Stephen Foley: Four words could return to haunt us


US Outlook: With each passing day, it seems the lessons we learned when the credit crisis reached its crescendo are becoming fuzzier, harder to grasp at or even slipping away. One of the symptoms of this is the ease with which the language of Wall Street has begun to reassert itself in the debate about how to reform finance.

The talk is once more of "flexibility" and "innovation", of "liquidity" and "competitiveness". After all, who can be against such things? But we should have learned what these four seductive words really mean, and we have seen what they have cost us.

The Obama administration has proposed legislation to finally force much derivatives trading on to recognised exchanges, something which would have prevented banks becoming so intertwined with each other in the credit default swaps market that the failure of Lehman Brothers and AIG threatened to bring them all down. Except that the legislation is full of holes, as Gary Gensler, chairman of the Commodity Futures Trading Commission, which will regulate these markets, argued in a letter to Congress this week.

Wall Street has lobbied hard for provisions that exempt certain types of swaps – currency swaps is the issue at hand for Mr Gensler – and which keep so-called "customised" derivatives off exchanges, too. Banks say they need to be given this flexibility to create customised products so that clients can hedge their unique risks. That Wall Street bogeyman, the "one-size-fits-all approach" to regulation, will stifle innovation, they have argued.

But every bit of flexibility granted to banks is a little bit more rope tying regulators' hands. In their infancy, the credit default swap was just such a customised product, an innovation that regulators never had an easy mechanism for getting under control, even when it was clear its widespread use had grown to a scale that was profoundly dangerous to the stability of the system.

And not all innovation is equal. Gillian Tett's Fool's Gold, a good primer on the development of credit derivatives, shows how the innovators at JP Morgan had to search hard to find clients that might have a use for their brilliant new inventions. Fee-driven innovation is not the same as client-driven innovation, and drawing the distinction will be a tough job when so much of the financial system involves banks and hedge funds trading with each other.

This is the reality that lies behind bankers' other justification for much of what they do: they are creating "liquidity". This was the word bandied in defence of the speculators who piled into the oil market, sometimes via exchange-traded funds, in recent years. Their presence dramatically increased price volatility, confounding the financial planning of airlines, factory owners and SUV-drivers alike.

Of course, market-makers have been needed to provide liquidity for almost as long as men have gathered on street corners to trade bushels of wheat. The more participants there are in the market, the higher the frequency and the greater the speed of their trading, the more liquid capital markets become. That makes it easier and cheaper for businesses that need investment to find it, and for investors who have money to put it into the most productive sectors of the world economy. But I fear we have built a system of rampant speculation, where there are more "market-makers" skimming a fee than there are people who really need to be in the market. Certainly we have stoked a cycle of boom and bust that undercuts proper long-term capital allocation, all in the name of liquidity.

Finally, we have already seen how the British Financial Services Authority rowed back from some of its proposed rules limiting bonuses – and exempted many foreign banks – after the industry told it they would harm the UK's competitiveness as a financial centre. But the demand for "competitiveness" implies a race to the bottom in regulatory standards, in capital requirements and in risk-promoting pay structures. Successive repeals of previous rules and standards, from the Eighties onward, contributed to the industry's headlong rush into dangerous new areas. It is a beggar-thy-neighbour approach that, like protectionism in the Thirties, makes each nation marginally richer in the short term, but leads to disaster later. International co-operation is hard, but the OECD-led clampdown on tax havens shows it is possible.

Flexibility. Innovation. Liquidity. Competitiveness. Wall Street's lobbyists use these as keys to unlock policies that are good for banking. It is important to have a healthy financial system, so some measure of all of these is necessary, but they must be seen for what they are and weighed accordingly. Our fundamental question should not be, what is good for banking; rather, what is banking good for? It is no good turning your country into the biggest financial centre in the world if it can overwhelm the entire economy; no social reason for creating financial products that do not contribute to the allocation of capital in the real economy; no moral imperative to give bankers the flexibility to write themselves dangerously skewed bonus plans.

The more we hear of these four seductive words, the more we should fear that bad old banking is reasserting itself – and that we are once again on a road to calamity.

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