The fulminating over what to do about our
miscreant socialized unrepentant and as yet unreconstituted financial services sector continues. Since massive subsidies have been extended in the form of help to the mortgage business and an alphabet soup of Federal Reserve facilities, with nary a demand made of the beneficiaries of this largess, it seems that the authorities have perilous little leverage over their wayward charges.
Of course, in reality that isn’t so; a determined regulator can, if nothing else, harass a company into submission (the Japanese are masters of this technique) and they have more powerful tools at their disposal. But that presupposes the will to intervene, which despite the crisis, still appears to be sorely lacking.
The collective response resembles the storied boiled frog effect: the heat goes up, or in this case, the public outlays continue, yet legislators, regulators, and the public remain remarkably passive as the expenses continue to rise. Of course, it doesn’t hurt that many of these costs are contingent liabilities, so the true damage will come to light only years later, when the perps have moved on to other roles.
But readers beware: the boiled frog is an urban legend. Real frogs have the good sense to hop out of hot water. But in a pot with high enough sides, even a frog that knows it is in trouble will be unable to escape.
The sightings today confirm the difficult of leashing and collaring a complex, sprawling, fast-moving industry. The Financial Times has a comment by Charles Dallara, the head of the Institute of International Finance, an international organization of financial institutions that verges on the sanctimonious. It confidently recites a list of four areas for action and asserts:
Thus, the debate is not about “self-regulation” versus “more regulation”. Instead, there is an emerging consensus on the benefits of reinforcing market-based corrections with improved regulatory incentives and structures.
A consensus among those who’d rather not be regulated, for sure.
Some regulators are getting mad enough to at least threaten action, but it isn’t evident that they will be taken seriously. As the Telegraph reports in “EU to launch assault on bankers’ bonuses“:
A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.
A confidential document prepared for the gathering in Brussels finds the “short-term” pay structure of modern capitalism has become deformed, causing firms to take on “excessive risk” without regard to the interests of stakeholders or society.
Note that these discussions do not include the UK.
Now one can correctly point out that this is silly; the main finance centers are not in Europe to begin with, and having the EU adopt even tougher rules will assure even less high powered finance take place there. But don’t assume the EU is that naive. I suspect the credit crisis has at least another bad episode or two coming. The Fed has had to coordinate closely with the ECB on recent interventions. The EU may be trying to take intellectual leadership to force the US and the UK, which is also showing signs of financial distress, into taking more radical action. The EU may be taking a tough public posture while privately harboring more limited, realistic aims.
Ironically, the most sensible proposal comes from a US hedge fund manager. As reported by Ira Ross Sorkin in the New York Times:
Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”
The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.
But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation…
When you read that UBS did not even view parts of its mortgage portfolio as having market risk, it becomes very obvious that a number of firms were not dotting the i’s and crossing the t’s when it comes to risk management,” he said while on the panel [at the Milken Institute Global Conference] to a packed room.
How did it come to this?
A problem, he says, is youth and inexperience — and that’s coming from a former child prodigy.
“Walk across any of the trading floors — they are full of 29-year-old kids,” he said. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.”
On top of that, many chief executives of big universal banks, the ones that combine all sorts of financial services under one roof, “only understand a small part of the business,” Mr. Griffin said, suggesting too many of them come from sales backgrounds. Put those two things together, the traders and the chiefs, and you have the making of an outright debacle.
The problem is compounded further by weak government oversight, he said. “The unwillingness of the Federal Reserve and the S.E.C. to require working capital” limits, he said, only exacerbates the risk-taking environment because the banks are playing the equivalent of no-limit poker. “The sad truth of the matter is it didn’t have to be this way,” he said.
But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.
First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.
But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.
It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.
That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.
“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.
Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)
But he also wants to warn against going too far. “It may be a moment in time where there is quite a bit of fervor to put in place significant regulatory regimes that in my opinion could set this nation way back on the playing field,” he said.
He’s particularly nervous that excessive regulation could send more jobs overseas. “I see thousands and thousands of jobs at Canary Wharf and in downtown London, jobs that should have been in America in financial services. Derivatives really were developed in America and because of regulatory uncertainty left America.”
Note that, as readers have pointed out, moving CDS to exchanges isn’t quite that simple. New contracts with different and more standardized features could be exchange traded; the current types don’t lend themselves well to that. So the worrisome and potentially wobbly overhang of outstanding CDS would have to run itself off over time. Still, any progress on that front is welcome.
And to Griffin’s point about regulatory arbitrage; that’s where the EU’s foray might prove useful. The idea of an international regulation, or failing that, greater international harmonization, is getting traction. But it will take a push, which may come in the form of another leg down in the credit crisis, for that to happen.