Be Wary of the Pendulum

It is the end of casino capitalism. The end of the era of greed. A new financial world order is on the way. These are the clarion calls coming from many people all of whom share the anger at a financial and banking system that has failed them. Central banks and regulators and politicians of all stripes have already signaled that important and systemic changes are on the way. They have all had to adjust- if not abandon- their previous commitments to free market capitalism in order to address the financial and banking system failures. People like Hank Paulson -who is the poster-boy for those committed to the principles of the free market- have had to admit to the failures of the existing system and turn to highly unusual and unpalatable options like bailouts, guaranteed loans for banks and government taking a more active role as an equity partner in financial institutions. Around the world it is a similar story. In places like the UK and rest of Europe, there have been even more dramatic system failures and more dramatic responses including bank nationalizations and provisions for government to play a role in the governance of financial institutions, particularly those who line up for financial assistance from taxpayers. European governments have nationalized some of their largest banks and have indicated that all financial institutions will come under greater governmental control and supervision.

While many of these governmental decisions were the result of necessity rather than choice, they will still have potentially far-reaching consequences. And the consequences are not limited to the financial costs of having taxpayers and their governments fix the banking system. Another serious consequence will be the impact of having government take on extraordinary responsibilities for the governance of financial institutions, for making policies on executive compensation and board composition, for making decisions on appropriate level of leveraging and appropriate levels of risk-taking. Though the markets have not done a particularly good job in managing theses issues, it is certainly optimistic- if not dangerous- to expect governments to do the job much better. Governments and taxpayers are certainly entitled to have a say on these issues; issues that are fundamental to the legitimacy of the banking system and capitalism in general. Governments and taxpayers are even more entitled to have a say now since they have assumed the financial risk for reviving a system that has failed under the burden of its own excesses and own mismanagement. But the political process has its own inherent flaws that usually prevent it from being an effective owner or manager and that preclude thoughtful depoliticized deliberation in times of crisis. The political and regulatory process has often been a breeding ground for unintended consequence. There are many who argue that the failures in the financial system have been at least partly due to incentives that the regulatory system itself created. For example, accounting and banking laws may have created perverse incentives to remove liabilities from banks’ books which they did through repackaging liabilities (and associated risk) and selling them to others, who did the same, and so on until it was difficult to determine the value and underlying risk of these assets.

If governments and regulators want to improve the functioning of the banking and financial system, they need to acknowledge and assess the consequences of previous attempts to regulate problems in the system. New policy and new regulation will not meet the challenges ahead just because it is new or fills gaps. Filling some gaps often leads to pressure in other areas; gaps and pressure that will be exploited by the talented chemists who toil tirelessly in the meth labs of finance. There is undoubtedly a role for improved regulation, particularly of those instruments and institutions that have so far largely evaded the regulator’s view: derivatives, securitization, hedge funds, mortgage brokers, credit rating agencies. But there is a level of complexity and sophistication that preclude simplistic and clumsy regulatory response. Regulators and politicians must proceed with a much better understanding than we currently have of what led to the current crisis. Though this should be a first priority, it will take some time and so too will creating a regulatory framework that does not merely shift problems around or create new ones.

Despite these cautions and calls for sober reflection, there is a political reality in play: the pendulum. The pendulum is a potent force in politics and it is currently building significant momentum away from a light regulatory hand to a heavier and more paternalistic grasp. This political and regulatory “shift” will likely have implications far beyond the banking and financial institutions. The regulators and politicians are already circling and discussing the need for changes to a wide variety of laws on corporate governance and supervision including executive compensation and a more diverse board elected through a more democratic shareholder process. And it is not only the banking and financial sector that should pay heed to this swinging pendulum. There are signs that the distressed auto sector will also require a governmental hand: a hand that will inevitably come with many strings (or mittens) attached.

With the financial crisis still fluid and severe, and with the political environment in the United States poised for imminent and potentially dramatic change, we should all be reconciled to some form of increased government involvement in the financial system, at least in the short term. Some will welcome it. Some will fear and oppose it. Whatever your ideological predisposition, we must all remain vigilant in our commitment to good financial regulation that encourages innovation, freedom of choice, the efficient movement of capital and depoliticization. And this will not be accomplished through a premature, unsophisticated and knee-jerk political reaction.

By Robert Adamson
October 16, 2008