March 24, 2010


By William Gruver

At least one valuable lesson from our experience in the last two or three years is an international one. The country that fared best in the global crisis was the command and control economy in China; the Communists in Beijing seem to be better managers of capitalism than democracies in Washington, London or Tokyo. Have global capital markets become so fast and sophisticated that the only way to restore trust is Big Brother? One hopes not, but are there lessons that we can adopt from the Chinese and adapt to our democratic system in order to improve our financial regulation? We cannot cast a blind eye to those who thus far have passed through this crisis relatively unscathed.

Clearly, an authoritarian state has certain enforcement advantages, which although they definitely create fear, are fundamentally inconsistent with western liberal democracy. Nevertheless, there are lessons. The Chinese, for instance, have been much more aggressive in restraining greed by using their central bank powers to set interest rates and adjust reserve requirements than our Federal Reserve.

Unlike the Chinese, our financial regulatory system is highly fragmented. AIG very well may not have been permitted to get so overextended had their subsidiaries not been overseen by various state regulators, but instead by an overarching federal regulator. Similarly, in our system derivatives were overseen by a different regulator than the one overseeing the underlying security. Once again, the Chinese with the ultimate strong central government had a better view of the systemic risks and were able to address them more quickly.

Greater transparency
China is a much simpler financial market than America. In order to protect their oligopoly the Chinese banks did not disintermediate their risks. Complex securities like CDSs or CDOs, which were at the heart of the American market's problems, did not exist in China. Banning such securities in our sophisticated market would be too blunt a remedy. Because of the greater complexity of our financial instruments, however, greater transparency is needed in our system than in China. If the market had been aware of more details of Lehman's inventory, the negative impact on Lehman's stock price would have occurred at a time when (in response to the price drop) management could have reduced its concentration of risk or its leverage, either of which may have saved the firm. Similarly, extension of the qualified investor criteria (currently used to limit hedge funds and limited partnerships to only the most sophisticated investors) to include complex derivatives would also lessen our systemic risk.

Looking for enforcement lessons from history, one must start in 1933. In that year President Roosevelt in his famous first inaugural showed that he knew the power of fear when he uttered the famous words "the only thing we have to fear is fear itself". Later in that same speech he, like President Obama today, did his share of demagoguery when he referred to the leaders of Wall Street as having "fled from their high seats in the temple of our civilization".

Unlike Washington today, however, Roosevelt quickly followed his words with action and, in turn, earned the trust of America. In the same year he was inaugurated a historic piece of legislation was passed that served our financial system well for 66 years — the Banking Act of 1933 (the Glass Steagall Act). Some in Washington have called for the de facto restoration of Glass Steagall, but the reasons for its abolition in 1999 are more important today than they were then — the complexity of the system and the globalization of finance.

Antidote to greed
Those who call for the return of Glass Steagall-like divisions within the financial system are missing the greatest lesson that can be learned from Roosevelt — the antidote to greed is an offsetting amount of fear. The year after he was inaugurated, Roosevelt created the SEC when Congress passed and he signed the Securities Exchange Act of 1934. Greed was too tightly woven into the human fabric not to have a tough cop going forward.

Unfortunately, the SEC has not progressed nearly as much as the securities markets and executives it oversees. Its resources have been inadequate and its incentives misplaced. Consequently, the SEC has become so myopically obsessed with discovering and pursuing relatively minor technical violations that they miss both major frauds being perpetrated by the likes of Bernie Madoff and the toxic combination of concentration of risk in tandem with excessive leverage at banks like Lehman Brothers.

Improving the compensation of SEC regulators so that the jobs attract an equal level of talent to those who now become Wall Street executives is part of the answer. In China a bank regulator holds a much more important position in the social hierarchy than is the case in the USA. The Chinese regulatory positions, therefore, are highly sought after jobs that attract the best talent.

Prosecutorial overreach
In order to make American regulatory jobs as attractive as those in China, some have called for a bounty system to compensate the regulators directly with rewards for the capture of Wall Street criminals. Much like those who call for the return of Glass Steagall, however, such a system would be too blunt an instrument. In such a system the temptation for prosecutorial overreach (already an issue) would only be further encouraged.

More talent is needed so better base pay is a fundamental necessity, but people who go into public service for the right reasons generally do not do so in order to make a fortune. The first Chairman of the SEC, appointed by Roosevelt in 1934, was a former Wall Street trader. Much of the trust that the public placed in the SEC springs from those earliest days when Joe Kennedy, with his insider knowledge of the workings of the financial markets, aggressively went after the bad guys. Of the 28 chairs since Kennedy, only three have come from Wall Street and only one of those had trading experience; the others were lawyers, professors and politicians. Joe knew where to look for the proble

SEC Chairman Mary Schapiro is a fine administrator with a proven record of organizational skill. The lesson of Joe Kennedy, however, argues in favor of appointing someone such as Jim Chanos or John Paulson. Both, like Kennedy in his trading days in the 1920s, foresaw the impending collapse and made fortunes. Both know Wall Street from the inside as a practitioner. Schapiro might turn out to be a great SEC chairman, but she does not create fear in the hearts of the bad guys on Wall Street; Jim Chanos or John Paulson would.

Visionary cures
There is one last lesson from financial regulatory history that is central to any of the foregoing suggestions being implemented. The statesman who authored both the Federal Reserve Act of 1912 and the Banking Act of 1933 was Carter Glass of Virginia. He had never worked on Wall Street. His constituents didn't work on Wall Street, but he knew its importance to the American economy. The vision that he implemented was not necessarily popular with his rural Virginia constituency, but it was vital to restoring trust in the system. Today's elected and appointed leaders in Washington, regardless of party, are either too closely associated with Wall Street to be objective, or they are too concerned with getting re-elected to avoid the populist temptation to demagogue and punish, rather than provide visionary cures.

Congressman Barney Frank, chairman of the House Financial Services Committee, could be the visionary leader that is needed before any meaningful effective reform will be enacted. He is certainly independent enough from Wall Street to be objective and, although the visionary cures suggested above might not be popular in his Massachusetts district, he runs little risk of losing his seat. Frank could be our Carter Glass.

For America to win the international competition to become the preeminent 21st century capital market, trust in our markets must be restored. In order for this to happen the American people must first trust Washington, before they will trust Wall Street. And they will only begin to trust Washington when they see more transparency, less leverage, more knowledgeable and aggressive enforcement, combined with open mindedness, innovation and selflessness in enacting regulatory reform.

Individual behavior
Washington's efforts at reform have been wrong because they are trying to change Wall Street's culture from the top down. Cultures don't change from the top down; they only change from the bottom up. Because Wall Street is so nimble and quick, Washington is always playing catch up — fixing yesterday's problem, but not tomorrow's. New financial regulation will only be effective if it changes the Wall Street culture and it will only change the culture if the new regulation directly affects individual behavior on Wall Street. Americans will begin to trust Wall Street again only when they see its culture changing and they will only trust Washington again when they see the government as a rigorous, sophisticated enforcer.

Posted March 24, 2010

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