Lessons from the credit bubble

Shares in banks may be have been ever so slightly ahead of the norm in this most recent run. The unrealistic expectations both from the banks as well as the buyers fed this distorted growth. The expectations fed the drive to use an increased amount of leverage which as we well know, is great on the way up but costly on the way down. We are on the way to better regulation but that too will take some time and will require constant attention and flexibility to change. The Bank of England and other world financial organizations are dissecting the recent rise and fall and reflecting on what needs to change.

"We should aspire to a financial system where there is greater market and regulatory scrutiny of future such money machines. In achieving this, there is a role for some body – a systemic overseer – which is able to detect incipient bubbles and fads and, as importantly, act to correct them. This role is about removing the punchbowl from future financial sector parties."

He said that in future there would have to be a greater distinction between management skill, which improves return on assets, and luck, when return on equity can be magnified by leverage.

"Good luck and good management need to be better distinguished. Put differently, returns to investors and managers need to be more accurately risk-adjusted if the right balance between risk and return is to be struck for individual firms and for the financial system as a whole."

A second lesson, he added, was that there would have to be much stricter system-wide limits on leverage, particularly among big banks whose stability is crucial to the whole financial system.

Even now I wonder how sustainable the high payouts are for the financial industry. In their rush to hold "talent" they are all trying to out bid each other, apparently in the hope for another quick run. As this market levels out and the big run fails to emerge, big payouts should cut into profit margins. If this happens, will there be more bleeding of workers in this industry? I wouldn't write this industry off but I also question its ability to sustain even the current numbers.