Reason Foundation

http://reason.org
http://reason.org/news/show/a-messy-story

Reason Foundation

A Messy Story

Book Review: How the financial system lost its way

James Groth
October 11, 2011

Prior to the 1970’s, the financial landscape was a quaint, rural community where a bustling metropolis now stands. Over the past forty years the banking industry has undergone extraordinary changes, moving from a simple and vast collection of small banks, securities brokers, S&Ls, investment banks, and insurance companies to today’s mere handful of complex, massively-interconnected megabanks.

In The Megabanks Mess, Herbert M. Allison, Jr., looks at this structural evolution and tells a story of competition, deregulation, and constant change to market structure that culminated in the current financial industry of huge, highly-diversified institutions. Allison argues that before this evolution took place, competition amongst bankers was “low-key, genteel, and localized.” Because of the fixed nature of many prices and rules, he notes, the need for financiers to expand and "innovate" was unnecessary. 

Over the past few years, the deregulation narrative has taken firm root as a leading explanation for what caused the financial crisis. Never mind that the financial industry was one of the most heavily regulated in the decades leading up to the crisis—with more regulations added than taken away in the George W. Bush years. While this irony is lost in the tale of The Megabanks Mess, it is true that there were some big regulations removed in 1980s and 1990s. 

Allison argues that as the rules changed, the market structure was modified, and this led to plunging profits for traditional financial products and businesses. Banks and securities firms were forced to find new ways of growing revenues and profits; these came in the form of new financial theories, products, and activities. The modern portfolio theory was developed, including CAPM (capital asset pricing model) and Black-Scholes mathematical modeling. Trading activity mushroomed in swaps, options, futures, FX, commodities, and tailored derivatives. Profits ballooned, and firms flourished.

Such immense growth in size and profits revolutionized the financial industry, changing its focus to short-term gains as opposed to long-term value—previously, the financier’s creed. Allison fails to note that contributing to this shift in mindset was the growing sense within the industry that the new, larger-than-ever financial institutions were becoming too big to fail. The incentive structure to ensure responsible risk management was left behind. 

Allison interprets this as greed (meant in a pejorative sense). He writes that it drove short-term minded players into innovations like junk bonds, exotic OTC derivatives, and an increasing amount of cross-selling and creative accounting, whereby, in an effort to increase the amount of fees garnered from transactions, financial firms would sell (1) as many products as possible (2) numerous times (3) to seemingly any buyer (4) with significant concomitant risks being imposed on clients.

Whatever the cause, The Megabanks Mess chronicles well that the outgrowth of market structure changes and innovation was a prolonged boom in financial assets that grew tremendously for almost forty years until the industry was abruptly brought to its knees during the financial crisis.

Allison points to flaws in the megabanks' business model as root cause of the crisis. He notes the obsession with short-term profit, excessive compensation plans, conflicts of interest with clients, and misaligned pricing structures as direct contributing factors. Though the actors, both junior level and board level, should clearly be faulted, the industry, itself, exerted perverse influence, as well. Allison writes: "Far more useful than 'greed' in explaining the bankers' excessive risk-taking is that they dutifully responded to the industry’s prevailing pressures and incentives, and to stakeholders’ expectations, without stepping back to reflect on the gradual distortion of corporate principles and personal behavior that was almost imperceptible in their day-to-day pursuit of narrow goals."

This is a fair point, and one that should be worked into the standard free market narrative. Yes, loose monetary policy and federal housing subsidies were key drivers in the financial crisis. But, the catalyst was a financial system that lost its way. The reason it lost its way is still important—those nasty misaligned incentives—but we should understand the way that market actors perform, and how challenging it can be to reject the ebb and flow of the financial industry. 

Ideally, The Megabanks Mess would have articulated how this analysis highlights the need to remove particular rules, subsidies, or lack of enforcement in prosecuting fraud. Instead, Allison skips over the root and offers a proposal for transforming megabanks. The way forward, as he puts it, must begin with a return to the industry’s guiding principle: “The clients’ interest comes first.” An outline is put forth containing the necessary steps to achieve this path which suggests breaking-up the banks, adopting client centric business models, changing compensation policies, and empowering shareholders. He also calls for the rewriting and restructuring of the financial regulatory framework stating that the current financial overhaul, the Dodd-Frank Act, is much like the failed regulations of the past in that it is reactive and not preventative. 

The goals of more accountability for managers by shareholders, less politically powerful banks engaged in perverse rent seeking or market-manipulating practices, and compensation practices that better align the interests of financial institutions are all good intentions, and Allison’s observations of the financial industry’s transformation over the past forty years offer clear and concise insight into the revolution that led to The Megabanks Mess. But, his solution to the problems these banks present is misguided, unattainable, and a bit naive. 

Although well-intentioned, to think that bankers would rather "connect with a mission that makes a difference to others in society as opposed to simply maximizing profit," and that "shareholders should be able to communicate easily with each other and call special meetings," is pie-in-the-sky. And, his solution to use the power of the government to dictate changes for shareholders, compensation, and bank size simply perpetuates the system of narrowly-defined rules by a group of supposedly enlightened men who will make every effort to save us, but just lead us right back down the path to destruction through a series of unforeseen and unintended consequences.


James Groth is Research Associate


Print This