Letter to the National Review re Need for Financial Regulation

Posted in Blog at 1:23 pm

In most conservative circles, the current push by the Democrats to pass more financial services regulation has been received with skepticism fading over into outright hostility at yet-another power grab by Washington.  The piece in the National Review’s online Corner column to which I was responding here was no exception.  I was becoming concerned that too many believers in free markets were convincing themselves that just because there was a lot of dirty bathwater, there was no baby in it.


As Frank Luntz was recently quoted in The Corner:

By the way, it’s time to hold Wall Street equally accountable, but there are better ways than creating yet another Washington bureaucracy.  It requires better enforcement, not new laws.

This has been the mantra of almost all those who oppose the latest regulatory bill in the Senate.  In principle, they are right.  The problem is, that existing laws don’t cover many of the problems that were exposed in the 2007 – 08 financial crisis.

Far be it for me to recommend that the bloated bureaucracy in Washington be made still bigger, or the federal government be allowed to become even more intrusive than it already is, but we have a problem that contains the seeds of the next financial catastrophe, and it is no good pretending that it isn’t there simply because its existence inconveniently contradicts the principles of free-market capitalism or libertarianism:  under the present laws, the big banks have license to run amok.

Without constraints on their size, we now live in a world where five or seven so-called “investment banks” (most are really ‘universal’ banks) completely dominate the capital markets.  All are “too big to fail.”  Given that there exists no authority to demand otherwise, there is no reason why mergers could not reduce their number still further.  If there is a bid, institutional shareholders must accept a higher offer for their shares; even if they wanted to reject a deal as being economically inadvisable, they have no choice.  Thirty years ago there were over a hundred significant players in the financial markets, fifteen years ago, there were still several dozen.  With so many players, the opportunity for systemic risk was greatly reduced.  Today, mistakes by just a couple of the survivors could bring down the system.  The process of consolidation has gone too far.

Conflicts of interest are now hard-wired into the system.  When I began my career as an institutional portfolio manager (for TIAA-CREF, let me add, not some small player), there was a great deal of worthwhile research available, and thus a proper range of opinions, from bullish to bearish, on any stock, new tactic, or market trend.  In some countries (e.g., the U.K. and France) the brokers who talked to investors were not allowed to have any position in a security, either long or short.  Since (aside from encouraging activity of course), their only interest was in keeping their investor clients satisfied, their opinions could be trusted not to be deliberately deceptive.  Similarly, investment bankers (the real ones, those engaged in corporate finance) had as their only interest making sure that their corporate clients got the best price at the best time for their securities issues.  They were not allowed to sell securities directly to the investing public, not even to the most sophisticated institutions.  Market makers were not allowed to deal directly either with investors or with issuers. Other traders—those who worked for their own account—were by definition investors, and as competitors to the traditional long-only funds, insurers, and private individuals, occupied no privileged position within the system.

In the United States, where the only legal barrier was between deposit-taking banks and all others, the division of function tended to be maintained by tradition, by client concerns about conflict of interest, and by the requirement that stock exchange members, at least, had to be unlimited partnerships.  We had wire houses and institutional brokers, investment banks specialized in corporate finance only, and there were research boutiques as well.  There were separate firms that specialized in risk arbitrage.  Critics—mostly the commercial banks which wanted to use their market capitalization to buy their way into the sexier business of the capital markets—complained of its inefficiency.  Everyone, naturally, wanted to game the system to his own advantage, and there were fads.  But by virtue of its fragmentation, the system worked as a free market, with sufficient numbers of participants to insure that the invisible hand could have an effect before total disaster set in.  There was euphoria at times, of course, and there were some nasty bear markets, but for fifty-four years, from the end of the Great Crash of 1929 – 32, to the  ‘portfolio insurance’ crash of 1987, despite World War II, several sterling crises, the collapse of the ‘nifty Fifty,’ Silver Monday, Franklin National, and Continental Illinois, etc. etc., there were no full-blown financial panics:  the survival of the system never was in doubt.

But major forces in the U.S. began chipping away at this system.  Stock exchange members were allowed to incorporate, then to issue shares to the public.  The blue-ribbon investment banks merged with institutional brokers, then with the wire houses, to obtain “distribution,” i.e., to have a sales force to push their issues upon the investing public.  Trading for the firm’s own account became accepted, then de rigueur, despite the fact that investors no longer knew whether they were being advised to take a good bet, or being sold a bill of goods by someone who knew more than they.  In self-defense, American institutions began to build up their research staffs (which was very expensive), but they could never command the kind of resources that market intermediaries could.  Issuers liked being able to call up ‘their’ banker, and tell it to silence any analyst who had unkind things to say about their share price, or their financial situation.  Armed by their wealth and huge market caps, the American houses began to take over brokers in other parts of the world.  Since then, we have had financial crises in 1987, in 1991, in 1997, in 2000, and most recently, in 2007 – 08.

The problem isn’t just that the principle of caveat emptor has been reaffirmed.  Any participant in the financial system, as in any market, should always be careful to look after his own interests.  It is that this is no longer enough. Financial intermediaries have been allowed to become so big, and so riven with conflicts of interest, that there is no longer a true free market in securities, and since everything is now securitized, the free market in financial services can no longer be self-correcting.  The invisible hand only manifests itself when the situation has gotten so out of hand that catastrophe is already upon it.  And of course, big government would then be there to bail out too-big-to-fail banking, but not market investors, who would have lost (a third? a half? three-fourths?) of their wealth.

Therefore, I’m afraid some sort of new regulation is required.  Hand-wringing on behalf of the poor boys at Goldman Sachs doesn’t help either:  they may or may not have broken the law, but there is no way I would continue to deal with any broker who had sold me such a deal, if I had any choice.  Sadly, no one has such a choice today.  The Dodd bill may have many lousy features, and one must be careful of anything from the people who gave us Fanny Mae and Freddie Mac, but just enforcing existing law is no longer enough.  Somehow, the financial system must be brought back within the realm of free markets.  Just relying upon the bid-and-offer mechanism of the stock market won’t do it under present conditions.

It should be incumbent upon conservatives to push for the right kind of regulation, even if this gives Washington some new powers.  The worst financial power the Government has right now is their ability to get in bed with a handful of giant banks in a corporatist muddle of interests, as one set of barons might deal with another.  Only by modifying the system can we reduce the risk of that.

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