Now that the horse has left the barn and is in the next county as far as the damage of overly lax financial industry regulations is concerned, a lot of people are in favor of having tougher rules. Even Tyler Cowen, who hews to the conservative side of the political spectrum, cites lax supervision as one of three major culprits in our economic crisis:
The third component has been weak governance and oversight. That includes inadequate control and monitoring by shareholders, regulators, creditors, accounting systems and ratings agencies, among others. Most people, including informed insiders, simply did not understand the systematic risk that financial institutions were accepting…
The end result was that both markets and governments failed miserably — at the same time and on the same issues. With hindsight, it is easy to argue that regulation should have done more, but in most countries, governments were happy about rising real estate and asset prices and didn’t seek to slow down those basic trends. (You’ll note that greed doesn’t play an independent role in this explanation because greed, like gravity, is pretty much always there.)
I have to quibble a bit with Cowen on the greed issue, since a cottage industry sprang up in the 1990s to justify outsized pay to CEOs and certain types of knowledge workers, so that compensation that would once have been deemed as outrageous came to be seen as normal.
Put it another way: when a former Goldman Sachs co-chairman, John Whitehead, lambasts Wall Street pay levels and calls for Goldman to cut compensation, you know there is something wrong.
But back to the main thread. While there has been some general talk about simplifying and consolidating the financial services regulatory framework, there has been perilous little discussion of specific measures, beyond some obvious ones, like putting more products on exchanges and subjecting mortgage brokers to licensing and supervision.
One reason for little progress, even on the conceptual level is it takes time, thought, and a lot of study to devise sound, lasting regulations. It requires both focusing on the right broad objectives and then getting the details right. The securities regulations implemented in the Great Depression (the Securities Act of 1933 and the Securities Exchange Act of 1934) were well though out, well integrated programs that have stood the test of time surprisingly well. Indeed, what undermined these laws was that their effectiveness in promoting deep liquid markets, which in turn mean that relations with shareholders are anonymous and arm’s length (even with extensive disclosure, a public company cannot tell its shareholders as much as a private firm would to venture capital investors for competitive reasons). Thus, governance, as Columbia professor Amar Bhide pointed out in a 1994 Harvard Business Review article, is inherently deficient in public companies.
But nevertheless, consider the 1933 and 1934 Act’s aims:
1. Provide frequent, timely disclosure about financial condition and results, top executive and director backgrounds, shareholdings, and compensation
2. Discourage insider trading
3. Prevent market manipulation
Elaborate and detailed regulations were devised to further these goals in order to protect investors against abuses by companies and broker/dealers.
John Hempton illustrates a case of how seemingly hoary US regulations worked well, and by contrast, the UK’s blind embrace of deregulation has done lasting damage to London as a financial center.
The case study is the Lehman bankruptcy. In both the US and the UK, the firm had hedge funds as customers. Hedge funds often take margin loans against their holdings. A broker has a customer sign an agreement giving the broker broad authority to loan (“repledge”) those securities. The broker needs to do that to fund the loan.
Here is where the fun bit comes in. The US has pretty tough rules on the use of these securities, while the UK had none, and it is becoming clear that Lehman abused its latitude in the UK, and the damage is considerable. From Hempton:
The US had huge problems with broker-dealers in the 1930s…Enter the US Securities Exchange Act of 1934. This is one piece of depression era legislation that survives and thank the Good Lord for that.
What the broker dealer act does is (a) ring fence the US broker dealer and (b) limit the amount that the broker dealer can borrow against your securities and the amount of collateral it may take.
I am hardly a lawyer – so take the bush lawyer caveat – but the way it works is that the broker dealer may not borrow against your securities to finance their own business, only client business. So Lehman Brothers US broker dealer could take collateral of securities and if they had 100 million out on client margin loans the most that they could raise using client securities is 100 million and not a brass razoo more. This is really important because it meant that client assets were not used to finance Lehman’s disastrous commercial real estate and other businesses.
Moreover when you deposit a million dollars at the broker dealer and give them the right to repledge those securities they can only rehypothecate 140 percent of your outstanding balances…
So (provided the broker is not acting criminally) you should get the bulk of your money back if the broker dealer fails. And provided the capital requirements are adequate (and they mostly are) the broker dealer won’t fail. Even the Drexel Burnham Broker Dealer did not fail….
The result. Whilst Lehman brothers went bust Lehman US broker dealer did not. This pretty well saved the US hedge fund industry.
Europe however was a different story. Lehman Europe failed – and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman. Many funds have folded. Far more have been nicked. Whilst the US hedge fund business is currently looking dazed, confused and a little problematic the UK business is on life support.
In some sense this is the end of the City of London.
I am on record as saying the UK took Maggie Thatcher to heart and deregulated financial activity to such an extent that the whole UK market worked without capital…
But now with the biggest bank in the world by balance sheet (Royal Bank of Scotland) effectively nationalised and the and a large part of the UK hedge fund community lying with open veins it looks a little stupid.
This puts in a different light the 8 billion dollars that Lehman London transferred to the US when it was failing. I stand open to correction – but I would guess that the money was obtained from client accounts from the European/London broker dealer. It is certainly being investigated by Lehman clients. This is a scandal of the first order allowed by an insane lassis faire approach to financial regulation.
So here is a plea for US Depression style financial regulation. Some of it (such as the Broker Dealer regulation) was well thought out and should be duplicated. (Some of it was less sensible…)
If I have a plea to my home country (Australia) after the Opes Prime debacle – a copy of the US 1934 Act would be a good start.
As for London – I am sorry, but it is a wreck. Maggie Thatcher you stand condemned.