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A Proposal for Financial Reform: Massive Deregulation

Is the path to a safer financial system a combination of massive deregulation and a return to partnerships?

Over at the Atlantic, Pascal-Emmanuel Gobry advocates partnerships and “almost complete deregulation of the financial system” as measures to prevent another catastrophic financial crisis.
(Full disclosure: I used to work with Gobry at Business Insider and I consider him a friend.)

Investment banks in the United States abandoned the partnership model and went public in two waves: first in the early 1970s and later in the 1980s.

The first wave was largely driven by a combination of technological improvement and the unintended consequences of regulations intended to promote financial stability. The second wave was driven by spread compression that drove down the value of human capital on Wall Street, and forced firms to scale up to earn the minimum required return on trading activity.

Gobry wants to undo this transformation, presumably by simply banning financial firms from being publicly-held companies. Obviously, this would be enormously disruptive and have serious social costs. As Gobry himself acknowledges, some of the more complex types of financial services may become unavailable or prohibitively costly and the supply of credit might contract.

These costs could be balanced out, Gobry argues, by massive deregulation. If financial services were freed from the various regulatory burdens and barriers to entry that the sector faces, more innovative products might replace those that appeared to demand the growth of financial behemoths. And we could ameliorate the contractionary effects on credit by having more firms accessing the pool of savings accumulated in pension funds and money markets.

Gobry deserves plaudits just for the boldness of his idea. If anything, I’m afraid he doesn’t go far enough.

The current shape of the financial sector in the U.S. is not a result of market processes. It is the result, largely, of government intervention. Government capital requirements on commercial banks and investment banks drove them to scale up and pursue short-term return on equity strategies. The first step on the way to Gobry’s reforms, therefore, might be to completely repeal government regulation of financial capital.

Look at it this way. In many ways, the recent history of Wall Street is very strange. Where technological innovation typically destroys existing market leaders in favor of newcomers, technological innovation seems to have had the opposite effect on Wall Street. The most successful firms grew as expanding computing power revolutionized financial services—largely because regulations confined financial start-ups to areas in which the government chose to allow relatively low-capitalization firms to operate. Think M&A boutiques and hedge funds. The main businesses of Wall Street were protected by a regulatory moat.

An absence of government-imposed capital requirements would not necessarily mean that firms would be under-capitalized. Indeed, you could argue that the existence of regulatory capital requirements has left firms undercapitalized.

  • Regulatory capital is always financial capital. Human capital was perhaps the most important kind of capital for old Wall Street’s partnerships. They zealously sought out the best recruits, and partners knew that their wealth required slavish devotion to the development and promotion of the young talent of their firm. Financial capital requirements forced firms to sacrifice human capital for regulatory capital—which left many of them hurting for smart, prudent decision makers when the crisis hit.
  • Regulatory capital homogenizes. As the book “Engineering the Financial Crisis” shows, regulatory views of risk resulted in firms gorging on assets such as mortgage-backed securities. This left them unstable when those assets proved riskier than regulators anticipated. And it left the financial system unstable, when it turned out that so many financial firms were exposed to very nearly identical risks.
  • Regulatory capital implicitly guarantees. Firms that adopt the regulatory view of risk by acquiring assets with improved risk-weightings can count on being bailed out, since they will typically only fail in a system-wide disaster.

It may not even be necessary to put in place an outright ban on financial firms being public companies. If freed from regulations—especially capital regulation—many firms might find that the advantages of access to public capital markets are outweighed by the costs of disclosure and shareholder-oriented governance.

We already seem to be moving in this direction. Increasingly, talented people are leaving the big Wall Street firms for hedge funds and other financial start-ups. So perhaps the place to concentrate reforming is wherever we find barriers to hedge funds and other small firms competing with the big boys.

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