Thursday, July 2, 2009

Comparisons to the South Sea Bubble

I love financial history. There is absolutely nothing new or different in the way people think, process information, and respond. As a result, history continually repeats and the same mistakes are made. A top Bank of England official compared the banking system to the infamous South Seas bubble. The South Sea Bubble occurred in the early 1700s and caused financial ruin for many. Isacc Newton lost a fortune. Was was the cause? The New World of course and the fortunes that were going to be made by 1000s. Hmmm, let's see that rhymes with the railrods in the 1900s, tech stocks, in the 1990s, and housing over the last decade. For more on the South Sea Bubble you can check out Wikipedia. To the article from the UK Guardian.

A senior Bank of England official today compared the banking system over the last 20 years to the South Sea bubble of the early 18th century and said bankers had merely "resorted to the roulette wheel" to keep up with each other.


"Banking became the goose laying the golden eggs. There is no period in recent UK financial history which bears comparison," he said.


"One of the South Sea stocks was memorably 'a company for carrying out an undertaking of great advantage, but nobody to know what it is'. Banking became the 21st-century equivalent."


He said that in future there would have to be a greater distinction between management skill, which improves return on assets, and luck, when return on equity can be magnified by leverage.

"Good luck and good management need to be better distinguished. Put differently, returns to investors and managers need to be more accurately risk-adjusted if the right balance between risk and return is to be struck for individual firms and for the financial system as a whole."

A second lesson, he added, was that there would have to be much stricter system-wide limits on leverage, particularly among big banks whose stability is crucial to the whole financial system.

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