The thrust of regulatory reform of Wall Street since September 2008 has been entirely regulatory in nature. In a recent column, I explored why such an approach is inappropriate both because of the limitations of enforcement and the ability of major players to game any set of rules that are put in place.
“The achievement of the regulatory reform agenda has been to ensure that when the next financial crisis occurs it will not take exactly the same form it did in 2007-8. The objective of preventing individual bank failures will largely be accomplished, but by socializing much of the downside risk in the financial system, rather than addressing the underlying issues.” John Kay, ‘Take on Wall Street’s titans if you want real reform’, Financial Times, September 19, 2012
As John Kay notes, bad lending in the United States mortgage market and the creation of debt instruments were only proximate causes of the 2007-8 crisis. Following the repeal of the Glass-Steagall Act during the Clinton administration, Wall Street established complex financial conglomerates, whose assets and liabilities largely were the liabilities and assets of other financial conglomerates. Such a structure guarantees that minor disruptions and shocks will generate large and unpredictable consequences throughout the financial system.
This time bomb cannot be suppressed by establishing government committees to watch it happen, and only then respond. To respond by socially insuring the structure is irresponsible both because it imposes obligations on helpless taxpayers and because it relieves private actors of the obligation to monitor their own counter-party risks.
Again, as John Kay notes, shareholders and managers of banks are highly unlikely to control such risk effectively. Shareholders typically provide less than 5 per cent of the capital of a financial institution. As such they are less equity participants than owners of a call option. Corporate executives with bonuses and remuneration plans hold options on these call options. When volatility increases the value of the instruments owned by those who make all the important decisions, how can we expect systemic stability?
The true equity participants in highly-leveraged financial institutions are the owners of debt. They have now been reassured that the businesses in which they invest are ‘too big to fail’. This is a recipe for crisis after crisis.
“We need instead smaller, simpler, financial institutions, which specialize in particular lines of provision of financial services to the non-financial economy, rather than trading with each other. The only sustainable answer to the issue of systemically important financial institutions is to limit the domain of systemic importance. Until politicians are prepared to face down Wall Street titans on that issue, regulatory reform will not be serious.” John Kay, ’Take on Wall Street’s titans if you want real reform’, ibid.
Unfortunately, Wall Street pours millions of dollars into the campaign funds of key politicians and presidents – Democrat and Republican alike – to make absolutely sure that John Kay’s systemic structural reform proposals are never allowed to exit the gates of the controlling congressional committees for debate and vote on the floor of the U.S. House of Representatives and/ or of the U.S. Senate. Even if such a slippage should occur, a presidential veto would await arrival of the reform bill in the White House.