by Gillian Tett
IN THE MONTHS AFTER the crisis, the new leaders at UBS tried to repair the damage. The bad mortgage assets were scooped off the bank’s books and placed in a special vehicle at the behest of the Swiss government. The idea was that this ring-fencing would create more transparency and make it easier to remove the rotten assets. The section of the bank where the risk managers worked—or the “risk controllers’ department,” as it came to be called—was overhauled, and its fragmented divisions combined, supposedly into a seamless whole. “We have changed the reporting lines completely—risk controllers don’t report to the business heads anymore,” Lofts explained. “We brought market risk and credit risk control together in the business divisions for the first time. They don’t just sit in silos anymore, but are joined, and not just at the top of the bank.”
The information technology systems were overhauled to make it easier for top managers to see all the trading positions held by the bank. “The recording of positions, their valuation, and the assessment of their risks and the effect on the profits and loss account are now regulated on a group-wide basis,” the bank explained. “Each business unit must be able to explain its balance sheet . . . on standardized measurements.”71 Independent directors were brought into the board in a bid to combat the dangers of groupthink. “Now we have a risk committee comprised of all nonexecutives, and none of these had previously worked for the firm,” explained Lofts, who was appointed as chief risk officer for the entire bank after the crisis hit.72
Different branches of the bank tried to introduce ways to think and act in a more holistic and lateral manner. Alex Friedman, chief investment officer, started holding brainstorming sessions with staff from different parts of the bank, encouraging people to toss around ideas in a free-form manner. In Switzerland, the retail bank started cooperating with the private bank in order to swap customers and ideas. Traditionally, these two units had been run as competing fiefdoms; now everyone was being encouraged to collaborate. “We manage the business in a more integrated way now,” explained Christian Wiesendanger, head of UBS Wealth Management in Switzerland.73 “We look at how we can leverage across business groups and we are now trying to talk about the company.” In New York, initiatives were launched to force different desks to collaborate in different asset classes and take a holistic view. The new mantra was that UBS would aim to be a flexible, joined-up bank. Rigid boundaries were to be torn down.
The UBS managers insisted that these reforms were changing the culture. In places it was true. But reform was, at best, patchy. In September 2011, a year after the bank had repeatedly declared that it would never again let itself suffer poor risk controls, it admitted that it had lost over $2 billion due to unauthorized trades carried out by Kweku Adoboli, a junior member of the synthetic equities trading team in London. Adoboli traded an instrument known as exchange traded funds, or ETFs.74 Like the mortgage CDO world, the business of trading ETFs was a corner of finance that was supposed to be slow-moving and safe. But, as with CDOs, the ETF world carried subtle risks. Nobody outside the department had spotted the problems until it was too late, since the ETF department sat in a tiny silo.
The UBS management tried to brush the incident off as an idiosyncratic mistake. They unveiled more reforms to the bank’s risk control system, senior managers resigned, and the remaining officials pledged to make the bank even more transparent and better run. But shareholders in UBS were wearily cynical. “The lesson from the banking crisis is that the management of all the banks that collapsed, or would have collapsed but for taxpayer funding, were not up to the job,” observed Tony Shearer, the former chief executive of Singer and Friedlander, a small British-Icelandic bank that failed during the 2008 crisis when the Icelandic parent company went bankrupt.75 “Management just does not appreciate that the task [of running banks] is bigger than they are capable of handling [and] institutional shareholders are too often part of those same ‘too big’ financial institutions to address the issue,” he added, lamenting that “financial institutions are too big, diverse, complex and geographically spread for any group of management.” The silo problem, in other words, seemed like the Hydra from Greek legends, or the famous snake monsters with multiple heads. From time to time the bank would slay its silos. But just when people hoped the problem had died away, it reared its head again. Fragmentation was an ever-present threat, and not just at UBS, but at almost every other big financial institution, too.
But thankfully, this is not the entire tale. There is another, more encouraging aspect to this saga, which this book will explore in later pages. The story of the Great Financial Crisis shows that silos were (and are) debilitating for banks. But there is another side of this coin: although silos create losers at the institutions that are plagued with tunnel vision, they can also create opportunities for rivals. After all, it is a long-standing adage of finance that whenever somebody loses money in the markets, somebody else is usually making it at their expense. The stunning losses that UBS and others suffered on CDOs were gains for somebody else. Silos spell disaster for people who are afflicted by them. They can also create opportunity for others.
In chapter 8, I shall turn to this aspect of this story, by telling the tale of how one hedge fund has deliberately exploited the silos that exist in finance and at big banks such as UBS. But first, we shall turn to another story, which illustrates another set of distortions in the financial markets, but one found in the public sector, not private companies: namely the tale of how economists at places such as the U.S. Federal Reserve and the Bank of England misread the financial system before the great crisis of 2008.
4
RUSSIAN DOLLS
How Silos Create Tunnel Vision
“An expert knows all the answers—if you ask the right questions.”
—Claude Lévi-Strauss
THE QUEEN OF ENGLAND WAS standing in a hall at the London School of Economics looking a little perplexed. The date was November 4, 2008, and the queen had arrived at the LSE, one of the premier universities in the world, to open a new building. Cheering crowds of tourists, students, and children lined the narrow streets, waving Union Jacks, as she arrived wearing suitably formal attire: a speckled cream suit, large matching hat with a cream bow, discreet pearls, and black gloves.
The event was supposed to be a celebration of academic achievement and genius. But the timing was poignant. Two months earlier the brutal financial crisis had erupted in London and many other parts of the West, which had caused a string of banks to collapse, the markets to freeze up, and the Western world to slide into a deep precession. The impact had damaged the fortunes of wealthy families (such as the queen). But it had had even more devastating consequences for the less well off: unemployment was spiraling upward, and thousands of families in America and the U.K. were being tossed out of their houses.
These dramatic events had left hordes of economists and pundits scurrying to provide analysis. The London School of Economics was no exception. Its economists were deemed to be among the most brilliant in the world, and the university has close connections with the British government, as well as ministries all over the world. Mervyn King, one LSE luminary, was governor of the Bank of England, an institution that sat just a couple of miles east. The dean of LSE, Howard Davies, had been the top U.K. regulator. Charles Goodhart, another LSE professor, also had a top role at the bank. All of these brilliant minds had strong views about how the financial system and economy was supposed to work; or sometimes not work. So, as the queen toured the building, Luis Garicano, yet another highly regarded economist, presented her with some charts that purported to show what was going on in finance.
The queen peered at the brightly colored lines. “It’s awful!” she declared, in her clipped, upper-class vowels. It was a startling break with the usual protocol: the royal family was famous for avoiding any comment on sensitive political matters.
“Why did nobody see the crisis coming?” she asked. “If [the problems] were so big, why did nobody see i
t?”1
Smoothly, Garicano tried to present an answer: the real issue, he argued, was not that economists and financiers were ill-intentioned or stupid; it was rather that they had been looking in the wrong places, at the wrong time. A dramatic shift had occurred in the financial system due to innovations such as securitization. But though lots of people had understood separate pieces of the picture, nobody had been able to take an overview, and see that a crisis was about to hit. “People were doing what they were paid to do, but nobody could see the whole picture, or join it up.”
The queen clutched her black handbag; she did not seem to find the explanation entirely convincing. No wonder: her subjects were baffled too, along with much of the West. To noneconomists it seemed almost impossible that a collection of people who were supposed to have some of the smartest brains on the planet, and be involved in running governments, could have been so foolish. It was hard to believe they could have all turned blind, or stupid, overnight. It seemed easier to presume that bankers had somehow “tricked” the regulators by hiding their activities in a fraudulent way.
But in truth, Garicano’s “explanation” was more telling than perhaps even he realized. For the story of the credit crisis shows that even experts (or, perhaps, especially experts) can collectively become very blind when they organize their surroundings into excessively rigid silos. Chapter Two of this book narrated the story of Sony to demonstrate how fragmented structures inside institutions can sometimes cause people to miss opportunities for innovation. Chapter Three related the tale of UBS to show that silos inside institutions can also make people blind to risks. This chapter provides another twist on this silo issue by telling the story of what happened to economists at places such as the Bank or England and the London School of Economics (or the U.S. Federal Reserve and Harvard University) before the 2008 crisis. Silos do not just arise inside institutions. They can also affect entire social groups. Networks of experts can become captured by silos, in the sense of displaying blinkered thinking and tribal behavior, even if they work in different institutions and countries. This is not a problem that is unique to the economic profession, any more than silos are an issue that is just found in banks. However, the story of the economics tribe is distinctly revealing, not least because it shows how skilled experts can become so confident in their own ideas that they end up missing dangers hidden in plain sight. Like the villagers in Bourdieu’s dancehall, economists were so busy watching the “dancers” (or the pieces of the economic picture that everyone was expected to watch), that they ignored the “nondancers” (or the parts of the picture shrouded in social silence). “Why did the crisis happen? It was partly about epistemology, the knowledge systems that we used,” Paul Tucker, the deputy governor of the Bank of England, later observed. Or as Charles Goodhart observed: “[The credit crisis] isn’t really just a story about the structure of the Bank, or the Federal Reserve or any other organisation, but about the mental map we used—in academia, in policymaking, everywhere.
“Ideas matter and economists were all using the same ideas.” They were sitting in the same mental silo.
THE TALE OF PAUL Tucker’s own journey through the tribal world of economic policy illustrates the problem of silos well. If a casual observer had met Tucker, the Bank’s deputy governor, in the autumn of 2008, or just as the queen was touring the LSE, they might have thought he epitomized the modern economist-cum-policymaker. A mid-sized man, with a round, ruddy face, he exudes an avuncular air and speaks with crisp, polished vowels. Friends sometimes quipped that he sounded like a cerebral Winnie-the-Pooh. But he also exuded gravitas and whenever he spoke about the economy his words commanded respect in financial markets.
Tucker never set out to be an economist. Born in 1958 to a middle-class family, he grew up in England and went to Cambridge to study mathematics and philosophy. He vaguely liked the idea of public service. So in 1979 he applied for a job at the Bank of England, and though he lacked an economics degree he was accepted. “In those days nobody thought that everyone had to have a PhD in economics to work at a central bank,” he explained. “We had people who had double firsts in greats [Greek and Latin], history, and things like that.”
That reflected a particular vision of economics at that time. The root of the word “economics” comes from two Greek words: the noun oikos, meaning “house,” and the verb nemein, meaning “to manage.”2 Originally oikonomia was considered separate from markets and trading. It referred to “the imposition of order on the practical affairs of a household,” or putting one’s “house in order,”3 as the anthropologists Chris Hann and Keith Hart point out. Echoes of that original sense have appeared in subsequent decades: the nineteenth-century English novelist Jane Austen writes about her female characters being “skilled at economics,” meaning clever at handling servants, while cookery and sewing classes in twentieth century American and British schools were sometimes called “home economics.” This vision of “economics” being akin to “stewardship” has also influenced the development of the Bank of England.
During the first two centuries of the Bank’s existence, it was taken for granted that money, society, and politics were entwined. Not only did the Bank create money at the behest of the government, but it also issued government debt, oversaw finance, and protected the interests of the City. Thus when young graduate recruits joined the Bank in the middle decades of the twentieth century, they were expected to be flexible about their jobs—and get a holistic view of how money moved around the economy. When Tucker joined the Bank he was initially placed in the financial monitoring section, where he tracked what was happening in the banking system and inside the commercial banks. Later he was sent to the macroeconomic research department, where he worked on monetary strategy using formal economic forecasting models (after teaching himself economics from lots of books he read on his vacations and weekends).4 Then he changed again, moving to Hong Kong, where he kept an eye on the securities markets in Asia. “By the late 1980s there was a clear sense that the Bank needed to upgrade its economics capability if we were to be a front-rank economic policymaker. But [we looked at] lots of signals, not just the economic data,” Tucker explained.
However, as Tucker ascended the Bank’s hierarchy in the 1990s, he started to notice a subtle shift in how oikonomia, or economics, was perceived—and practiced. Back in the eighteenth and nineteenth centuries, when men such as Adam Smith, Thomas Malthus, David Ricardo, and John Stuart Mill pioneered the idea of studying the economy, it was considered normal to look at underlying economic forces alongside political and cultural analysis. But by the late nineteenth century, economics was becoming a distinct discipline of its own, separated from the other social sciences. And as the twentieth century wore on, this separation grew deeper. In the middle of the twentieth century economists such as Robert Lucas, of the University of Chicago, developed a theory of economics that assumed humans were always driven by rational expectations that could be accurately modeled. It lead to an assumption that economies were driven by uniform forces or laws of motion that could be equated to the universal laws of physics. Then economists started to use increasingly complex quantitative mathematical models to identify and make sense of economic trends. “In economics, you get kudos from the subtlety and complexity of the mathematical approach as any ability to actually meet empirical tests,” points out LSE’s Goodhart. “The mathematical model is everything.”
The obsession with mathematics did not just affect academic economics; it spread into finance too. Just before Lucas was developing his vision of economies based on “rational expectations,” Harry Markowitz, another economist, created the so-called capital asset pricing model, which tried to measure the risk of assets (and thus their supposed price) with statistics. This approach used a set of models that had been created by Kenneth Arrow and Gerard Debreu and became very influential. “[The Arrow-Debreu] mathematics was seized on as a road map towards the utopia of complete and efficient markets,” as Bill Janeway, an Ame
rican venture capitalist and economist, observes.5
From time to time, social scientists poked fun at this obsession with numbers. So did some maverick economists. In 1973, for example, an unusually freethinking economist named Axel Leijonhufvud at the University of California, Los Angeles, wrote a droll essay called “Life Among the Econ” in which he teased his colleagues over their obsession with mathematical models, describing these in the same terms that a Victorian-era anthropologist might employ to talk about a primitive tribe. “The extreme clannishness, if not xenophobia, among the Econ [tribe] makes life among them difficult, if not dangerous, for an outsider,” he wrote.6 “For such a primitive people their social structure is quite complex. . . . The status of the adult male is determined by his skill at making the ‘modl’ [i.e., mathematical model] of his ‘field.’ ”
Indeed, economists were so obsessed with their “ornate, ceremonial modls,” Leijonhufvud joked, that it was almost impossible for an academic to become a tenured professor at a university unless they could show competence with these tools. Economists who were less interested in mathematics, and consorted with nonmathematical “tribes,” such as political scientists or sociologists, tended to have low status. Quantiative economists sat at the top of the tribal hierarchy. “The fact that the Econ are (a) highly status-motivated, (b) that status is only to be achieved by making ‘modls,’ and (c) that most of these ‘modls’ seem to be of little or no practical use, probably accounts for the backwardness and abject cultural poverty of the tribe,” he continued.7
Leijonhufvud’s comments created mirth in social science departments. But mainstream economists ignored them. The discipline was not used to thinking of itself as a “tribe,” or reflecting on its own cultural patterns. That was partly because economists were downplaying social analysis in their own work. But another factor—as the anthropologist Bourdieu often liked to point out—was that the “Econ tribe” was becoming so powerful that it had no incentive to question the status quo. By the middle of the twentieth century, governments, companies, and banks were increasingly hiring economists to work out what was happening to the economy and predict what might happen next. Most ordinary onlookers had little idea how economists actually made these seemingly impressive predictions. The complex mathematical models they used were as mysterious to nonexperts as the Latin that priests spoke in the Catholic Church in Europe during its Middle Ages. But to outsiders, these models seemed powerful and the economists almost priestlike. University economics departments, such as that of the London School of Economics, began to look like seminaries.