Avoiding another global financial collapse – how?



Time to do it is now


Looking back we now recognise the negative influence of PR agencies, lobby groups and spin doctors hyping up the property speculation of the Tiger years. Much of the PR industry here mimicked the activities of their lobby group colleagues in Washington, promoting short term policies and deregulation. (And, strange to say, on radio these days we often hear the same people “talking up” their clients’ prospects, defending the HSE, the actions of state sponsored companies or acting the role of “objective” commentators on current affairs).


Hélène Rey of London Business School identifies where the malign forces of the lobby groups receive their strongest direction (and cash), from the financial institutions of Wall Street. She explains that current economic trauma will continue unless those who created the problems are brought under control. And the time to do it is now.



What happened

The worldwide economic downturn sprang largely from the US and, more specifically, from the investment banks, rating agencies, Washington regulators and other players in big-time Wall Street finance.


So at this juncture — when the US Congress is considering financial regulation reform and the US Securities and Exchange Commission (SEC) has at last brought action against all-purpose bad guy Goldman Sachs — we would do well to take a look back at what we learned about the origins and unfolding of the American financial crisis, so we may take an informed look ahead at whether we may reasonably expect reform of US financial regulation potent enough to avert a similar future collapse.


Looking back

With a nascent economic recovery seemingly underway, a number of participants and observers of the financial collapse have come forward, willingly or not, with treatises, letters, testimony, books and seemingly numberless email messages — a critical mass that permits some conclusions regarding the origins of and reactions to what became a global financial crisis:


  • The massive consumer indebtedness and current account deficit of the US preceded, and contributed to, the crisis — as did the US Federal Reserve’s monetary policy, which held interest rates too low for too long.


  • The structure of compensation within large US banks (and Irish banks!) encouraged wild risk taking, while regulators were too complacent or too indulgent in the face of the banks’ charm offensive.


  • A revolving door of officials who have shuffled over the years between Wall Street’s major players and various US presidential administrations — particularly those of Clinton and Obama — has raised more than a few eyebrows.


  • Ratings agencies, wishing to protect their ever-increasing profits from Wall Street, failed to properly assess risk of the overly creative and complex financial instruments built on the shaky foundation of sub-prime mortgages.


Some economists warned of the inevitable bursting of the “housing bubble”, but others were vocal in their flimsy justifications of unprecedented increases in house prices. When the financial mess moved from Wall Street troubles to worldwide economic crisis, policy makers reacted more often with confusion than assertiveness. In the institutional collapse that we now know most merited a US government bailout (that of Lehman Brothers), the US Treasury Department declined to act and thus contributed to the further destabilisation of financial markets. (In his subsequently released memoir, then-US Treasury Secretary Hank Paulson attempts to shift blame to the British Treasury for this failure. The latter, he claims, blocked the Barclays takeover of Lehman Brothers at the last minute, due to surely justified fears of a devastating impact on stability of the British financial system.)


While the US government failed to aid Lehman as it should have, its multiple rescues of insurer AIG appear to have been misguided. The principal beneficiaries of the government’s AIG assistance — no surprise — have been the largest of Wall Street’s banks.


Looking ahead

Just about everyone in Washington — from the White House to the regulatory agencies to Congress, on both Democratic and Republican sides of the aisle — is agreed that significant reform and strengthening of US financial regulation must occur to prevent another financial collapse and further bailouts of Wall Street by American taxpayers.

But one must wonder if this across-the-board momentum toward reform will be turned back, or watered down to ineffectiveness, under the withering lobbying firepower of Wall Street’s powerful financial institutions. From January through September 2009, financial institutions spent $126 million to influence Congress. The financial sector’s frenzied lobbying is already hammering away at stopping or weakening proposed regulation of derivative products, particularly the credit default swaps at the heart of many speculative strategies.


Prospects for meaningful financial reform may be called into question with a look at recent scholarly writings that examine the effectiveness of US lobbying activities by financial institutions. For example, a recent research article (“A fistful of dollars: Lobbying and the financial crisis”, www.imf.org/external/pubs/ft/wp/2009/wp09287.pdf ) poses an important question: why was the regulation of the mortgage market so faulty before the economic crisis? The authors respond simply and precisely: the financial institutions implicated in the excesses of the sub-prime market are those that spent the most money lobbying the US Congress.


Between 2000 and 2006, American financial institutions spent from $60 million to $100 million annually on lobbying efforts. Most of these efforts were focused on proposed legislation dealing with real estate lending and securitisation. Securitisation, more than any other factor, led to both the transfer of toxic assets to the balance sheets of many financial institutions, pension funds and government units and to the deterioration of credit quality. Banks that securitise and sell financial products to other institutions have little incentive to be concerned about the quality and ratings of the loans they sell off.

The financial institutions that spent the most money on showering Capitol Hill with campaign funds, lavish trips and other favours are also precisely the institutions that issued the riskiest loans, resorted to securitisation the most and had the fastest-growing portfolios of ever-riskier real estate loans. It seems reasonable to suppose that these same institutions were able to influence the quality of market regulation with their lobbying prowess.


Given the revenues, profits and compensation schemes of Wall Street’s heavy hitters in lobbying, it’s hardly surprising that they’re now throwing all their weight into shaping regulation of the financial system in a way that would preserve their rents. Will Congress, the White House and the regulators be able this time, unlike previous times, to resist?



Hélène Rey, Professor of Economics at London Business School


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