When we look back at the last four years, from the Bear Stearns conference call to its forced sale, and then the collapse of Lehman when all hell broke loose, we do not observe that the long-term fundamental problems have been resolved or that needed structural changes in the banking industry have been implemented. We quote from Robert Wilmer’s latest letter to bank shareholders (HT: BP):

our overall financial services industry continues to be characterized by attributes which contributed to that crisis — characteristics which distinguish it from traditional banking, which impose burdens on those banks (such as M&T) that pursue a traditional approach and which pose significant risks to the long-term health of the American economy.

Specifically, I am concerned about a powerful combination of factors: increased concentration in the financial services sector, where profits are driven by how well one trades rather than the prudent extension of credit that furthers commerce; a resulting outsized-compensation system which disproportionately draws talents away not just from traditional banking but other professions crucial to economic growth; a government regulatory regime which both enables what I have described as this “virtual casino” to continue, notwithstanding its role in precipitating the financial crisis — and which, by not recognizing the difference between Main Street and Wall Street banks, financially burdens the “real economy.”

This story begins with one of increased concentration. Banking, traditionally, has been a community and regionally based enterprise in the United States, one which relied on local knowledge to guide that crucial process of gathering and safeguarding customer deposits and in turn extending credit for enterprise and commerce. Done well, this intermediation ensures that those deposits are deployed into a diversified pool of investments and provides American households with liquidity and a return on their savings. Over the past generation, however, the profile of the financial services industry has changed dramatically…

the largest bank holding companies have come to rely on a much broader and complex range of activities, in exchange for the prospect that higher returns might be realized. These activities include trading in all shapes and forms of derivatives, credit default swaps, mortgage-backed securities and other even more complex and exotic instruments (often associated with high amounts of leverage) — for which the collapse in value played the key role in precipitating the 2008 crisis…

In 1990, the largest six financial institutions accounted for 9% of all U.S. domestic deposits and 14% of all banking assets. As of September 30, 2010, the six biggest banks accounted for fully 35% of such deposits and 53% of banking assets…

In 2009, the six largest bank holding companies had combined trading revenues of $59.7 billion and pre-tax income of just $51.4 billion. In 2010, the story is similar. The top six made $75.7 billion in pretax income aided with $56.1 billion of trading revenues…the trading revenues of these six institutions during those two years represented 93% of such revenues at all American banks…the combined trading revenues of just four of the six banks amount to more than the total income, before taxes, of the rest of the entire U.S. banking system…

To categorize such institutions as of the same species as traditional commercial banks is akin to describing dinosaurs as simple reptiles — it is true but profoundly misleading…those financial services institutions which engage in and rely on [such trading revenue] are fundamentally different than traditional banks — and that the public should not view them as indistinguishable and government should not regulate and support them as if they were.

You may recall that one principal cause of the 2008 financial meltdown was the $60 trillion (or maybe much more) in the unregulated and potentially toxic derivatives called Credit Default Swaps. You may be surprised to learn that progress to date in changing that has been very slow, to put matters charitably. Indeed, there aren’t even fully vetted rules in place on how things will eventually be handled.

Top down solutions are occasionally effective, but often cause more problems than they cure. Sarbanes Oxley did just that, according to many small and mid-cap directors, changing public company boards from 80% strategy and 20% process into just the opposite, a ridiculous waste of time all for government CYA. Our approach after Enron would not have been to pass new laws, but to enforce the ones on the books and make it clear that heads will roll (as indeed they did in that case).

Likewise, a top down regulatory regime on derivatives runs the risk of creating its own worst nightmare: traders and banking executives who are completely focused on gaming the system while remaining ever-so-technically within its limits. That’s a recipe for disaster. There are perhaps other alternatives. Metaphorically, one would consist of a self-regulating industry group of wise-guys, working in a conference room with a guillotine in the corner. That may not be perfect, but it seems to us better than what’s been done in the four years since this mess started.

This entry was posted on Thursday, June 2nd, 2011 at 6:15 pm and is filed under business, Democrats, General, Law, Republicans. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.