Stewart Hamilton, professor of accounting and finance at business school IMD, argues that corporate governance failures, and particularly a lack of expertise among nonexecutive directors, were largely to blame for the financial crisis. Here he proposes a number of solutions, including that shareholders should take more of an interest in the qualifications of company directors, and that the “Big Four” accountancy firms should be broken up. He has been professor of accounting and finance at IMD since 1981, and dean of finance and administration since 2008. His areas of interest are corporate failure, governance, risk management, and investor protection. Formerly a senior partner of a UK national accounting firm, Hamilton has served on professional committees and working parties on company law reform, conduct of serious fraud trials, and financial services legislation. He is the author of numerous cases on corporate failure, including The Barings Collapse and The Enron Collapse. Hamilton is a graduate of the University of Edinburgh, and a member of the Institutes of Chartered Accountants of Scotland, of Alberta, and of Ontario.
Did the regulators do enough to rein in irresponsible behavior in the banking sector in the 1990s and 2000s?
Two years before the collapse of Barings Bank in 1994–95, I met a board director of the Swiss National Bank (the central bank of Switzerland). He told me that his greatest worry—one which he said was at that time widely shared by central bankers across Europe—was that the directors of the institutions they were supposed to be monitoring had very little understanding of the risks they were taking. He said this was particularly true where the rapidly growing derivatives market was concerned. Not nearly enough was done to address that.
Given that the wholesale funding markets briefly froze up after 9/11, why do you think the boards of banks dependent on these markets were oblivious to the risk that this might happen again?
It comes down to flawed assumptions. It is worth taking a look at Long-Term Capital Management. That was a highly sophisticated, computer-based options pricing model on a massive scale. The problem was that the models it used were based on a number of unreasonable assumptions—including that there is perfect liquidity. Long-Term Capital Management collapsed because the liquidity in the market in which it operated totally dried up.
Isn’t it bizarre that people who are supposedly very bright are capable of making such flawed assumptions?
The Black–Scholes model for derivatives pricing, the Chicago School of Economics, and the perfect market hypothesis have heavily influenced financial thinking. My concern is that the use of these models, with their flawed assumptions, has replaced judgment. The models were primarily designed by people with a limited understanding of banking—they were mainly mathematicians and physicists—and they were being used by people who didn’t even understand the models. The lack of resources among bank regulators meant they took far too much on trust where these models are concerned. This is reflected in the Basel II liquidity proposals, where the concerns of individual central banks have been brushed aside.
Would one solution be to pay the regulators more, as already happens in Singapore?
The Singapore regulators are very smart, knowledgeable, and well-resourced. They are also streets ahead of the bankers in their ability to identify risk. They picked up on the lessons from the Barings collapse, in marked contrast to the Bank of England, which was much more complacent.