From financial market deregulation to fragmentation: Ladies and gentlemen, you screwed up

Don't blame us

Don’t blame us

Today’s post is by Markus Schuller of Panthera Solutions, a participant in the recent OECD Financial Roundtable.

On October 17, delegations from the OECD’s 34 member countries, central bankers and financial market actors met to talk about financial fragmentation (geographical and sectoral segmenting) at the semi-annual OECD Financial Roundtable. It was an interesting discussion on how serious fragmentation was and how much financial integration we need, but the focus turned quickly on financial regulation, with the lobbyists talking their book (they could have sent a recording and saved themselves the time and expense of coming to Paris).

In the Eurozone for example, financial fragmentation means that a company in the peripheral countries will face higher financing costs than it would in one of the core countries of the currency union, for the same level of idiosyncratic risks and opportunities. This prompts the question of whether financial fragmentation hampers economic convergence and contributes to the painfully slow recovery.

Fragmentation isn’t necessarily negative: it can for instance allow more accurate pricing of the different, separable components of a system. But since the early 1980s, the increasingly global exchange of goods and services has relied on a more globally-integrated banking system and financial markets to allocate real economy resources. As a consequence, inter-connectivity increased, separability decreased.

Nationally-based regulation was clearly not the best framework to deal with the emerging financial system, but instead of a multilateral approach, governments listened to the banks’ “self-regulation” mantra, in harmony with the 1980s deregulation zeitgeist advocated by Reaganomics and Thatcherism.

It didn’t work. The dysfunctionality of self-regulation is not a specific characteristic of the banking industry. In numerous industries we got cartelization, price rigging and other forms of wheeling and dealing. In the banking industry, the combination of globalization, deregulation and digitization led to balance sheet inflation, followed by a fast-increasing gap between real economy utility and financial markets profiteering. We also got what Nassim Taleb and Warren Buffett called participants with “no skin in the game” – not playing with their own money. The people making the decisions didn’t stand to lose anything personally if they got it wrong. Investors and taxpayers took the hits for “Too-Big-To-Fail” institutions.

The blame game between market participants is still hard fought, especially between the big banks which are impacted most by the current re-regulation wave and governments. The banks complain about insufficient international coordination for the new set of rules. Governments blame the banks for socializing losses and accuse them of being responsible for the current regulatory countermovement.

Ladies and gentlemen, you both screwed up. But a couple of examples allow us to see that it didn’t happen overnight.

First, the repeal of the 1933 Glass-Steagall-Act (GSA) that prevented US investment banks operating as universal banks, contrary to their European peers. In the 1980s, European institutions aggressively entered the US underwriting market with competitive offers, thanks to significantly larger balance sheets and higher gearing (debt to equity) and started taking IPO business away from US banks. In 1999, insisting lobbying by US banks bore fruit and Glass-Steagall was repealed.

Second, investment banking partnership. For over 100 years, US investment banks were organized as private partnerships. Partners clearly understood the meaning of being finally responsible, as they ultimately had to pay for mistakes with their private wealth. Merrill Lynch went public in 1971, Bear Stearns followed in 1985, Morgan Stanley in 1986 and Lehman Bros in 1994. Goldman Sachs was waiting until GSA was repealed and got listed in 1999. These changes in status can be seen as a sign that the banks had less “skin in the game”. Or as the last stage of a rocket blasting them into irresponsibility.

Governments thought they were doing the market – or at least their largest party donors – a favor by loosening regulatory norms. Banks took this an invitation for unethical behavior and for unproductive profit maximization as far as the real economy is concerned. Big central banks had managed to position themselves as independent guardians of a stable monetary system. Now, almost as innocent bystanders, they (that is you and I) have to pick up the bill for both blame-game parties. The central banks pay with their independence.

The re-regulation wave symbolizes the attempts of governments and regulators to level the playing field with financial market participants. These attempts lack proper international coordination, for two reasons I explained in my contribution to the Roundtable.

Governments and regulators need to decide whether they want to use their systemically relevant banks as a tool for geostrategic power or for establishing an efficient market. Officially, the latter is the goal. In off-the-record conversations though, some officials express concern at the fast rise of banks from emerging economies, especially Asian banks, in terms of balance sheet and market capitalization, allowing their governments to use them as strategic options in the global power game. Given that, the argument goes, developed market representatives should not to be too restrictive regarding their own systemically relevant banks.

The second reason is more fundamental: economics is a social science, and the same goes for finance as a subset of economics. We are dealing with human behavior and social interactions that cannot be modeled using the deterministic approach of natural sciences, where for instance gravity always pulls the apple down from the tree. In systems theory, we would call that a trivial machine, but we’d have to call humans and human society “non-trivial”. With us, the same inputs can lead to different outputs. Pity the poor regulators trying to tame a moving, non-trivial social construct while being in motion themselves. Even when assuming high technical competence, high ethical standards and a strong will for implementation, this is an extremely complex task. Consequently, a lasting, single-shot version of re-regulation cannot be expected, and all financial market participants are currently paying the price for a culture of irresponsibility.

While developed market governments fail to make it clear explicitly whether they’re going for the geostrategic power option or for efficient markets, an implicit preference for the power option remains, and the foundation for further social and economic collateral damage is laid.

Useful links

OECD work on financial markets

Finanzielle Fragmentierung. Mein Beitrag. Markus Schuller