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Perspectives Journal
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May 2009: Essay

Financial Crisis and the Culture of Risk

by John P. Tiemstra

In the Josiah Stamp Memorial Lecture which he delivered on January 13, 2009, at the London School of Economics, Ben Bernanke, Chairman of the Federal Reser ve System, listed the causes of the credit boom that led to the current financial breakdown: "widespread declines in under writing standards, breakdowns in lending oversight by investors and rating agencies, increased reliance on complex and opaque credit instruments that proved fragile under stress, and unusually low compensation for risk-taking."

This is not moral language but the language of the scientific economist looking for explanations rather than making judgments. What Bernanke described was the behavior of many important actors in the financial system. Yet that behavior had a moral dimension, and it can only be described as irresponsible at best. Sir Josiah recognized as much in his 1938 book Christianity and Economics, when he talked about "the reign of law, decency, honour, industry and thrift in which alone a complex industrial system can work" (p. 189). Justified as passing judgment is, however, to understand the roots of our financial crisis we must examine how risk changed from being a morally fraught but unavoidable problem of human existence to being a commodity traded on markets like wheat or copper. The neglect of the moral reality of risk is a recent phenomenon that lies at the bottom of our problems.

The Christian church and the western cultural heritage traditionally considered risk to be a problem that was a consequence of sin in the world. In a sinful world, things can and often do go wrong, but the Christian trusts that God will make sure that ever ything works out for good. The Christian would not take unnecessary risks because that would be to tempt God. The Christian would not try to lay risk off onto other people because that would be to shirk moral responsibility for one's own decisions and cause problems for others for whom we are supposed to show love. The biblical prohibition of usury can be understood in this light: borrowing at fixed interest lays the borrower's risk of failure off on the lender. Better to form partnerships where all parties share in decision-making and risk. Christians long viewed insurance with suspicion, especially life insurance, and instead formed "burial societies" in which church members for a small subscription would share the burden of funeral costs. Widows would be supported by church benevolence funds. Christians especially opposed gambling in all its forms as the unnecessary taking of risks with no possible benefits for family or community, and in most Christian countries gambling was forbidden or strictly regulated. Though the usury prohibition was not observed after the Reformation, many of these attitudes and practices sur vived well into the twentieth century and were reinforced for many by the experience of the Depression.

Practices in the world of banking and finance also reflected this cautious attitude towards risk. Most lending was done through the banking system (rather than through investment banks or the bond market), and bankers practiced "relationship banking."   The neglect of the moral reality of risk is a recent phenomenon that lies at the bottom of our current economic problems.   They took a lot of trouble to know who their borrowers were and did a lot of business with regular customers over a long period of time so that they understood a business, and the character and practices of its managers, very well. Regulatory limits on branching in the United States meant that banking was always a local affair. Bankers stayed away from making loans in industries they did not understand, even if these were the fashionable, new, high-tech, "hot" areas of the economy.

In the 1950s and 1960s all of this began to change. The development of Las Vegas as a successful resort city based on a combination of casino gambling and glamorous entertainment led cities and states all across the country to rethink their opposition to recreational gambling. Virtually all the states began to allow limited casino development, and Native American tribes looked to casinos as an important source of revenue. State governments found a new source of revenue in state-sponsored lotteries, supported by heavy advertising. Compulsive gambling was treated as a problem limited to a few people, in the same category as alcoholism, and not a reason to prohibit gambling. Gambling became just another form of entertainment, with no particular moral baggage.

At the same time economists were developing the modern theory of finance. One major result of this research was the finding that the riskiness of a portfolio of loans or securities could be reduced (to a point) by diversification; this finding gave a real boost to the mutual fund industry. The stock market did very well in this period as more ordinary people put part of their savings into stocks, confident that the mutual fund portfolios they held had diversified away any systematic risk. As economists began to understand risk better, they developed mathematical models that allowed the calculation of an "efficient" or "rational" price for risky assets of all descriptions, as long as the probability distribution of possible outcomes was known. Since risk could be priced rationally, it could be packaged, marketed, and sold in an infinite variety of forms, especially after the coming of cheap computers made complex calculations easy. People were seduced into assuming things about risky assets that they didn't really know. Even if they knew nothing about the borrower or the market, they bought financial instruments in the confidence that the assets had been priced appropriately by a competent computer program.

With the coming of the Reagan administration, there also developed a popular ideology that idealized the risk-taking entrepreneur. This way of thinking suggested that the main source of economic growth and new jobs was risk-taking by small entrepreneurs which created new businesses based on new technology--or at least on new insight into the wants of consumers.   Lending money is not a game we play for thrills, nor is it simply an easy way to make money without working; it is a serious expression of our responsibility before God.   Big corporations could also create new jobs to the extent that they cultivated this entrepreneurial spirit, or at least imitated the more successful new businesses. Therefore to encourage growth, the returns to risk-taking had to be increased, preferably by reducing the taxation of income from capital to zero. Reagan sharply reduced income tax rates for high-income people and reduced capital gains taxes. This period also saw the introduction of the "Roth Individual Retirement Account" and the Section 529 education savings account, both of which exempted dividends, interest, and capital gains from any taxation. President George W. Bush took this further, exempting most stock dividends from taxation and sharply reducing the estate (inheritance) tax. Of course, this ideology stands the Christian tradition on its head. Where the usury principle favored income from work and was suspicious of income from capital, the new ideology favored capital income and tried to shift the bulk of the tax burden onto wages and salaries.

The policy environment produced by the new ideology increased the degree of inequality in income distribution. As high net-worth families saw their standard of living increase, middle- and lower-income families saw their living standards fail to keep up with what they were assured was a growing economy. To make up for this shortfall, many families reduced their saving and made greater use of debt that was made available to them with very few questions asked. This pile-up of household debt reduced the stability of the system in the face of a shock to asset prices, especially the prices of households' biggest assets, their homes.

The new theory of efficient capital markets and the new ideology of job creation led American and other developed- country policymakers to advocate an integrated global capital market. This was part of what came to be called the "Washington Consensus" on globalization. By allocating capital to the most promising opportunities for job creation and growth around the world, and by further diversifying risk, the Consensus held, such a market would lead to global growth, the reduction of poverty in the global South, and generous profits for the providers of capital in the global North. It was only required that all countries should adopt institutions and business practices modeled after those in the successful developed countries, most notably the United States, so that the new global market would have a "level playing field."

The new technology for marketing risk led to a separation between the underwriting and pricing of risk and the actual assumption of risk by the lender. This was the major problem with "subprime" and "Alt-A" mortgages but it became a problem with other kinds of loans as well. Lenders relied on loan originators, servicers, and packagers to assess the risk, service the loans, put together a diversified package of risky assets, and price it appropriately. For this, the servicer received a fee. The risk was borne by the lender, who had done no investigation or "due diligence" and did not really understand the risk.   If the church can stand resolute for honest and prudent behavior, consistent with God's will for society, maybe we can avoid such problems for a long time to come.   This kind of behavior by lenders is imprudent at best, but the gambling culture that has grown in American society leads lenders to view it as a game, not a serious enterprise. The new ta x structure encouraged it. The investment banks and mortgage companies that under wrote and priced these financial instruments, and the agencies that rated them, presumably had some interest in protecting their reputations, but since they bore little risk themselves, there was an over whelming temptation to make as many loans as possible and sell them on as quickly as possible with little attention to controlling risk. This was also imprudent and irresponsible, but nevertheless was a very profitable business until the most recent financial collapse.

The collapse brought to the surface the systemic risk inherent in these practices. Once an unexpectedly large number of loans began to default, it became obvious that many of these loans were riskier than they appeared, and were inappropriately priced because optimistic assumptions had been made about the distribution of outcomes. Calculations of efficient prices tend to be based on the assumption that financial crises almost never happen, even though we have now had four such crises in the last twenty-five years. With a crisis, uncertainty enters the picture. Uncertainty is different from risk. Uncertainty is the situation in which the parties to the contract do not know the probability distribution of the outcomes. Under uncertainty, an efficient price for the loan cannot be determined. Investors hate uncertainty and f lee it at any opportunity. Once investors believe that they cannot know the risk involved in any loan or determine its appropriate price, they refuse to make loans or buy risky financial assets at all. This leads to a collapse in the prices of risky financial instruments and lending activity freezes up. The consequence for the real economy is that purchases by businesses and consumers cannot be financed, and so economic activity collapses.

Fundamentally this is a moral issue. I don't mean this only to say that clearly dishonest and fraudulent activity took place, although it surely did. Bernard Madoff and people like him took advantage of the atmosphere of optimism and trust to cheat people out of billions of dollars. Mortgage originators conspired with clients to falsify loan applications and connived with appraisers to inf late house values. Ratings agencies paid too much attention to the wishes of their clients and too little to their public duties. Investment banks and other businesses hid liabilities in offbalance- sheet entities to conceal from the investing public the degree of leverage they had taken on. Hedge funds refused to reveal anything about their investment strategies on the grounds that they were private entities open only to the super-rich, but then marketed themselves to the public through "funds of funds." There must and will be legal consequences for those involved in these activities, as well as new regulations designed to reduce the amount of risk in the system.

But besides such straightforwardly illegal activity, there was a lack of the kind of prudent attention that is called for by the biblical idea of stewardship. The managers of financial institutions, investment advisors, and ordinary individuals failed to take the most basic steps. Questions about borrowers and risk were not asked. Ratings were taken at face value, so independent risk assessment was not done. Investment banks, insurance companies, and hedge funds ran up too much leverage, and households borrowed too much money. A premium was placed on innovation, so new, risky derivative instruments were invented that had no real business purpose. Brokers were so concerned about selling products that they forgot about their fiduciary duties to their clients.

As we have seen, taking risks with our money, which is really God's money, is not generally a good thing to do, whether it involves borrowing for a risky venture, investing in risky financial assets, or buying too little (or too much) insurance. It calls into question our willingness to be responsible for our own behavior, our concern about the welfare of others, and our faith in God's providence. It is acceptable to take risks if it is likely that the community as a whole will benefit, so taking good business risks is acceptable. Since the Reformation, Christians have accepted that lending money at interest is a business practice that can be useful and beneficial to all people. But there must be prudence. There must be due diligence. Lending money is not a game we play for thrills, nor is it simply an easy way to make money without working; it is a serious expression of our responsibility before God. Our problem is that we have not taken it seriously enough.

The church needs to reassert moral leadership on the topic of risk. We need to stop caving in to the prevailing cultural pressures and assert what the Bible, our moral tradition, and our experience teach us to be true. First, we must begin to preach against gambling again, not only describing it as sin but explaining to people why it is inconsistent with God's will. We also need to bring back the moral tradition that excessive debt is not a healthy thing for households or for businesses. Yes, there are good reasons to take on a prudent amount of debt to buy a house or expand a business, but debt is not a game and it is not right to take on debt just to look for a ta x break or to fend off a corporate takeover. Nor should we be financing ever yday expenditures by borrowing.

The church needs to emphasize that in lending or investing, there need to be prudence, due diligence, and a full regard for the effect our actions will have on the larger community. It is not just bad business to take on risks that we don't understand; it is immoral. It puts our whole economy at risk for our lack of prudence. In our age of instant information about ever ything on the Internet, there is also no excuse for not investigating where our money is going. If the people soliciting your money can't answer all your questions, don't invest with them.

The church also has a witness in the area of public policy. We need to point out the dangers inherent in financial globalization. Crises spread easily from one country to another in a world of closely linked markets. Investing at a distance makes it harder to do due diligence and makes investors more inclined to judge projects by quick summary measures, like profits, and not look into the effects on communities. We Americans also end up imposing our business practices on people whose cultures, religions, and values we don't always understand very well. This creates resentment of our power.

There are also dangers in public policies that increase income inequality and disadvantage work. Let income from work and income from capital be ta xed at the same rates. This is just. Let the benefits of economic growth bless both workers and investors because both contribute to that growth and both bear the risks of change in a dynamic economy.

Many people thought that after the lessons learned in, the financial crisis of the 1930s, no such disaster could ever happen again. Now the disaster has happened again. There is no guarantee that once the current crisis is over, we will be done with financial catastrophe forever. But if the church can stand resolute for honest and prudent behavior, consistent with God's will for society, maybe we can avoid such problems for a long time to come.

John Tiemstra is professor of economics at Calvin College in Grand Rapids, Michigan. This essay is adapted from an article to be published in Reformed World, a quarterly journal of the World Alliance of Reformed Churches, and is printed here by permission.