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.

Start your day with The Independent, sign up for daily news emails
News
The two faces revealed by the ultraviolet light
newsScholars left shaken after shining ultraviolet light on 500-year-old Welsh manuscript
News
Rosamund Pike played Bond girld Miranda Frost, who died in Die Another Day (PA)
news
Arts and Entertainment
books
News
newsHow do you get your party leader to embrace a message and then stick to it? With people like this
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Marketing Manager - B2B, Corporate - City, London

£45000 - £50000 per annum + benefits : Ashdown Group: A highly successful, glo...

Neil Pavier: Commercial Analyst

£50,000 - £55,000: Neil Pavier: Are you a professionally qualified commercial ...

Loren Hughes: Financial Accountant

£45,000 - £55,000: Loren Hughes: Are you looking for a new opportunity that wi...

Sheridan Maine: Finance Analyst

Circa £45,000-£50,000 + benefits: Sheridan Maine: Are you a newly qualified ac...

Day In a Page

General Election 2015: The masterminds behind the scenes

The masterminds behind the election

How do you get your party leader to embrace a message and then stick to it? By employing these people
Machine Gun America: The amusement park where teenagers go to shoot a huge range of automatic weapons

Machine Gun America

The amusement park where teenagers go to shoot a huge range of automatic weapons
The ethics of pet food: Why are we are so selective in how we show animals our love?

The ethics of pet food

Why are we are so selective in how we show animals our love?
How Tansy Davies turned 9/11 into her opera 'Between Worlds'

How a composer turned 9/11 into her opera 'Between Worlds'

Tansy Davies makes her operatic debut with a work about the attack on the Twin Towers. Despite the topic, she says it is a life-affirming piece
11 best bedside tables

11 best bedside tables

It could be the first thing you see in the morning, so make it work for you. We find night stands, tables and cabinets to wake up to
Italy vs England player ratings: Did Andros Townsend's goal see him beat Harry Kane and Wayne Rooney to top marks?

Italy vs England player ratings

Did Townsend's goal see him beat Kane and Rooney to top marks?
Danny Higginbotham: An underdog's tale of making the most of it

An underdog's tale of making the most of it

Danny Higginbotham on being let go by Manchester United, annoying Gordon Strachan, utilising his talents to the full at Stoke and plunging into the world of analysis
Audley Harrison's abusers forget the debt he's due, but Errol Christie will always remember what he owes the police

Steve Bunce: Inside Boxing

Audley Harrison's abusers forget the debt he's due, but Errol Christie will always remember what he owes the police
No postcode? No vote

Floating voters

How living on a houseboat meant I didn't officially 'exist'
Louis Theroux's affable Englishman routine begins to wear thin

By Reason of Insanity

Louis Theroux's affable Englishman routine begins to wear thin
Power dressing is back – but no shoulderpads!

Power dressing is back

But banish all thoughts of Eighties shoulderpads
Spanish stone-age cave paintings 'under threat' after being re-opened to the public

Spanish stone-age cave paintings in Altamira 'under threat'

Caves were re-opened to the public
'I was the bookies’ favourite to be first to leave the Cabinet'

Vince Cable interview

'I was the bookies’ favourite to be first to leave the Cabinet'
Election 2015: How many of the Government's coalition agreement promises have been kept?

Promises, promises

But how many coalition agreement pledges have been kept?
The Gaza fisherman who built his own reef - and was shot dead there by an Israeli gunboat

The death of a Gaza fisherman

He built his own reef, and was fatally shot there by an Israeli gunboat