Clowns to the left, jokers to the right.
Clouds and silver linings and all that… Yes, it would seem that the US might finally get a more intelligent, less balkanized regulatory environment for financial services. Before the announcement yesterday, Forbes reported that Treasury Secretary Paulson would be unveiling a comprehensive ‘overhaul of US financial regulation’:
Paulson’s plan would give the Fed regulatory authority over all financial institutions that operate with government guarantees such as deposit insurance for banks and would cover the insurance industry. A new regulatory agency would oversee consumer protection issues while the Office of Thrift Supervision, which supervises thrift institutions, would be folded into the Office of the Comptroller of the Currency, which regulates banks.
The plan is also understood to include merging the Securities and Exchange Commission with the Commodity Futures Trading Commission, and to provide for tightened regulation of mortgage origination.
The proposals are likely to generate intense scrutiny in Congress and within the financial services industry. Past efforts to change how regulation is handled have met with strong resistance, especially those affecting the insurance industry which has fought off past efforts to switch its regulation from state to federal level.
In the event, this was pretty close (via Reuters):
The proposals, in the form of a 218-page “blueprint” that was started before markets unraveled in August, offer no quick fix for the credit contraction that threatens to tip the U.S. economy into recession. The plan was already meeting some resistance from Capitol Hill and competing corners of the government bureaucracy as a potentially protracted debate took shape.
Under the proposals, the current patchwork of as many as seven federal regulators would be consolidated under three agencies: the U.S. Federal Reserve, a newly created financial regulator, and a third agency for consumer protection and business practices.
As a starting point (and without having read the underlying report), it would seem like this is a fairly sensible direction. Of course and unsurprisingly, the reactionaries in the room are already crying foul; in trading that’s called “talking your book.” Indeed if your competitive advantage and or your livelihood is predicated on maintaining and/or navigating a thicket of over-complex and over-lapping regulatory regimes, it is hardly surprising that you aren’t exactly going to enthusiastically embrace simplicity and transparency. I mean without the kafka-esque and byzantine system of state insurance regulation, you might get far too many upstarts innovating and competing…that wouldn’t do at all…and it is logical to assume that no one but the CFTC could properly regulate futures markets right?
While removing unnecessary complexity from the regulatory environment is a good thing in and of itself - a necessary but not sufficient - response to contemporary financial market stresses, it doesn’t really get to the heart of what drives most (if not all) systemic crises in financial markets. In my opinion, the combination of substantial leverage with significant hubris lies at the root of the excesses that are now being unwound. Of course I am not alone in articulating this opinion, and there are many who would in fact look to specifically target regulation with the goal of limiting both of these elements. I would strongly caution however the law of unintended consequences is likely to apply in spades and so would be loathe to try to manage either of these via legislation or prescriptive regulation.
That said, for any institution that is either ‘too big and/or complex and/or interconnected’ to fail (and thus subject to a de facto government or central bank bail-out) it would seem reasonable to expect them to have their leverage signed off by a regulator. The key is to make a distinction between allowing someone to blow themselves up (no problem, no need for outside interference) and allowing someone to start a chain reaction (due to their size/complexity and/or connectedness) - and this irrespective of what kind of institution they are (bank, securities firm, hedge fund, insurer, etc.)
Hubris is harder to manage or regulate. Mandating what bonuses are to be paid would be a fools game, solve nothing and almost certainly give rise to toxic unintended consequences (not to mention the ‘wasted’ creativity dedicated to navigating around whatever rules were invented.) If a private company wants to line it’s employees pockets in a highly asymmetrical fashion that is a matter for its shareholders to take-up with management… Instead, I would suggest that the only way to mitigate hubris in the financial markets is to allow creative destruction has to operate over time. Clearly the compensation paradigm of the investment banking industry is inappropriate to the nature of the business and risks that they run. The least worst form of organization and compensation structure for the industry is I believe the partnership. (It is not surprising that Goldman Sachs is consistently the most successful bulge bracket investment bank given that it was the last to end its formal partnership and still to this day maintains by far and away the culture and compensation policy closest to that of a traditional partnership.) It is also unsurprising that on average, the investment banks have fared far worse than hedge funds over the last year. So if this is true, why did partnerships largely disappear (or become marginalized) over the past 20-30 years? Firstly, the rise of OTC derivative markets and other facets of ‘modern’ finance required ever larger balance sheets and capital resources to the extent that these became out of reach for even the largest and most successful partnerships. Secondly, the sustained bull market (and quick intervention of the Fed in times of duress) papered over many of the intrinsic advantages of partnerships - ie banks (and bankers) could have their cake and eat it too.
I would speculate however that the next decade or so might see a return to prominence for small and medium sized banking and investment partnerships. Indeed to some extent this is already happening. Don’t get me wrong, I’m not suggesting that the giants are going to disappear, just that they will inevitably refocus on the elements of the business where large financial resources are a true sine qua non and/or competitive advantage and retreat from the elements of the business where these are just a license to take inappropriate risk. For example, instead of a monolithic Citigroup as we know it today, you might have a galaxy of small to medium size firms orbiting the core Citigroup balance sheet and banking functions (payments, deposit taking, etc.)
For a number of years I’ve been saying that fundamental change in the investment banking industry was inevitable; it was only the timing that was uncertain. As long as record profits kept rolling in (however fragile or unsustainable they may have been in the long term) nothing was likely to change. Unfortunate but understandable. But turbulence and losses typically catalyze change; this just might be the beginning of the new paradigm I’ve been waiting for. 
