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The Financial crisis as an inTelligence FailureAvner BArneA, Ono Academic College

“. . .the largest financial corporations took

endless risks leading to unprecedented crisis.”

In my recent paper about intelligence failures I pointed towards noticeable similarities between intelligence failures in national intelligence and those in business administration (Barnea 2010). My assumption was that national intelligence failures were often learnt carefully to help avoid them in the future, but in the corporate world intelligence failures were often ignored and wrongly attributed to mistakes by senior management. Looking further into this mater indicated that some of the corporate failures were evident intelligence failures.

We are not often granted an opportunity to research an official report which shed light on a significant industry crisis where business intelligence mistakes played a major role. However, this was the case with the Financial Crisis Inquiry Commission Report that was published by the US Government in January 2011. This comprehensive report not only illustrated the events that led to one of the largest failures in US history (and subsequently in the global financial world), but also presented evident conclusions concerning those organizations responsible for this crisis. In April 2011, the Senate Investigation Subcommittee Levin-Coburn Report (2011) provided another viewpoint into the key causes of this mega financial disaster.

Looking into these reports makes it almost impossible to avoid creating an analogy to major national intelligence failure, such as the Yom Kippur war (egypt and Syria attack on Israel 1973), the Pearl Harbor attack, and the 9/11 attack by al-Qaeda on the US. We can also add to this list the intelligence failure before the war in Iraq (2003), with the misjudgment of Iraq’s programs weapon of mass destruction (WMD), as seen in the report of the Select Committee of the US Senate on Intelligence on the U.S. Intelligence Community’s Prewar Intelligence Assessments on Iraq (2004) and also in an article by robert Jervis (Jervis 2006) and others.

The financial crisis was a horrendous surprise to the federal administration, financial institutions, and Congress. eventually, it matched the definition

of ‘predictable surprise’ and thus could be avoided (Bazerman, Watkins 2003). Many significant signals were present long before the crisis had exploded.

The financial crisis reached to its lowest point in September 2008 with the sudden collapse of Lehman Brothers and the giant insurance group AIG. The surprise was partly a result of alerts not being delivered because of the belief that the largest global financial institutions were “too big to fail” (Sorkin 2009). The global economy went into a deep recession, considered by many scholars as the most severe in the history. The sudden event was the collapse of the housing bubble, which had been fueled by low interest rates, easy and available credit, scant regulation and toxic mortgages, and led to full- blown crisis in 2008.

When the bubble burst, hundreds of billions of dollars lost shook the markets as well as the financial institutions not just in the US but around the world.

According to the Financial Crisis Inquiry Commission Report, the “red flags” were in front of the regulators:

• From 1978 to 2007 the amount of debt held by the US financial sector increased from $3 trillion to $36 trillion.

• By 2005 the ten largest commercial banks held 55% of the industry assets, more than double the level in 1990 and more than double as a share of the gross domestic product.

• On the eve of the crisis, the financial sector profits constituted 27% of the corporate profits in the US, up from 15% in 1980.

• From 2001 to 2007, national mortgage debt almost doubled and the amount of mortgage debt per household rose more than 63%.

This information, combined with many other related issues, strongly signaled that the largest financial corporations took endless risks leading towards

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unprecedented crisis. This information was mostly transparent to executives and to policy-makers in federal organizations and the business sector, including the regulators, but as shown by the inquiry reports it was completely ignored.

WAS THE FINANCIAL CRISIS AVOIDABLE?The financial crisis was undoubtedly avoidable. The

public sector and the financial system ignored the warning signs and failed to understand and manage the risks and threats within the system. The biggest failure to notice was among the people involved in this system. Both reports pointed towards many red flags but little meaningful action was taken to quell the threats in a timely manner. The Federal reserve’s pivotal failure was that it was empowered to deal with the crisis in time but did not. As Dr. Coburn said: “blame for this mess lies everywhere from federal regulators who cast a blind eye, Wall Street bankers who let greed run wild, and members of Congress who failed to provide oversight” (Coburn p1).

The failure of regulationThe financial regulation and supervision systems did

not fulfill their obligations to protect the investors. This systematic failure mainly by the Federal reserve, but also included the SeC (Securities and exchange Commission) and the Federal reserve of new York. The regulation system had the power to impose restraint on the financial system to stop its risky behavior but did not. However they still could have affected the outcome if they had just evaluated the situation accurately.

The Inquiry Commission report related to the pivotal failure by the Federal reserve to stem from the flow of toxic mortgages and emphasized that “it was the only entity empowered to do so, and it did not” (p17). The report went on saying “We do not accept the view that the regulators lacked the power to protect the financial system….they chose not to use it” (p17). The commission added “We conclude widespread failure in financial regulation and supervision proved devastating to the stability of the nation’s financial markets’ (p18). The Levin-Coburn subcommittee has reached to the same conclusions. The regulation failed to transfer information into intelligence for effective decisions.

As reported in Levin-Coburn, many serious unsafe and unsound lending practices were known to the regulators in time, but the regulatory system did not act as

they were designed to. One way to look at the regulation system is as a function that was monitoring multiply threats in the business environment and failed to develop necessary capabilities to detect early these changes.

The fault of the financial institutions Dramatic failures within the internal risk management

functions of many financial institutions contributed to this crisis. Too many acted recklessly by taking uncontrolled risks backed by too little capital. In a major management failure, senior executives were not aware of (or paying attention to) their high exposure to risky securities, instead focusing on profits and bounces, not the overall picture. According to the Inquiry Commission, this “went from the corporate boardroom to the mortgage broker on to the street” (p19). It is possible that the early-stage small risks in each financial institution gradually became a major risk. But since so many of these institutions acted similarly, the accumulative effect became significant.

In this situation it is hard to differentiate between a management failure and an intelligence blindness -- possibly both happened. A better understanding of where the financial markets were moving and a proper evaluation of the risks could have lead them to impose self-regulation, thus reducing the overall risks. In the absence of a quality evaluation of risky practices, this system was unrestrained until its fatal crash. James (Jes) Staley, a senior official in JP Morgan Chase (a company that avoided these risky activities), was interviewed when he visited Israel (Yedioth Ahronot, 2011): “We acted differently as we had a leadership that knew how to navigate in the storm. Our bank was blessed to have such a leadership. Before the storm, we have taken brave decisions -- we did not follow in the same direction and opposed to invest in risky securities only because somebody gave them high ranking.”

Poor performance of corporate managementA combination of excessive borrowing, risky

investments and a lack of transparency put the financial sector on a crisis course. The Inquiry Commission report showed that the five major investment banks operated with extraordinary capital while the leverage rate was 40 to 1! The leverage rate (like other pieces of annoying information) were known to the regulators but this was the ultimate responsibility of senior banking management to set up appropriate checks and balances on their activity.

The inquiry reports mentioned that executives, regulators and policy makers were all aware that the

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percentage of borrowers who defaulted on their mortgage (within a short time after taking their loans) nearly doubled from the summer of 2006 to late in 2007, and the number of individuals who did not have the capacity to pay was increasing quickly. The Levin-Coburn report recounts how high risk mortgages continued to be issued while at the same time executives predicted the burst of the housing bubble, but they did not actually believe that the worst scenario could happen.

Whose responsibility was it to look at these irritating figures and take decisions on how to respond? The Inquiry report singled out the managements of the financial institutions that failed to protect the strength of their banks, which was their primary responsibility, and also failed to evaluate the situation rightly and to act (p.18). These senior executives cannot share their failure on the regulation. The Inquiry Commission has said very clearly “Our examination revealed stunning instances of governance breakdown and irresponsibility”(p.19).

Poor performance of the Administration referring to the government, the Inquiry Commission

has said very clearly (p.21): “The government was ill-prepared when the crisis occurred and its inconsistent response added to the uncertainty and panic in the financial markets.” Key policy makers who were in the best position to watch over the markets performed poorly before the crisis, when it was clear that risks were emerging especially in 2007 and 2008. The Inquiry Commission report emphasized “they lacked full understanding of the risks and interconnections in the financial markets” [p.21].

The problem of not understanding the overall picture and the significance of the threats was highlighted by the SeC’s Chairman Cox. After the collapse of Bear Stearns in March 2008, approximately six months before the beginning of the financial landslide with the sudden bankruptcy of Lehman, Cox said [p. 21] he “felt comfortable about the capital cushions at the big investment banks.”

THE OPTIMISM BIASWe have long been aware about the effects of

cognitive biases on people as they process information and especially how these biases create difficulties for analysts as they prepare assessments (Sinclair 2010). I looked at the financial crisis and cognitive biases from a different perspective, not the “usual” ones such as confirmation bias that leads people to ignore evidence that contradicts

their own notions. As I read these two reports it struck me as almost impossible to understand how so many people from various organizations and disciplines misunderstood the obvious threats and ignored early warning signals. This led me to look at another bias not very known in the intelligence work – the optimism bias (Sharot, 2011).

Different studies have usually looked at the effects of the optimism bias and the impact it has on shaping human life. One of the core capabilities of the memory system is to imagine the future and to enable us to prepare for what is likely to come. In the absence of relevant memories, the mind tends to develop further optimism regarding the future.

In business this optimism bias is often displayed as illusions (Lovallo & Kahneman 2003). Making decisions may be complex, but once you make up your mind, you view the option you have chosen as inherently better by far than the other options. Leon Festinger wrote that we re-evaluate our post-choice options to reduce the tension arises from making a difficult decision (Festinger 1957).

From the theory of optimism bias we can extrapolate that once business executives made the choice based on the belief that the success of the markets will carry on, there was little chance that new information would change their minds, particularly when they did not have memories of crucial business failures. Thus, positive assumptions can lead to disastrous miscalculations.

SIMILARITIES BETWEEN NATIONAL INTELLIGENCE AND BUSINESS INTELLIGENCE

A close examination of these two financial inquiry reports highlights their strong resemblance to the content of governmental inquiry reports released after serious intelligence failures. Both inquiry reports pointed towards an overall breakdown of outstanding organizations and successful senior executives who failed in the process of assessment, not as a result of an information shortage. This failure could have been largely preventable if those in command had not been motivated by hubris and over-confidence.

The financial crisis caught executives and policy makers by surprise. They did not have the full picture on the growing volume of threats to the financial markets and were not ready to deal with them either before or after the Lehman Brothers collapse. Some individuals anticipated the crisis and tried to signal its arrival, but they were few in the number and were ignored and silenced, as it happened in many occasions in history when warning were ignored.

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regarding the financial crisis early warnings, the Levin Coburn report referred to ignored warnings by “insiders” such as the chief credit officer of Washington Mutual and credit rating agencies personnel (p.2). nobel’s laureate Professor Paul Krugman wrote: “There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, raghuram rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as ‘misguided’ “(2009). In September 2006 Professor nouriel roubini warned that “the United States was likely to face an once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and, ultimately, a deep recession” (2006). Krugman added that roubini’s “seemingly outlandish predictions have been matched or even exceeded by reality” (2009). Fortune magazine wrote, “In 2005 roubini said home prices were riding a speculative wave that would soon sink the economy. Back then the professor was called a Cassandra. now he’s a sage” (2008).

CONCLUSIONSSidebar 1 summarizes the main reasons why the failure

of intelligence led to the 2008 financial crisis. A comparative study of intelligence failures in both

national intelligence and the business sector highlights an intriguing asymmetrical situation. While the resources dedicated to national intelligence are immense, in the business sector they are usually very limited. However, the expectations that this resource gap would convert into a qualitative advantage in favor of a better performance by national intelligence than competitive intelligence were not fulfilled. The causes of intelligence failures in both national and business intelligence were unexpectedly similar, not in the collection system but in the analysis – both ignored valuable signals and acted routinely. The answer to the question -- how to deliver a better value to enable better decisions -- does not rely on the amount of resources allocated but on other variables.

A final note: A crisis of this magnitude need not have occurred if the intelligence discipline had been effectively implemented. To paraphrase Shakespeare, the fault lies not in the stars, but in us.

1. Failure in human judgment.The crisis, a result of human mistakes and misjudgment, stemmed from systematic failures. The growing risks in the financial markets were not a secret -- even people outside the financial sector were aware of the threat’s progress. Officials and senior executives ignored the ‘red flags.’ The lowering of the regulation was cited s another reason for this blindness. Those in influential positions wrongly evaluated the situation and did not believe that a collapse was possible, particularly since such a disastrous event had never happened before. This was not a failure of a few individuals, but systematic mistakes by official organizations as well as many senior executives.

2. Failure of coordination and sharing of information.Many organizations, both official and in the business sector, were involved in this failure -- no coordination existed between the decisions taken before September 2008 that could avoid this catastrophe. This only intensified the difficulty of assessing the threats. Furthermore, high tensions between different organizations impeded their efforts to see the picture and to take the right decisions.

3. Failure at the senior executive level.The regulators, financial organizations, and Congress failed to alert policy- makers of the emerging threat. The main responsibility is placed on the public leaders charged with protecting the financial system. They had tools available to monitor the situation. As a result of this failure of the regulatory agencies and the chief executives of companies, leading policy makers did not receive the early warnings needed to reconsider different policy options.

4. Failure by overlooking the aggregation of threats. The emerging risks were long dispersed among a large number of financial institutions. Without coordination and with no pivotal directive, many of them took a high risk pace. The regulators had never been faced with a similar situation, and they recognized the actions taken by the financial institutions but failed to evaluate where it would ultimately end up.

SIDEBAR 1: FINANCIAL CRISIS FAILURE OF INTELLIGENCE

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Avner Barnea, a former senior member of the Israeli Intelligence Community, holds a MA from the Hebrew University of Jerusalem and graduated from the Tel Aviv University Graduate School of Business Administration. He is a strategic consultant in the field of competitive intelligence and business strategy in Israel and abroad. Avner is lecturer on competitive intelligence in the MBA program of the Ono Academic College and a guest lecturer on competitive intelligence at the Hebrew University of Jerusalem Business School. He has an intensive experience in the integration of competitive intelligence systems into Israeli corporations. Avner can be reached at: avnerpro@netvision.net.il