"As a protection against financial illusion or insanity, memory is far better than law"
The words of JK Galbraith in his seminal book, The Great Crash 1929, quoted above, are as poignant now as they were when written in 1954. The post-war boom was in full flow then and the regulations that governed financial institutions were relatively conservative certainly more restrained than during the roaring twenties.
No doubt some new academic will look back at the recent period of speculation and ponder whether memories of previous bouts of boom and bust should have prevented the sub-prime bubble. The myopia that afflicted so many participants and regulators regarding sub-prime suggests that memories rapidly fail. One year ago even as HSBC announced savage write-downs in its Household division and the sub-prime market began to collapse bankers insisted that the problem was contained.
Was the credit bubble a result of lax regulation or just bankers indiscipline? Probably a bit of both.
In an ideal world all the market participants who gorged on easy credit and are now paying the price would be left to their own devices and to nurse their self-inflicted wounds. But given the mayhem that the credit bubble has created and probably is yet to inflict on the global economy it would be remarkable if there not a significant policy response.
At present there is a push by the EU to increase disclosure and transparency in structured finance products. This is a good thing: no one would argue that opaque markets are ideal. And yet some navel-gazing must be going on in Basle.
The first Bank for International Settlements accord failed comprehensively to create an appropriate banking regime. The creation of non-banking banking entities, in the form of SIVs and other financing vehicles, was a factor that contributed to the current dislocation. The incorporation of privately owned rating companies as the arbiters of credit is another.
Instead of solving the problems that Basle I helped create, it is highly likely that Basle II could compound them. Rating agencies are again at the heart of the regulatory regime. Many US banks are not included other financing entities are ignored. The new regime indicates lower capital requirements just as banks are scrambling to put more fat on their backs.
It also ignores profound conflicts of interest in banking. The Glass-Steagall Act was designed to prevent banks from endangering themselves, the banking system, and the public from unsafe practices and conflicts of interest. In the 1920s banks were deploying their own assets in securities that put deposits at risk. Banks then speculated by making new dodgy loans to support the prices of their investments. Then bank branches were pressed into persuading their customers to purchase the same securities that their investment banking operations had created/invested in and ramped up.
In 1933 Glass-Steagall answered the question whether investment banks should engage in commercial banking or vice-versa with a straight answer: no.
And yet the Acts provisions were gradually whittled away before it was repealed in 1999. US banks found ways to get around its provisions including moving into international markets where there were no limitations. No one believes at present that banks are under direct threat of widespread insolvency from losses made in investment banking activity. Nor should any attempt be made to turn back the clock on technological advances. But investment banking is full of conflicts and the observation that these contributed to the mispricing of credit is hard to ignore.