This is dated post. In April I gave a talk before the Tulsa Council on Foreign Relations. It was formed in 1943. The talk was on The Globalization of Financial Policy-Making: Implications and Choices for the USA. It was my contention that one unexpected result of the global financial crisis and the government’s response to it is a move toward greater international economic coordination.
Philbrook Museum, Tulsa Oklahoma
Now, in the latter part of May, the Senate has passed a financial services reform bill. I think it’s better than many expected. It now goes to conference committee to iron out the differences.
Once the bill is signed by the President, all eyes should turn toward Basel, Switzerland. Large parts of the talk are still critical. Here are some excerpts of the main points, at least the ones that aren’t out of date because of Congressional action.
The rise of global financial centers and global financial companies helped knit together an evolving global economy, especially after the fall of the Berlin Wall. Still, it not all that clear how much all the trillions of dollars in financing has meant to everyday entrepreneurship, however. Not much. It seems clear that too many smart people went into finance in recent decades and did much more to enrich themselves than society. Fact is, finance got too big and too much money was made off of being in the right place at the right time to profit from an uptick in stock prices or gold.
So what’s to prevent that from continuing? The risk remains great.
(I use the word bank, Wall Street, financiers and finance interchangeably. But the focus of my remarks is on those financial firm’s judged too-systemic-to-fail here and abroad, in London, Frankfurt, Sao Paolo, and Shanghai, as well as Wall Street. The reason why I say too-systemic-to-fail rather than too-big-to-fail is that while much of the concern is rightly focused on giant multinationals such as Citi and BofA, Barclay’s and UBS, the key isn’t size but links throughout the global capital markets. Would an institutions failure put the entire global economy at risk. The insurance company AIG almost did. So did the hedge fund Long-term Capital Management several years ago. Goldman Sachs can.)
First, a critical question to think through is can a global financial system be made safe without creating a global regulator? Mike Mandel, BusinessWeek’s former chief economist, once argued that in theory what the global credit crunch showed is that the world needed a global board with the power in a crisis to decide how much each country will contribute to financial bailouts and guarantees. But, he quickly added, let’s get serious: Can you imagine Barack Obama, President Hu Jintao of China, Chancellor Angela Merkel of Germany, and other G-20 leaders allowing a global authority to control trillion dollar spending decisions during a crisis?
University of Tulsa
Sovereign nations will remain the key players. But we don’t need a global regulator. What we do need is is uniform global rules for those institutions deemed too-systemic-to-fail—no matter if there home country is China or the U.S. Put it this way: Better regulation is necessary, but it needs to be done internationally.
That an international reform agreement is even more important than many of us think. By the way, a focus on beefing up U.S. regulation is good but it won’t work in a global economy. This came home to me recently reading Roy Smith’s new book, Paper Fortunes: Modern Wall Street: Where It’s Been and Where It’s Going.
Smith is a professor at New York University and a former Goldman Sachs partner. He graduated from Harvard Business School in 1966 and took a job at Goldman Sachs. He estimates that only 5% of his class of 800 went to work on Wall Street, probably because the industry’s reputation still hadn’t recovered from the debacle of the 1930s and its pay wasn’t competitive with other leading businesses. Smith started out at $9,500 a year, with no mention of a bonus.
Back then the investment banking business was tiny, comprising some 20 partnerships with an average of 500 employees and an aggregate capital base of around $100 million. Morgan Stanley dominated the blue-chip securities business, yet in the mid-60s “many of the partners sat in one large Dickensian room behind matching mahogany roll-top desks so they could easily communicate with one another when they needed to,” he writes.
It has since evolved from a fragmented community clustered in lower Manhattan into a global behemoth dominated by large, publicly traded firms that earn more than half their income outside the U.S. Foreign nationals making up over half their workforce. Wall Street is Goldman Sachs and Citigroup. It’s also UBS and Deutsche Bank.
The big financial players will continue to expand their reach beyond any single national government. Rather than being concentrated in New York or even London, they will go where the growth is. As a result, they will have their revenues and assets spread more or less equally across the U.S., Europe, and Asia.
Second, governments and regulators can’t stumble on major international regulatory reform or the odds are that we’ll end up in an even bigger financial crisis several years. Financiers learned during the credit crunch that the path to true riches lies in making as many “heads-I-win, tails-the-taxpayer loses” bets as possible. It’s now in their DNA.
The lesson financiers have learned over the past three decades is that the government safety net has been widely extended. It won’t happen tomorrow or even next year but when the good times roll again—and they will—memories will fade and profligacy will drive out prudence. Financiers will take bigger risks by borrowing way too much to speculate and gamble, well aware that the profits remain privatized while the losses have been socialized.
Downtown Tulsa
The lesson for everyone else is simple: The more financiers puts the global capital markets at risk the more it needs to be tightly controlled. The proper oversight now will eliminate the need for apologies later.
Third, governments and regulators can’t afford to risk another implosion. The next one could inflict the kind of body blow we just managed to miss this time around. In many respects the U.S. acted as lender of last resort for the global economy. Yet with the dramatic rise of public debt in the U.S and the unpopularity of bankers on Main Street the American political economy might not allow for a reprise. Put it this way: Do you really think Congress would pass another TARP? Would the Germans go along with another bailout of Greece?
Europe is in worse shape than the U.S. The European Union may have a single currency and a single monetary authority, but the fiscal position of many European states is a mess. Japan is burdened with the world’s largest public debt. Investors fear that developed nations have added to their fiscal burden just as their enormous entitlement spending obligations for older citizens are about to kick in. Americans are well aware that the roughly 76 million baby boomers born between 1946 and 1964—the most talked about generation in history–is entering its retirement years. The oldest boomers were eligible to collect Social Security in 2008 and they’ll be eligible for Medicare in 2011.
The rest of the wealthy economies are even older. Japan is the world’s oldest country. For the first time in the European Union the number of 60 to 65 year olds approaching or entering retirement outnumber school graduates by about 200,000.
William Buiter, chief economist at Citigroup, calculates that more than 40% of the global GDP—and its mostly advanced economies—is running fiscal deficits of 10% or more. These are far from comforting numbers. Countries will be forced to face highly contentious issues about increasing taxes and cutting spending. Another major shock to the global economy through a bank-led credit crunch would be a fiscal disaster.
Fourth, and this is the one optimistic note, a sensible outline for reform has emerged from discussions at the Bank for International Settlements, the IMF, the OECD, the Fed, other central banks, think-tank’s, and academia. No system is foolproof. Managements will push their accountants and lawyers to game the system. Memories do fade the longer the good times roll. Bank lobbyists are savvy and well-paid.
Nevertheless, the outline of a compelling internationally based regulatory regime has emerged. It would be far better than what we had yesterday or we have today. Simply put, the global rules would require higher capital ratios and liquidity requirements linked to the phases of the credit cycle. Banks would be limited in how much leverage they could take on. Greater transparency would be mandated through the use of exchanges for derivatives and similar securities. Banks would be forced to accept market-based mechanisms for strengthening market discipline over risk taking. These measures would include being required to sell bonds that would automatically convert into equity during periods of stress. It’s essentially establishing a mechanism for a quick pre-packaged bankruptcy to minimize the turmoil and fallout.
The economy and taxpayers are at risk to many kinds of leveraged firms whether it’s called an investment bank, insurance company, commercial bank, or hedge fund. The key is to end up with a modernized, streamlined regulatory structure that reflects the reality of competition and overlap among financial-services companies.
Here’s the good news. A set of guidelines has emerged that would be a huge stride forward. The international regulatory framework known as Basel 111—there have already been Basel 1 and Basel 11—touches on some of them. Even Alan Greenspan in recent Congressional testimony lent his support—not sure if that’s helpful or not!
Leveraged financial firms should be required to carry higher capital ratios. Derivatives would be traded on exchanges or in the sunlight and move out of privately negotiated deals or the shadows.
But the real trick is internationally requirements that essentially rely on creating automatic market-based mechanisms that reinforce regulatory discipline, punish wrongdoers, and limit the odds of a government handout.Highly interconnected financial firms be required to issue debt with covenants that automatically convert the bondholders into equity owners in times of trouble. The trigger for the ownership swap could be regulators saying the system is in crisis or the firm’s finances breach certain safe ratios of capital and assets. The requirement would include everyone from Goldman Sachs to Citigroup to John Hancock to Barclays to UBS to deutche bank.
The covenant could certainly make existing owners wary of making too-risky bets. It certainly would help keep losses painfully private.
The combination of new capital requirements and a new market based trigger for regulatory action offers the hope of avoiding future major bank bailouts and, by the way, allowing for genuine competition among financiers.
It’s ideas like this that could both allow for protecting the dynamism of global capitalism and protect the taxpayers of the world from banker profligacy.
.
