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The financial carnage of the last 18 months resulted because too many in the financial services industry forgot a simple truth: It wasn’t their money; it was people’s money. The way financial service firms conduct business should never be the same again. That’s the main lesson I’ve taken away from the financial crisis of 2008.
I believe every individual has the power to improve his or her financial condition, and that saving and investing are how the average person turns hard work into something that grows and lasts. But the current crisis has done real damage to people’s confidence in the very foundations of our economic system. Many people are wary of trusting the financial services industry again, and many are tremendously angry.
I’m angry, too. But as the founder of a firm that serves millions of individual investors, I’d like to see the industry make some significant changes to restore people’s confidence.
THE NEED FOR CHANGE TODAY
The numbers tell us that 2008 was the worst year for the stock market since 1931. We’ve witnessed an incredible shock to the system since the Dow Jones Industrial Average hit its peak of 14,164 on October 9, 2007, and then began to tumble, particularly during the closing months of 2008. Most individual investors watched as their stock portfolios – including their hard-earned retirement accounts – dropped in value by 40 percent or more.
I’ve been through many economic cycles and stock market reversals in my career, including nine significant corrections. They were painful, but they all eventually resolved themselves. I am confident the stock markets will correct themselves over time as they have in the past.
But something is different this time. The faith of ordinary investors has been shaken severely over the past 18 months. They’ve begun to believe – with a good deal of justification – that the system was biased in favor of the few and the powerful.
There are lessons to be learned from what happened, and the industry must take them very seriously. If we ignore them, we are asking our children and grandchildren to bear even greater burdens in the future. I would hate to see us bounce out of this market slump, only to land right back in the same old ruts that led us to this crisis.
As bad as things are, this crisis presents the opportunity for transformative change. It gives the industry the chance to learn and grow from its mistakes. The industry can take actions that restore the faith of the people it serves and do a better job of helping them manage their financial lives. WHAT WENT WRONG?
Before our very eyes we have seen the annihilation of the old model of the financial services company. Enormous banking empires have crumbled. Venerable names have been sold off or disappeared. How did it happen?
The complexity of what happened in the financial meltdown of 2008 is immense, involving esoteric products and concepts that few people understood – from “liquidity crunches,” to “counter-party issues,” to “derivatives,” and “collateralized debt obligations.” But I think the underlying cause of the crisis was actually very simple: The financial services industry lost sight of the fact that its primary purpose is not to drive profits and revenues higher at all costs, but to pursue reasonable growth and manage risk carefully in order to maintain public trust and confidence.
In an effort to squeeze every last penny of profit out of every single transaction, many financial services companies simply took on too much risk and leveraged themselves too far. In 2008, they discovered their foundation wasn’t granite; it was quicksand.
Yes, individuals played a part in this meltdown. Many consumers took on more debt than they could handle – whether it was applying for a subprime mortgage or racking up thousands of dollars in high-interest credit card debt. But they were often led to those choices by unscrupulous people and practices.
FUNDAMENTAL PRINCIPLES FOR THE FUTURE
Operating this business for some 35 years, I have learned quite a bit about what average American savers and investors are looking for in their financial services providers. Ordinary people’s expectations for saving and investing are fair and reasonable. They want a system that provides safety and liquidity. If they need their money, they want to be able to get it. They want to know that the system won’t suddenly seize up and shut down as it did in the Great Depression. Many want the opportunity to invest in the growth of the economy, and if they invest, they are willing to take risk to achieve that growth. But they want clear information that helps them understand the nature and extent of that risk. And they want to know the deck isn’t stacked against them.
If the financial services industry is going to restore the faith of ordinary investors, it has to remember ordinary people’s needs – and work hard to safeguard them – every day. The stability of the system depends on people’s faith that the system is fair. The industry didn’t hold itself to that standard, and regulators, legislators, and ratings agencies didn’t oversee the process effectively.
I believe there are three fundamental principles that would help assure that average Americans get what they want and need from their financial services providers and help our system become strong and healthy as a result.
These three principles all underscore the responsibility financial institutions have to the people and their hardearned money.
We need financial transparency, not financial secrecy.
Secrecy and a lack of visibility can be found throughout our financial system and are fundamental reasons for the current crisis. A financial system that is opaque is bound to be abused. There is nothing more cleansing in our economic system than transparency: It puts a natural brake on bad behavior and promotes positive behavior. The best solution for maintaining trust is to provide the means to verify the facts.
Financial services companies of any significant size should provide transparency into their holdings. There is no excuse for bombshell discoveries that unleash huge changes in a company’s financial condition. That information should be transparent and readily available. In this modern age of the computer and Internet, presentation of the information can be as simple as the click of a mouse.
This need for transparency applies to the capital markets as well. Today, exchanges report volume and trade prices on an instantaneous basis, but what about other information that could help the investor see underlying trends in market sentiment as they develop? For example, information related to short selling is not presented on an up-to-the-minute basis, and it should be. Again, technology could make that information available instantly and at little cost.
Transparency applies to financial products as well. All financial products should provide transparency in terms of their underlying holdings.
Transparency should also apply to the securitization of debt obligations. During this crisis, companies underwrote loans, packaged them, securitized them, and then sold them off entirely. Ultimately, buyers were many layers removed from the issuers, unaware of the strength and quality of underlying risk assessments. In the future, investors should be able to identify the original issuer of any security they buy or sell. In addition, the original issuer should have to maintain a material stake in the performance of the underlying security. That provides assurance they have performed effective risk management and due diligence. It’s simply wrong to create junk and then unload it – along with its associated risk – to unaware downstream buyers.
The use of leverage requires greater restraint.
Financial institutions must operate with a higher level of fiscal responsibility to the public they serve. Financial institutions carry the public’s trust and are expected to be good stewards of the money entrusted to them. They should be obligated to borrow, invest, and manage their capital structure in ways that recognize that responsibility. This means acting responsibly in terms of leverage and liquidity.
Over the course of the last decade, America experienced a complete overextension of leverage and debt in just about every place where debt could be incurred. Everyone from government agencies to rating agencies to financial services companies to individual consumers played a role in creating this situation. The liberalization of leverage for investment banks and hedge funds contributed tremendously to the situation we’re in today. Exotic real estate lending, such as subprime, was a culprit, and the explosion of derivatives of all sorts simply multiplied financial leverage further.
Credit – borrowed money – isn’t inherently bad. It’s really a necessary and positive part of a well-functioning, freemarket system. It’s a growth engine that allows people and corporations to borrow against their future earnings. But when it comes to financial institutions that serve the public, leverage must be used responsibly, in moderation, and with a realistic assessment of the risk involved.
Some basic financial principles must always be in place. Leverage ratios must be clearly established and ceilings put in place for banks and hedge funds (which have largely avoided this kind of governance and scrutiny until now). An entity that benefits from leverage must put significant amounts of its own capital at risk, based on conservative ratios.
Financial services firms should be held to strict liquidity metrics including overnight, 30-day, 60-day, and 90-day liquidity metrics. I believe firms should be required to publish their liquidity metrics, liquidity management policies, and contingent funding plans, making the information available to all.
As described before, all the risks that leverage and liquidity entail should be clearly communicated and made transparent to all parties, giving investors significant visibility into positions and risks held by regulated financial services firms, along with how those risks may impact them.
All financial institutions should abide by business practices that balance the needs of the customer with the needs of management and shareholders.
Much of the “bad debt” that built up in the system in the form of subprime mortgages and other credit problems stemmed from practices that encouraged risky behavior. There were powerful, perverse incentives at work. Mortgage lenders – who were encouraged to bring in riskier loans – dreamed up deals that encouraged borrowing with few of the standards of the past, such as no-documentation home loans. People should be confident when they borrow that they will not fall victim to rates that have no relationship with the true borrowing cost they will ultimately need to carry.
When it comes to investment help and advice, it’s time to root out unethical behavior once and for all. The industry has a long history of providing conflicted advice and selling inappropriate or risky investments.
Going forward, the industry should consider adopting higher standards, so investors can have confidence that when they do business with a regulated financial services firm, the person they are interacting with has the client’s best interests in mind.
Next to Social Security, defined contribution plans have become the most important element of most citizens’ retirement security. For tens of millions of people, an employer-sponsored plan, such as a 401(k), is their first experience with investing. Workers should have confidence that their plans are managed in their best interests. Today, the system faces challenges in this regard, including potential conf licts of interest related to fees paid to plan providers, plus the selection and costs of investments available in their plan. Full disclosure and transparency around fees paid by employees is an easy solution the industry should apply, along with other structural changes to minimize potential conflicts of interest.
The business model behind ratings agencies must be overhauled entirely. Buyers of corporate and other debt securities are dependent on ratings agencies to determine risk. Yet we’ve had countless examples of “highly rated” securities imploding, and as a result, there is a complete lack of trust in the ratings system. It’s a conflict of interest when the issuer of a security is the client of an agency that rates that same security. We must develop payment models that better align incentives among the providers of the ratings and users of the ratings – and that ultimately permit users to hold ratings agencies accountable for the quality of their work.
At Schwab, we have seen that these three principles can work.
Transparency, prudent financial management of credit and liquidity, and business practices that limit conflict of interest: All of these will work to improve consumer confidence.
ADOPTING NEW GUIDING PRINCIPLES CAN RESTORE AMERICANS' FAITH IN THE POWER OF THE MARKETS
My own faith in the power of the markets remains strong. When the economy turns around – it will take time, but it will turn around – we need to make sure that all Americans benefit from the “rising tide.” Those who are sitting on the sidelines out of frustration and lack of confidence risk missing out on the inevitable turnaround, which often occurs quickly and without warning.
When the financial services industry erodes the faith of the ordinary investor, it erodes the foundation of our nation. Our industry’s descent into excessive leverage and self-interest has shaken people’s faith in the essential fairness of the market – shaken it badly. Now begins the long, hard work of restoring that faith. We can and we must do that together.
If the financial crisis of 2008 has taught us anything, it’s that the way financial institutions operate in the future must change. This extraordinary time will benefit us only if we use it to guide us to a better future – if we allow it to remind us that the assets we manage are not just money, they are people’s money.
This industry should never conduct business the same way again. Chuck Schwab is founder and chairman of The Charles Schwab Corporation.
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It’s critical for the industry to refocus all its efforts on restoring the confidence of ordinary investors. Each firm’s success – and the success of the industry overall – must be tied to individual investors’ success, because when the individual benefits, we all do. The more confidence ordinary investors have in the market, the more willing they are to invest. The more they invest, the better their chances of participating in the American dream, and the stronger our economy grows as their investments are put to work building new business and jobs. And the more people who share in the American dream, the more fertile the conditions for a stable, enduring democracy.
