In 2009, Larry Summers, former Secretary of the Treasury, observed that "in the past 20-year period, we have seen the 1987 stock market crash. We have seen the Savings & Loan debacle and commercial real estate collapse of the late 80's and early 90's

Question

We have seen the Mexican financial crisis, the Asian financial crisis, the Long Term Capital Management liquidity crisis, the bursting of the NASDAQ bubble and the associated Enron threat to corporate governance. And now we've seen this [global economic crisis], which is more serious than any of that. Twenty years, 7 major crises. One major crisis every 3 years.". How could this happen given the large number of financial and information intermediaries working in financial markets throughout the world? Can crises be averted by more effective financial analysis?

Answer 1

Financial intermediaries perform a variety of functions that are designed to mitigate problems in our financial markets.
Auditors certify the credibility of financial reports; audit committees hire the external auditors and oversee both the internal and external auditors to ensure that they do a thorough job of assuring the company's financial information is reliable and not fraudulent. Corporate boards are tasked with monitoring and appointing the firm's CEO and with overseeing its strategy. Financial analysts evaluate a firm's financial performance and valuation and assess whether a stock is a worthwhile investment, and also ensure that there is common information on a stock in the market to reduce adverse selection problems. Investment banks help to provide good companies with access to capital and to help insure that investors can allocate capital to good businesses. And so the list goes on, including investment managers, hedge fund managers, and the business press.
It is an interesting question as to why these various institutions failed to detect the problems underlying the crisis identified by Larry Summers. One explanation is that they face their own conflicts of interest. Auditors have certainly received criticism for audit failures. Some suggest that this arises because auditors are (perhaps unconsciously) reluctant to take a hard line against important clients for fear of losing the account. Similar concerns have been raised about financial analysts, which either worry about the reactions of corporate managers, major clients, or investment bankers at their firm if they write negative reports about companies they follow. Corporate boards have been criticized for being beholden to the senior executives of the companies they oversee. Recent governance changes were intended to correct some of these conflicts of interest. For example, in the U.S. the Sarbanes Oxley Act was intended to give Audit Committees more clout and change the incentives of auditors. The Global Financial Settlement and Regulation Fair Disclosure were intended to reduce the conflicts of interest for financial analysts. Many of these changes were also implemented outside the U.S. However, it is difficult to eliminate the conflicting incentives of intermediaries, who by their nature are in the difficult position of trying to work for two bosses.
A second potential explanation is that human beings are subject to behavioral biases that lead them to make common mistakes. For example, most retail investors extrapolated performances at Enron, internet stocks, and mortgage backed securities to conclude that these would continue to be terrific investments. They poured money into these sectors and stocks and showed little interest in hearing from analysts, auditors, investment bankers, etc. who had a contrarian point of view. For example, at the height of the internet boom, Warren Buffet expressed concern about the sector but was dismissed as a dinosaur who didn't understand the new economy. Less informed or less confident intermediaries would find it difficult to challenge the popular view of such hot markets or to judge when such hot markets wouldcrash.
Given these problems, we will probably continue to have crises unless we can correct the fundamental conflicts of interest that pervade the industry and can figure out how to modify human behavior.