The Failure of Good Governance: How it led to the Financial Crisis

The concept of good governance has typically been used in development economics as a way to describe the system of aid-recipient countries – developing economies. The recent economic crisis has brought this concept into light in developed economies where governance, both public and private, has been assumed to be sound. Euphemistically put, the unfolding of recent events has proven that this is not always true.

Governments create the conditions for the functioning of markets, operation of private firms, strength of civil society, and welfare of communities and individuals. (Or at least that’s what they’re supposed to do.) Systems of governance affect the performance of the state in executing its core functions and through this, the performance of countries in meeting their major economic and social goals. In the private sector, the same concept applies – firms’ leadership enables the functioning of various departments and is responsible for the welfare of the firm’s employees. A firm’s leadership also largely determines the firm’s performance and its ability to meet its goals.

In recent months, developed economies around the world experienced an unprecedented shock – credit markets froze up, equity markets tumbled to record lows and major banks failed and whole countries were on the brink of default. While the crisis cannot be blamed on one single entity because it came about as a result of greed and complacency of consumers, investors and businesses alike, it is widely argued that the lack of good governance at the public and private levels led to this meltdown.

PUMA’s Six Pillars of Governance

Good governance, in the private and public sphere, is the ability to exercise power, and to make good decisions over time, across a spectrum of economic, social, environmental and other areas. There are many ways to define good governance, however, there seems to be a general consensus that key factors, as outlined by the OECD programme on Public Management and Governance (PUMA) include:

  1. Technical and managerial competence
  2. Organizational capacity
  3. Reliability
  4. Accountability
  5. Transparency and open information systems
  6. Participation

Technical and Managerial Competence Under Question in The Wake of Crisis

Technical and managerial competence of leadership is an obvious factor of good governance. In this financial crisis, it is hard not to question the competence of the regulatory bodies responsible for overseeing the financial institutions, and the competence of the financial institutions themselves. It became obvious that neither public sector leadership nor private sector leadership really understood the complex financial instruments that were structured, packaged and sold during the boom years.

Rewind to April 2004. Only after the crisis had begun unfolding did the New York Times publish an account of the brief meeting between Security and Exchange Commission (SEC) officials and the heads of the large investment banks. The investment banks wanted the SEC to exempt their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would free up billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities, credit derivatives, and other exotic instruments. This meeting was sparsely attended and went unreported in the media. It lasted a total of 55 minutes, states The NY Times.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the SEC also decided to rely on these investment banks’ own risk models, essentially allowing them to monitor and regulate themselves. The 2004 decision was a chance for the SEC to supervise the banks’ increasingly risky investments in mortgage-related securities, but the agency never followed through on this and it remained a low priority, until now.

Inadequate Organizational Capacity: Failure of the Fed?

Another factor of good governance is organizational capacity. Good governance has to be built on the quality of organizations so that development is based on this rather than simply relying only on the political or personal will of a strong leader, which may not be sustainable over the longer term.

Both government and private sectors firms proved to be inadequate in this regard, and a case in point is the failure of the Federal Reserve under Alan Greenspan. The Federal Reserve under Greenspan was operated by the will of one rather than by a system of checks and balances. Stephen Roach, Chief Economist at Morgan Stanley said in an interview with the Financial Times that the Federal Reserve, led by the “libertarian ideology” of Alan Greenspan was “very reckless in condoning the excesses of complex financial information and setting the price of risk far too low.” Roach’s views are echoed by many other economists who say that Greenspan encouraged the bubble in housing prices by keeping interest rates too low for too long and that he failed to rein in the explosive growth of risky and often fraudulent mortgage lending.

The Fed chairman had been one of the nation’s leading voices for deregulation, and there are past statements in which Mr. Greenspan had argued that government regulators were no better than markets at imposing discipline. The Fed slashed interest rates
from 2001 to mid-2004, which led to warnings of a potential bust, but Greenspan brushed these worries aside, according to the NY Times. Greenspan, along with most other banking regulators in Washington, also resisted calls for tighter regulation of subprime mortgages and other high-risk exotic mortgages that allowed people to borrow far more than they could afford.

The Freddie Mac and Fannie Mae Case: The Case for Reliability Highlighted

Reliability is another factor of good governance. Reliability requires governance that is free from distortionary incentives – through corruption, nepotism, patronage or capture by narrow private interest groups. The story of Freddie Mac and Fannie Mae is a classic case of policy capture that highlights the importance of reliability in governance and the effects when it is absent. The Wall Street Journal and CBS have reported that Freddie Mac and Fannie Mae spent millions of dollars lobbying some influential members of congress, in exchange for, among others, lax capital reserve requirements. As a result of their lobbying prowess, these obsolete institutions became virtually untouchable behemoths.

Congressman Ron Paul has said that “the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions.”

Accountability: too little, too late?

Accountability is a crucial way to ensure that the power that is given to those in public office is used appropriately and in accordance with public interest. Accountability requires clarity about who is accountable to whom, for what, and that civil servants, organizations and politicians are held accountable for their decisions and performance.

Accountability is a convoluted concept with respect to this financial crisis because of the global nature of the financial system. Consumers are at fault for over-borrowing, banks are at fault for over-lending, investment banks are to blame for over-securitizing, and regulatory institutions are at fault for allowing this excessive behaviour.

At some level, the leadership at the public and private institutions that has been involved in this crisis are being held accountable – top executives at these banks are being questioned and will be missing out on some of their bonuses; Greenspan is being called into question for his lax oversight of the markets. But perhaps this call for accountability is a case of too little, too late.

Financial Crises: Due to A Breakdown of Transparency

Transparency is another important aspect of good governance. Governments have access to a vast amount of important information. Dissemination of this information through transparency and open information systems can provide specific information that firms and individuals need to have to be able to make good decisions.

This financial crisis was a case study of the breakdown of transparency at many levels. Take for example, AIG and its ‘small’ derivatives unit, headed by Joe Cassano. This unit was conveniently classified and located in London so to ensure particularly lax oversight over the dubious accounting and disclosure practices evidently abetted by its chief. The insurance behemoth came to its downfall because its leadership had made some very risky bets, hid them from regulatory oversight, and moved the risky business abroad.

Capital markets depend on information openness and transparency but the nature of these complex derivative products made it difficult for most people to understand, much less regulate. The collapse of the giant investment banks and the financial system are due to the lack of transparency surrounding these products and the loss of confidence in the counterparties involved. As a result, investors panicked, causing the markets to tumble.

Lack of The Right Kind of Participation Triggered The Crisis

Another factor of good governance is participation. Participation involves consultation in the development of policies and decision-making, elections and other democratic processes. Participation gives governments access to important information about the needs and priorities of individuals, communities and private businesses. Governments that involve the public will be in a better position to make good decisions, and decisions will enjoy more support once taken.

Before the crisis happened, in boom times, participation was everywhere. However, it was not the right kind of participation – this was participation in a party of excess, complacency and greed, and the participants were not just greedy investors, but large banks and even regulators. As Professor at Columbia University, Joseph Stiglitz put it, “it was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America’s best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system.”

The lack of the right kind of participation – participation in developing sound policy and regulation, has contributed to the unraveling of financial systems worldwide. Due to poor governance, America’s financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole had not been doing what it should have been doing and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system were exported to the rest of the world, according to Joseph Stiglitz.

The global financial crisis, triggered by the mortgage and financial derivatives debacle in the US, was not just a failure of dogmatic ideology, or of know-how, or of technical regulations. As illustrated at the outset, powerful ‘vested’ interests, at the intersection between politics and business, and corruption, played a role in shaping the flawed oversight, the absence of transparency, the regulations, and their lax implementation.

The Effect on Pakistan

In Pakistan, people watched from afar as the capital markets crashed in the US and Europe. According to sources within the banking industry, the global financial crisis has not affected Pakistan yet because the country is not a large financial player in the global economy. However, the SBP’s First Quarterly Report issued last month states, “the domestic economy is now more open and prone to external shocks than ever before”.

Former president of the Overseas Chamber of Commerce and Industry, Zubyr Soomro believes that the primary impact for Pakistan would be tightened terms for access to international debt markets. Some analysts view this crisis in the West as a chance for Pakistan to establish a stronger economic foothold in the region. They believe that investment will pour into the country as returns in developed markets fall. According to the Head of retail banking of the National Bank of Pakistan, Amir Siddiqui, “We need to prepare ourselves on a war footing by getting floating barrages from the Middle East to overcome the energy shortages and to receive a fat chunk from the investment that would be diverted to surging economies of Asia.”

But Pakistan has a crisis of its own to take care of for now. While Mr Musharraf’s prime minister, Shaukat Aziz, frequently likened Pakistan to a “tiger economy”, the former government left an economy on the brink of ruin without any durable base.

No Bail

The Pakistan Rupee has lost more than 21 percent of its value so far this year and inflation now runs at 25 percent – by conservative estimates. The rise in world prices has driven up Pakistan’s food and oil bill by a third since 2007, according to Wilkinson in the Telegraph. President Zardari told the Wall Street Journal that Pakistan needed a bailout worth $100 billion from the international community.

President Zardari is expected to ask the international community for a rescue package at a meeting in Abu Dhabi next month. This gathering will determine whether the West is willing to bailout Pakistan. However, with developed nations vying for bailouts of their own, it is unclear if they even have the capacity to provide this rescue package.

Whatever the outcome, it is clear that good governance is key to steering Pakistan, and the rest of the world, out of a global recession. It will take cooperation at an international level and for many governments to not only make the decisions that are right for their domestic situations, but also work together with their counterparts abroad to find a solution to mend this problem and reduce its trickle down effect on real economies.

References

www.nytimes.com
Edmund L. Andrews. The NY Times.
www.nytimes.com/
(Joseph Stiglitz, The fruit of hypocrisy; Dishonesty in the finance sector dragged us here, and Washington looks ill-equipped to guide us out, The Guardian, September 16)
governanceblog.worldbank.org/
www.dawn.com/
Isambard Wilkinson. Pakistan Facing Bankruptcy. November 17, 2008
www.telegraph.co.uk/

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    Author Information

    Jia En Teo is an online entrepreneur and writer who currently resides in New York City. Aside from her online ventures, she has great interest in issues related to social entrepreneurship, corporate social responsibility and the environment. She graduated from the University of Michigan with a Bachelors in Political Science and Economics.

    2 Responses to “The Failure of Good Governance: How it led to the Financial Crisis”

    1. Sohail Ansari #

      well done, very impressive and informative article…

      April 21, 2010 at 10:36 am Reply
    2. Muhammad Kamran Jamil #

      With refernece to this article, kindly allow us to publish the same in Institute of Cost and Management Accountants of Pakistan’s official bi-monthly “Managment Accountant” journal (Sep-Oct 2009 issue).

      With regards,

      November 4, 2009 at 2:22 pm Reply

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