Why Wall Street's big squids keep slipping free
Efforts to reform the financial system and the institutions that dominate it are mostly falling flat as Wall Street manoeuvres to preserve the status quo via technical nitpicking and political lobbying.
Efforts to make financial institutions small enough to manage have found some surprising supporters.
When Sandy Weill said recently that he was in favour of breaking up conglomerate financial giants such as Citigroup, it looked like a major 'mea culpa'. After all, he engineered the final demise of the Glass-Steagall Act at the end of the 1990s by merging Travelers Insurance and Citibank to create the financial conglomerate Citigroup.
But there was much less in this road-to-Damascus conversion than meets the eye. For a start, he didn't admit that conglomeration was wrong when Citi and Travelers got together: just that it might no longer be appropriate (perhaps he was just impugning his successors' ability to manage such a conglomerate).
In any case, Weill is a retired bystander with no influence on how the financial structure might develop now. This is akin to a statement routinely seen from retired politicians, who climb the moral high ground only after they have relinquished the reins of power.
Back in the real-world policy debate, reform prospects are far less dramatic, despite new evidence that big conglomerate banks can't be effectively managed. JP Morgan Chase's 'London whale' trading loss has now risen to nearly $6 billion. Barclay's chief executive has fallen on his sword over the Libor interest rate fixing. But the key managerial failings exposed in the Libor scandal have been confounded in a welter of mutual recriminations involving both the Bank of England and the US Federal Reserve.
Thus none of this has had much impact on efforts to make financial institutions small enough to manage. Fed governor Susan Raskin has reported that she was outvoted in her efforts to toughen up restrictions on banks. It looks like the Volcker Rule, the modest efforts to limit banks' ability to take risks via proprietary trading, effectively will be buried under a mountain of red tape and exceptions (known as 'carve outs'), as Wall Street manoeuvres to preserve the status quo. If the JP Morgan Chase trading losses had any influence on this debate, it was only to confirm the difficulty of distinguishing between risky proprietary trading and risk-reducing hedging.
At the international level, the Bank for International Settlements has engineered new rules requiring banks to hold more capital. These, however, don't come into full force until 2017 and there is so little faith in the arcane calculations of risk-weighted capital (with its abundant opportunities for gaming) that an additional overall leverage ratio will be imposed. This crude and distortionary belt-and-braces approach is a reminder of how difficult it is to make global rules.
The current BIS effort is focused on identifying systemically important financial institutions whose failure might threaten the global financial system. But crises (including 2008) have been triggered by problems in rather modest-sized institutions. The danger lies not so much in an individual institution being 'systemically important'. Rather, the financial system as a whole develops ways of doing business which make it collectively vulnerable, so the demise of even a modest-sized institution triggers system-wide contagion.
Other problems remain unaddressed. Despite the traumatic experience of unravelling the worldwide tangle of Lehman Brothers' collapsing balance sheet in 2008, no global plans are in place for handling the much larger possibilities (Citi, for example, is about three times as big as Lehmans and JP Morgan Chase is much larger still).
Every effort to improve the resilience of the financial structure is met by the argument that this particular problem didn't cause the 2008 crisis. So many different factors contributed in the years leading up to 2008 that this argument is hard to refute. Even when a key weakness is identified, it is then argued that whatever measures are taken will not be enough (for example, more capital wouldn't have saved the institutions that got into trouble).
A resilient financial sector will be very different from the structure of 2007, with its excessive trading, over-leverage and the sloshing back and forth of vast international capital flows. The financial sector will have to reverse at least some of its pre-crisis expansion, which doubled the sector as a per cent of gross domestic product in the US and the UK. This process has hardly begun. Trading is still where the sector hopes to earn a good part of its livelihood, playing a zero-sum game in which these profits come at the expense of non-financial businesses and households.
High-speed transactions and 'dark pools' of trading have no benefit in price discovery or market liquidity, but are attracting new capital. US regulators are still no match for the political power of Wall Street. The credit rating agencies, having totally failed to identify problems before the crisis, now make a living out of walking the battlefield, stabbing the wounded. Salary incentives are still unreformed and those who headed the failed institutions have walked away from the wreckage, well remunerated. Banks, already too big to fail and too big to manage before the crisis, have merged to become bigger still.
There is still much unfinished business here.
Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.