The top five unlearned lessons of the financial crisis

By Bethany McLean
September 24, 2013

In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks. Seriously, how many times have you read that more capital will save the banks from another Armageddon? Even the banks point to capital as a reason to have faith. “Financial institutions have also been working alongside regulators to make themselves and the financial system stronger, more transparent, more resilient and more accountable,” wrote Rob Nichols of the Financial Services Forum, which is made up of the chief executive officers of 19 big U.S. financial institutions. “Specifically, capital, which protects banks from unexpected losses, has doubled since 2009.” If you were a cynic — who, me? — you might say that the mere fact that the banks are pointing to capital is proof that capital is not all that.

Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct. On his Interfluidity blog (which I found courtesy of Naked Capitalism), Steve Waldman writes, “Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital,’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank.” In other words, even if you give bankers credit for good intentions, the accounting that would truly capture “capital” may not exist. Or as Waldman writes, “Bank capital cannot be measured.” Layer in some real world realities. The next time things get tough, will regulators once again practice forbearance and allow firms to overstate their capital, which has the perverse effect of making no one trust reported capital? Let’s not forget Lehman, which according to Lehman had a very healthy Tier 1 ratio of 10.7 percent on May 31, 2008 and a total capital ratio of 16.1 percent. This didn’t matter, because no one believed Lehman’s capital was real.

On the list of cures for the sick financial system, the concept of “risk retention” ranks right behind capital — but there are a couple of neat little twists here. The narrative of the crisis is that because mortgages could be sold off to banks, who would turn them into securities and sell those on to investors, who thought they were buying triple-A paper courtesy of the rating agencies — well, no one had any incentive to care about credit quality. In a piece in the Wall Street Journal entitled “How to Create Another Housing Crisis,” MFS Investment Management’s former chairman Robert Pozen writes, “With ‘no skin in the game,’ the originators had little incentive to determine whether the borrower was likely to default.” As a result, one provision of Dodd-Frank requires securitizers of any asset, not just mortgages, to retain 5 percent of the risk of loss. Barney Frank has said that the risk retention rules are the “most important aspect” of the legislation that bears his name.

The first twist is how risk retention became risk liberation. The housing-industrial complex went to work. Into Dodd-Frank went a provision that certain “safe” mortgages, called qualified residential mortgages, or QRMs, would be exempt from the risk retention requirement. “Safe” was left to the regulators to define. Cue more lobbying. The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement. In other words, the very asset that most people believed led to the credit crisis is also the asset that is pretty much exempt from the new rules! Classic. In the joint announcement on August 28, the regulators wrote, “The Commission acknowledges that QM does not fully address the loan underwriting features that are most likely to result in a lower risk of default. However, the agencies have considered the entire regulatory environment, including regulatory consistency and the possible effects on the housing finance market.” (That last bit is super scary.)

That said, the real twist here is that risk retention is no silver bullet. After all, firms like Countrywide, Washington Mutual, Merrill Lynch, AIG and Citigroup went under or almost went under precisely because they retained so much risk on their own balance sheets. Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.

Which leads to the next issue. So much of the safety of the financial system still depends on the Street’s ability to manage risk. But if the last years have taught us anything, it’s that risk management might be an oxymoron: Maybe risk is risk precisely because it can’t be managed. Just for the fun of it, I searched Merrill Lynch’s 2007 10K. They used the phrase “risk management” 76 times. “Subprime” was mentioned 11 times.

Next, I searched JPMorgan Chase’s 2012 10K and found 166 mentions of risk management. (Give or take — I got a bit dazed.) But while JPMorgan was busy talking about how great they were at risk management during the crisis, and while we were busy listening, the bank’s chief investment office was busy making crazy bets that ultimately cost the company more than $6 billion — bets that the CIO was valuing at different prices than the same positions were being valued in the investment bank, thereby violating a cardinal rule of Risk Management 101. And no one inside the bank seems to have noticed!

So now, JPMorgan is spending $920 million to settle civil charges brought by a host of regulators. A criminal probe is ongoing. As part of its settlement with the SEC, JPMorgan agreed that its trading losses “occurred against a backdrop of woefully deficient accounting controls” in its chief investment office; the OCC said in its consent order that the bank’s oversight “did not provide an adequate foundation to identify, understand, measure, monitor and control risk.” And according to the Wall Street Journal, JPMorgan is spending an additional $1.5 billion and committing 500 extra employees to get better at what it was supposedly already great at. “Fixing our controls issues is job No. 1,” CEO Jamie Dimon told the Journal. “This is a huge investment of people, time and money … but it will make us stronger in the long run.” Oh, I sure do hope so. But big banks are very subversive places.

Speaking of subversive, I think that both risk management and new regulations are set up to be subverted if the incentives aren’t right, too. (Put rules, regulations and incentives in a 2 on 1 Ultimate Fighting Championship, and incentives will score a knockout every time.) Yes, there have been lots of changes to incentives after the crisis. There’s more disclosure, and firms often have “clawback” provisions, meaning that bankers who do bad things have to give the money back. (Three JPMorgan traders were hit by this.) And bankers are getting a smaller percentage of their pay in upfront cash. A chunk, which is often in the firm’s stock, is held back, or deferred.

This is all well-intentioned and I’m trying to be optimistic. But the history of attempts to align individual compensation with a firm’s results is a case study in unintended consequences. (See stock options.) And there are warning signs about the current “fixes.” Take deferred compensation, which often means that bankers get a small part of their bonus in upfront cash, and the rest in stock, which can only be cashed out over a period of years. One problem is that for bankers to cash out their deferred stock, they often have to remain employed at the same place. One of the good things about the old system was that people moved on. Now, people are encouraged to stick around even if they’ve already checked out, thereby clogging up the system. “The inefficiency generated by the current illiquidity of people moving now can not be underestimated,” a former senior banker tells me.

While we’re on the subject of inefficiency, let’s talk about our regulatory system. In 2007, before most people realized there was a crisis brewing, Hank Paulson, then the Secretary of the Treasury, released the Blueprint for a Modernized Financial Regulatory Structure. You can dismiss this as writing reports while housing burned. Fair enough. But one of Paulson’s key ideas was to streamline the regulators, and he was right. As he later wrote about regulators in a Financial Times piece, “It is clear that their overlapping jurisdictions, gaps in jurisdictions and authorities, uneven capabilities and competition among themselves created the environment in which excesses throughout the markets could thrive.” We did get rid of the worst regulator, which was the Office of Thrift Supervision. But if you think the problem has been solved, just read the Wall Street Journal’s excellent piece on the skirmishing over the Volcker Rule (which seeks to ban proprietary trading by banks). According to the Journal, Treasury department officials had to bribe staffers from other agencies like the SEC with Bojangles fried chicken to get them to make the trek across D.C. History repeats itself, first as tragedy, second as farce.

PHOTO: People stand next to windows, above an animated sign, at the Lehman Brothers headquarters in New York September 16, 2008. REUTERS/Chip East (UNITED STATES)


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Regulation is so easily bypassed. “Would you like to use our house in Aspen?”, “I hear you will be looking for a directorship in about two years time?”. Banking is the only industry underwritten by the government and the only industry allowed to print money (fractional lending). It is time Joe Public wake up but all the smart money is on that they won’t.

Posted by BidnisMan | Report as abusive

“The top five unlearned lessons of the financial crisis”
The above misses the point of learning a lesson in that there is a motivated person who wants to learn instead of childishly paying lip service. Take Jimmy Dimon as a prime example. He said he was taking responsibility for the whale incident. Instead, when push came to shove by the shareholders, he played the role of the recalcitrant little boy and not the reflective mature adult male.

Posted by keebo | Report as abusive

tic-tock, tic-tock, tic-tock…by 2015 we will crash again.

Posted by tmc | Report as abusive

Excellent piece, Bethany. But I could rearrange much of what you write, and produce an argument that the foremost of unlearned lessons is that the biggest banks are too complex to manage. Regulation of unmanageable institutions is obviously a lost cause.

Posted by OkieRedux | Report as abusive

“I searched Merrill Lynch’s 2007 10K” – I think you meant that 2008 10-K. The 2007 one contains only two references to “subprime.”

Posted by leachim | Report as abusive

This is an excellent article, as so many in Reuters are. Ms. McLean’s skepticism about Dodd-Frank is well grounded. Glass-Steagall was about 40 pages. Dodd-Frank, when all of the rules are finally written, will be thousands of pages long with thousands of rules. It is hard to believe that such a volume of rules can be effectively administered by under-budgeted regulators with revolving doors. One wonders if that wasn’t the Congressional intention all along (pardon my paranoia).

Posted by alwayspuzzled | Report as abusive

Presumably, the “financial” crisis was an artifact of the “financial” system and how it is organized. This may well include accounting systems that are part of the financial system.

Posted by Bob9999 | Report as abusive

An absolutely wonderful article with an honest perspective.

“Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct.”

“The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement.”

“Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.”

The last I have heard as “Never attribute to malice that which could result from mere incompetence”.

Encore! Encore!

Posted by OneOfTheSheep | Report as abusive

Well-written and sobering piece. I must say I enjoy this writer’s style. But I believe the nod to Marx’s “Eighteenth Brumaire” is a bit hopeful. We seem to have already seen the farce this last time.

I believe from now on it’s just old fashioned tragedy to a laugh track recorded by sociopaths.

Posted by gacha | Report as abusive

I’m grateful beyond words for this outstanding article.

Thank you Bethany, and thank you Reuters!

Posted by Laster | Report as abusive

There’s very little of substance in this article. McLean’s use of the noun ‘malevolence’ is incorrect, and her use of the adjective ‘subversive’ is also incorrect. Bottom-line: McLean is posing.

Posted by highlandlad | Report as abusive

Very well written and a wonderful piece, BUT, these lessons were NOT unlearned. In fact they were studied, applauded, and refined. Corporate America learned plenty from this whole supposed collapse. First, it was not a collapse to them, they emerged stronger, wealthier, and more secure. Learning from it, they will be able to execute it again with even better results. Many more corporations will participate the next time now that the playbook is more apparent and validated.
Welcome to the new USCA.

Posted by tmc | Report as abusive

And what is the top question of the crisis that’s unfolding before our eyes, whose principal signs are a disconnect between stock prices and the real US economy, a Fed who’s incapable of climbing down from the tall tree that they climbed, and a national debt that no one knows how to pay back (higher taxes? hyper inflation? nah…)
Time will tell.

Posted by reality-again | Report as abusive

In all of this (including political attacks on entitlement programs), the real question is: has the US economy reached a point at which we (financial institutions with the blessing of regulators) have to be creative in order to induce purchases and, subsequently, create jobs that expand demand? With peer economic competitors on the rise and the US long-past (i.e., 1945-1977) being the manufacturer/supplier for the world, have we reached a time at which the post-WWII Middle Class (i.e., good wages, benefits) and Great Society entitlements are no longer sustainable? I believe the answer to both is a resounding yes. We are in trouble, as our politicians (of both main parties) are unwilling to accept that the US is in domestic and foreign over-reach.

Posted by bald1 | Report as abusive

To add to the list of five things is a people problem. Have extracted quoted some parts from the article to demonstrate.

“…no one had any incentive to care…
The other problem is sheer stupidity.
…violating the cardinal rule…
…people are encouraged to stick around even if they’ve already checked out,…”

Sounds like it is a lack of incentive for goods ethics, or to do what is right, as well as perhaps the people need some education on exactly what is right and wrong.

Posted by BC5000 | Report as abusive

Dud-Frank is an exercise in futility since the enforcement of future potential regulations is unfunded. The too-big-to-fail, too-big-to-prosecute financial institutions are now bigger and more powerful and back to the profligate gambling that threated the Wall Street Casinos six years ago…

The only question left is: Will the federal government again use taxpayer funds to cover the coming losses at full value? Crony capatilism and the corruption of Congress is too entrenched to stop it.

Posted by ptiffany | Report as abusive


There is no such thing as a “job” with good wages and benefits. There are only employer “needs”.

Today employers are redefining complex “positions” into a series of relatively simple tasks anyone warm and breathing with basic Junior High reading/writing and math skills can master in one or two weeks of “monkey see – monkey do” “on the job training. These can easily be filled by part-timers (no overtime, no benefits, sick days, vacations, or pensions).

One fails, replace with another…like light bulbs. No sweat, no future. In this “new reality” the sweat of an American is worth NO more than the sweat of someone in a third world country (except when they must physically be here to flip burgers or stock shelves).

The “Great Society” entitlements (and since) are most certainly no longer sustainable. Why? Look at the “finished product” of our loins and schools exiting High School. A full third of our young people are too fat, too stupid, felons, or otherwise unacceptable for military service; which has traditionally been the “employer of last resort” for those without genuine experience, competence or skill.

If someone must get off their butt and stand up to reach the “golden ring” it’s just too much trouble. Why work when our government can just print more money and pass out more and more of it? We need a “national attitude and expectations adjustment” if such exists.

Posted by OneOfTheSheep | Report as abusive

When bankers’ pay is partly in deferred stock, why not just let the deferment schedule stand even if the banker’s employment is ended?

Posted by bcrawf | Report as abusive

The dumbing down of the workforce is one of the pillars of success of Walmart* as designed by Sam Walton. He stated that any job in Walmart* could be performed by any Associate with a week’s training. Of course, this is not the case, but it sounds great to the unwashed, uneducated and is a great way to justify paying minimum wage or less. Loyal Associates are expected to “volunteer” some of their time beyond their standard 45 hours per week. Paid overtime? Huh?

Our society has been encouraging this behavior for many years. Every time you buy cheap Chinese products in Walmart* you’re rubber-stamping these abusive treatments of their workforce. (Then, there’s the Chinese and Bangladesh kids that make products for Walmart*, Apple and many other retailers. Got it, Kathy Lee?)

Isn’t that called hypocrisy?

Posted by ptiffany | Report as abusive


No, hypocrisy (and gullibility) is suggesting (or believing) that a “perfect world” is possible today in the “here and now” in which everyone is more or less “equal” in potential and achievement and no one is or need be hungry or unable to do whatever it is they want to do. That’s Disneyland (a for-profit fantasy enterprise not all can afford), not reality.

If hammers are the only tool commercially available, the greatest success will go to those builders who figure out how to build products with only hammers. Sam Walton’s Walmart “job/task simplification” is brilliant. Some of their workers are successful “hires” that are autistic. You would deny these citizens honest opportunity to be self-sufficient?

I have confidence that any NON-MANAGEMENT “job” at Walmart can eventually be organized and simplified to “monkey-see monkey-do” simplicity in the very near future if that day isn’t today. With all the people interviewing for such employment today and all the part-time Associates crying for more hours, why would ANY have to put in “free time” (which would be illegal…documentation of propaganda, please?) or work “overtime”?

The people I interact with at Walmart are pretty much what I expect. They are generally pleasant, occasionally helpful and seldom knowledgeable. Contrary to your inference, hiring someone at or near the minimum wage to do honest work is NOT “abusive treatment”.

The “minimum wage” essentially defines the commercial value of MINIMUM SKILLS. It isn’t the JOB of an employer to educate…to teach how to read, write, add or subtract. That is for society to do, a job being progressively less and less well done.

As to the “Chinese and Bangladesh kids that make products for Walmart, Apple and many other retailers, WHAT PLANET DO YOU LIVE ON? There are starving kids picking through the dumps in dirt poor nations like India, much of South and Central America, Africa, etc. They are begging on the streets, prostituting themselves and/or their siblings, happy just to survive in a world that neither needs nor wants them.

You’re concerned that it is somehow “beneath” a starving person to try to feed themselves by assembling or sewing products some American stores sell? If the few pennies of what I spend winds up in their pockets and keeps them alive, GOOD FOR THEM. And a lump of coal in YOUR stocking for Xmas.

Would you PERSONALLY sign up to support them or have them starve? They exercise the best of their perceived options to survive. If their societies would take measures to stop or even slow the ceaseless production of USELESS human beings there might be some hope in a distant future of a life without hunger or want. Don’t hold your breath.

Choices must be made from AVAILABLE options, not pie-in-the-sky dreams of how things “should” be. If your feet ever touch the ground, we might have an honest debate. But so long as you float along above it all in your hot air balloon I’m not going to make myself hoarse trying to explain how ridiculous you and your thoughts sound.

Posted by OneOfTheSheep | Report as abusive

Again I say this article, though well written and laudable, is also naïve and plays into the USCA hands. Much was learned including all of the topics she suggests, but from a different angle. The USCA emerged stronger and wealthier, and with less competition form the crash. It will happen again and they will make even more next time!

Posted by tmc | Report as abusive

I am surprised that Bethany wrote an article about the unlearned lessons of the financial crisis in which she seems to be saying that the number one lesson learned that is false is that additional capital is important for banks.

And to buttress her claim, she quotes the head lobbyist for the bankers; the same bankers who have been fighting the calls for banks to raise additional capital.

Her premise would have more creditability is she took on the book, The Bankers’ New Clothes.

The whole premise of that book is that additional capital not regulation is the key. However, this well written book might be a tougher opponent than a straw man bank lobbyist and a blog.

Posted by bigdog33 | Report as abusive

It had, at one point, been termed a balance sheet recession. The idea that you could add liquidity to right an imbalance that had more inherent structural flaws than liquidity could possibly heal, had to be the lesson here.

Posted by Laster | Report as abusive