Stephen Foley: Time to snip Wall Street down to size
Saturday 25 July 2009
US Outlook: It is 1909 all over again. A red-in-tooth-and-claw capitalism is seen being manipulated by gargantuan companies, extending their tentacles into all areas of business and wielding their power to cow governments and extort the citizenry. Then, the clamour was for the break-up of Standard Oil, the behemoth assembled by John D Rockefeller, which controlled 80 per cent of US oil production and used its monopoly to squish rivals.
Today, of course, it is the Wall Street banks, Goldman Sachs most popularly but in truth the whole gang of them, who feasted so heartily in the boom economy that their implosion threatened to destroy the financial system.
Exactly 100 years ago, a US president unleashed the nation's nascent anti-monopoly laws on Standard Oil, and two years later it was broken apart. In another time, an incoming Democrat president, blaming over-mighty banks and speculators for triggering a Great Depression, backed the Glass-Steagall Act of 1933 that broke up JP Morgan and forced financial institutions to choose retail or investment banking.
In the US, there is a foot-stamping fury that no such attack is being launched today on banks whose very existence seems to have endangered us all. This despite the inescapable logic that, in a free market firms which are too big to fail are too big to be. In its proposed reforms, the Obama administration seems to be trying to make it possible for big banks to fail safely, with a special "resolution mechanism" of as yet uncertain detail. It has shown precisely no inclination to stop firms becoming too big in the first place.
But those who are looking to politicians for a new Sherman Antitrust Act, like the one used in 1909, or a new Glass-Steagall are looking in the wrong place. The break-up of the banks can and should happen, but it will happen by stealth. It can happen if regulators learn the lessons of the past two years and use the new tools being provided to them.
A Congressional hearing yesterday on the Obama administration's plans for regulatory reform was a pretty unedifying spectacle, of competing regulators trying to salvage as much of their turf as possible. The structure of regulation, though, is less important than the substance, and on this there is very real grounds for optimism. Whether powers to examine the financial system as a whole reside with the Federal Reserve, or a committee of regulators, we cannot go back to the days of narrow institution-by-institution regulation. The people inside the regulatory bodies must judge not just whether a firm's behaviour is dangerous to its own future; they will take a wider perspective about the risk and value of each financial product and innovation. That is a fundamental change, and the consequences will flow widely. Specifically, it will hold up growth, as the systemic impact of new innovations is debated more thoroughly. In these circumstances, we should avoid a repeat of the situation where the credit default swaps (CDS) market could swell to $40 trillion before anyone noticed.
The move to push most structured products on to exchanges will also crimp the activity of the big banks. There is no reason why mostly standard contracts such as the CDS should not be traded transparently, instead of over-the-counter where banks are profiteering from the lack of information. This will be a one-time downsizing of Wall Street's biggest banks – which is why they are lobbying so hard against it. Politicians should stand firm.
Sheila Bair, head of the Financial Deposit Insurance Corporation, has floated the idea of charging a levy on the bank activities which we have learnt are particularly risky. There could be, in effect, a tax on proprietory trading, crimping an area of speculative business where so many outsize bonuses are being generated.
And we are just at the beginning of a whole new era of financial modelling that factors in what we have learnt over the course of this financial crisis, namely that financial products once thought to be independent of each other can all collapse in value at the same time, if liquidity evaporates from the system. The lesson is that banks must put aside more capital to protect against losses, and the cost of that capital will limit banks' appetite for such risks.
Most promising of all, if the Obama plan goes through, there will even be a specific category of regulated firm that, because of its scale, is required to post extra amounts of capital to compensate for the risks its failure would have on others. Whatever horse-trading is needed to get the laws passed, this provision should remain. It is the key to breaking up the banks. The shareholders of these super-sized banks ought to baulk at the prospect of ponying up capital to protect other banks' shareholders.
By making the cost of doing business increasingly expensive, the bigger and riskier the firm, regulators can set natural caps on the size of Wall Street's banks.
Rockefeller's empire was blown apart by the courts; Depression-era banks by an act of Congress. Today's masters of the universe can be regulated down to size. Let's get to it.
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