And as a result, financial-industry scandals will continue to arrive on a semi-regular basis. When they do, they will always be accompanied by calls for stronger regulation: rules-based, or principles-based, or some combination of the two. But the real problem here isn’t regulatory, and as a result there isn’t a regulatory solution. The real problem is deeply baked into the architecture of too-big-to-fail banks. And frankly I don’t see any realistic way of unbaking that particular loaf.
It’s rare and refreshing to encounter this level of clear-headedness following scandalous financial revelations. Salmon here sounds like H.L. Mencken writing about the world view of that magazine’s editors in the inaugural issue of American Mercury.
“The Editors have heard no Voice from the burning bush. They will not cry up and offer for sale any sovereign balm, whether political, economic or aesthetic, for all the sorrows of the world. The fact is, indeed, that they doubt any such sovereign balm exists, or that it will ever exist hereafter. The world, as they see it, is down with at least a score of diseases, all of them chronic and incurable…”
My only point of departure with Felix is that he doesn’t look clearly enough at how we baked the loaf of too-big-to-fail. The truth is, as I’ve explained through a long series of posts here at NetNet, is that this loaf was leavened with well-intended government regulations from the get-go.
In the early 1960s, the Kennedy administration reversed a decade-long trend away from activist regulation in the financial sector. Kennedy upset the balance at the SEC, which was mostly staffed by professional regulators with legal expertise in securities laws, by appointing a Columbia law professor named William Cary and three of his allies to the Commission.
Cary’s SEC conducted something it called the Special Study of the Securities Markets. One of its findings was that understaffing and underfunding of the SEC had led to lax enforcement that was also inefficiently slow.
Here’s how the site SEC Historical describes the findings:
In 1963, the SEC conducted its Special Study of the Securities Markets. The study concluded that, from 1959 to 1962, "activity in new issues took place in a climate of general optimism and speculative interest" but as a result of agency understaffing, the SEC extended the average review of registration statements from twenty-two days in 1955 to fifty-five days in 1961.
Cary’s ideas about market regulation did make it into law in the form of the Frear-Fulbright Act of 1964. Among other things, the budget of the SEC was dramatically increased and new rules were put in place to encourage companies to list themselves on the New York Stock Exchange by imposing burdensome disclosure and reporting requirements on non-listed companies. (These are the same rules that—decades later—forced Facebook to go public.)
We now have a far better understanding of the limits of disclosure. In particular, a paper published by a trio of scholars in 2011 demonstrated that the additional disclosure requirements provided almost no additional value to investors. The main beneficiary was the New York Stock Exchange, because so many previously unlisted companies listed on the big board. The other beneficiaries were the brokerage houses who were members of the NYSE.
But the new disclosure requirements were costly. They were a severe blow to brokerages specializing in over-the-counter markets. Many folded or merged with exchange-based brokers.
The newly-staffed SEC was processing new listings faster and companies were pouring into the exchanges from the OTC market. Volume on the NYSE increased 33 percent from 1966 to 1967. Meanwhile, NYSE brokers saw their oligopolistic hold on securities markets grow even stronger—resulting in falling efficiency at the very time when trading and listing was rapidly growing.