priced? Can enough of information/data be moved to investors and do they have the capabilities to analyse it?
Ben Morton-Harmer, London

Pete Hahn: The originate and distribute model is good for the global economy. It assists in moving capital to the sources that can best use it. What you have pointed out are the failings in the securitisation and structured financing models. I am on record stating that no security should be offered publicly without a commitment to provide sufficient regular data for a sophisticated third party to value. This is actually the same requirement that we have of corporate securities. BP regularly provides data that allows analysts to value its securities, that didn’t happen with CDOs. We have to reach this point to help clear markets. A startling aspect of the current losses are that they are at ’Sophisticated Institutions’ and not widows and orphans. Can a Swiss bank claim to not be sophisticated? The latter seems to point to greed as the driver of our current problem.

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Is the discrepancy between the timescales on which bonuses are paid and on which investments prove their worth a key factor in this and other banking crises? What can be done?
FT.com

Peter Hahn: Bonuses and incentive pay are now part of our culture. The key to making them work is aligning them with shareholders’ and regulators’ interests. New business people should get their bonuses now, however, those in credit positions and senior management need a longer term approach. Perhaps the most important factor for senior management pay is their focus on making sure the right balance between credit (or risk managers) and new business is struck. With no new business, there is no profit and no business at all. What we are witnessing is the dominance of new business over credit and that must change. A few firms, notably Goldman and Lehman seem to have worked this very well. Could it be that their senior managements have much of their wealth tied up in their firms? We can’t have that at the average bank, so we need regulators to examine the balance of power in deposit -taking firms. I wonder if Société Générale’s risk managers got paid like their traders?

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Do you think that a change in the way that bank directors are selected would improve risk management? If so, what would you suggest as an alternative method to the present system?
Richard Bassett, Vancouver

Pete Hahn: Banks have changed. We still like to think of banks as local or regional deposit taking and lending, and their boards are too often made up of former government people, community leaders, and the heads of leading industrial companies. Do any of these seem like they would understand the super senior tranche of a sub-prime CDO? The challenge is that on every bank board we now need at least a few men or women that understand risk and banking. I’ve looked at many European and US banks and I don’t find there are many directors with this knowledge. They may be honest distinguished people, but they don’t understand the risks. Shareholders should ask for more. But they don’t and leave management to it. Regulators should demand action. We now demand financial literacy for audits – this is one more step in increasing competency.

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Has the recent fallout in investment banking cost the wider economy more than the value created during the many years of innovation and growth which preceded it?
Jon Kirk

Peter Hahn: The innovations in banking over the past decade have created immense value, but they are impossible to measure. Mortgage securitisation provided lower costs and funding availability to millions, but it got carried away. Some economists will undoubtedly try to find a measure for this and look back in a couple of years with a more precise answer, but my gut says yes we have benefited. Our system is based upon trial and error and now it’s time to figure out which parts we take forward and where we went wrong. The lessons usually serve us well....but we don’t always learn.

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Are sovereign wealth funds really the answer to the big banks’ problems with liquidity?
James Byard, London

Pete Hahn: Sovereign Wealth Funds (SWFs) are indeed damping down volatility for the moment in that we don’t have any crises at those banks where they have invested. However, I feel they have many drawbacks. First, the speed with which they invested didn’t come with any key changes. For example, if I were a shareholder of UBS I would like to have been asked if I wanted to own a Swiss deposit bank and wealth manager and a London-based investment bank or maybe just one of the above. Citigroup got its money before making any strategic decisions. So are these investors just filling holes in the dam? Second, SWFs are likely to be poor investors. I joke, but my first academic degree was in Politics and there were no classes in investments so will politicians be better investors than the market? Because of their size, SWFs also invest in such large scale that they lose the ability to threaten to sell. Third, they carry the political baggage that if they make demands of management they may be construed as overstepping. They seem like silent partners in film investments....they put up the money but may need luck to see a return.

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Why did central bankers and governments have such a hands-off policy as respects regulation of banks, oversight of the creation and marketing of ever more “ingenious” investment devices, and the participation in such schemes by the credit rating agencies and monolines, which poses an obvious conflict of interests? Were they simply clueless as to the profound risks, or were they perhaps secretly jubilant that such new-fangled financial activity bolstered their GDP bottom lines? What excuse do regulators now have for not preventing it in the first place?
W. Joseph Stroupe

Pete Hahn: When I began working in banking, bank inspectors regularly visited and inspected paper trails. But as banking moved on to the trading of risk, regulators became ever more dependent on whether banks were modelling their risk profiles correctly. In a certain way, it’s the forest and trees problem. The regulators were so focused that they missed the big picture, in many ways banks were no longer banks. They became investors, traders, and, indeed in certain cases, speculators. We need to re-address what a deposit taking institution is (better name than “bank” these days) and what it should be allowed to do. Our taxes can’t be allowed to support every activity that a bank wants to to.

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Experts estimate that current subprime losses are about $400 billion, but we have only seen about $100 billion in write offs so far. Who is holding the other $300bn and when will that shoe drop?
Selwyn Nakan

Pete Hahn: So far ’real’ or ’realised losses’ are much less than $100 billion but banks have chosen or been advised to write-down this level based upon their predictions of how far they believe US house prices may fall over the next few years. So two big assumptions: house prices and resulting losses. As assumptions change we may see more coming....and soon. Who has the rest? There is a lot more in the same banks, but the rest is a guessing game right now and quite a bit depends on the ’monoline issue’, but that is another question.

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As a retail shareholder in some of the Big Four Banks, I have asked one in particular to present a breakdown of its total CDO holdings, both hedged and unhedged, and to give details in ’table form’ of all counterparties to the hedging. I have further asked for a breakdown of CDOs by originator, type, and age and a table of the underlying securitised assets. What do you think of my requests ?
Edward McGarrell, London

Pete Hahn: I absolutely agree, for their own benefit (in share price and overall confidence) they should be very detailed in their disclosure. But my worry for the UK’s banks isn’t their US picture (save a bit of RBS), but their UK picture. How much commercial real estate? How precarious are their retail exposures?

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I have personally made bad investments and suffered loss without expectation of being reimbursed. Is it fair to bail out banks, brokerages, bond insurers and such for their incompetence, and, in some cases, their criminal fraud, just because they are too big to let fail? Ted Feimer

Pete Hahn: It is not fair to bail out the shareholders and, in many cases, the bondholders of failing banks. The problem is regulators allowed too many banks to become ’too big too fail’ on the premise of big is diversified and safer. But the biggest ones also seem to make the biggest mistakes. We need to re-think who and what we save.

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How long do you think the liquidity crisis will continue for and what factors will assist its alleviation?
John Ford

Pete Hahn: It is hard to say that we have a liquidity crisis at all. Central banks have pumped so much money into the market we are awash in cash. The issue is capital or the cushion against losses and confidence. Banks no longer believe each other’s credit positions - this is a big issue. But the biggest issue that’s been long overlooked is retail credit-driven economies. Three years ago commentators in the UK noted that the average person had a stark choice of paying his or her mortgage or providing his pension....obviously, having a house but not being able to afford food wasn’t the right choice. We need some restructuring or repricing of assets and debts to restore the balance. I’m afraid it’s the usual banking cyclical problem.

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Is Citigroup going to survive?
Yusuf Samad

Peter Hahn: As a Citigroup alumni I am prejudiced positively, however, here is a dispassionate attempt.... Citigroup’s last set of numbers highlighted some great businesses amongst some real problems and most unsurprisingly, some of the worst businesses are sub-scale or not in the first league. No matter how much capital Citi raises, it can’t continue to invest in all these businesses so it must decide on which ones shed. It probably isn’t the best time to shed US retail businesses but that may be the answer. Can anyone suggest that emerging market consumers have lower long term growth prospects than the US? Citi has a great leg up in this business, similar to global corporate banking. Many of the former and current leaders of Citi are arguing for it not to break-up, but I have to wonder if this isn’t about preserving a legacies more than reality.

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