Time to rein in investment banks?

One of the most chilling warnings came from London-based investment banker and author of the book Cityboy: Beer And Loathing In The Square Mile, Geraint Anderson. Anderson tells the story of traders with a reckless attitude to investment based purely on maximising their own short-term profits. Their aim, he says, is to make profits at any cost, even at the exspense of the wider society.

Like many others, Anderson has called for more regulation of investment bankers. He sums up with the chilling warning: "We do need more regulation, we need tighter controls, because otherwise there will be another one of these (financial crisis) events in 10 years time, and then there really will be blood on the streets."

In case you think that such warnings are exaggerated, you should know that Anderson’s view is shared by many prominent commentators. Another experienced operator in the financial markets, Michael Lewis, who chronicled the "greed is good mentality" in the US in the 1980s in his book Liars Poker, recently revisited Wall Street, and published a similarly damning account.

But perhaps the most dire warnings of all have come from one of the world’s most experienced economists -- the former chief economist of the International Monetary Fund, Professor Simon Johnson. Acknowledged as an expert on financial crises in both the developed world and emerging markets, Johnson is now Professor of Entrepreneurship at the Sloan School of Management at MIT, has held many academic and policy-related positions, including Professor of Economics at Duke University’s Fuqua School of Business and Research Fellow at the Centre for Economic Policy Research. He is also a member of the Congressional Budget Office’s Panel of Economic Advisers.

Someone with such solid credentials in academe and government is not usually in the habit of making alarmist predictions, but this year he has been carrying out something of a campaign in the media to get people to take the causes of the financial crisis of the past two years more seriously. He began with a lengthy article in the Atlantic magazine in May in which he argued that the Government of the United States is now in the hands of a "finance oligopoly", intent on pursuing its own interests at the expense of the country -- and the rest of the world, for that matter. Since publishing the article, Johnson has been continuing to warn of a financial meltdown through the wider media. (If you want to catch up with some of his television appearances, just do a search on Youtube.)

He sums up his view of what may be in store in these words: "The conventional wisdom among the elite is still that the current slump ‘cannot be as bad as the Great Depression.’ This view is wrong. What we face now could, in fact, be worse than the Great Depression -- because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances."

The problem, says Johnson, is that economic policy is now being dictated by the financial elite who inhabit Wall Street. Of greater concern, he says, is the fact that this elite is acting like the oligarchies that tend to run developing countries that end up in financial crises similar to the one that he believes is affecting the US. In short, he believes the US has become just like so many banana republics that have been forced to go cap in hand to the IMF for assistance and loans.

Johnson says the financial elite in the US have been making such huge profits over the past two decades that their influence in Washington has become supreme. While the financial sector has grown over the decade from 4 per cent of the US economy to 8 per cent, its share in corporate profits has skyrocketed to 41 per cent. "Pay rose just as dramatically," he says. "From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

"The great wealth that the financial sector created and concentrated gave bankers enormous political weight -- a weight not seen in the US since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the re-emergence of an American financial oligarchy is quite recent."

Professor Johnson emphasises the role that the investment banks played in the lead-up to the financial crisis: "The oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But major commercial and investment banks -- and the hedge funds that ran alongside them -- were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitised, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.

"Because everyone was getting richer, and the health of the national economy depended so heavily on growth in real estate and finance, no one in Washington had any incentive to question what was going on. Instead, Fed Chairman Greenspan and President Bush insisted metronomically that the economy was fundamentally sound and that the tremendous growth in complex securities and credit-default swaps was evidence of a healthy economy where risk was distributed safely."

Since the bubble burst, according to Professor Johnson, the main problem has been that the influence of Wall Street has been preventing government from taking hard decisions to fix the economy. Instead he says, both Republican and Democrat governments have been bailing out investment banks on terms that are highly favourable to the interests of the banks: "The principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector."

Johnson points out that the US Treasury and Federal Government have not been acting according to any "publicly articulated principles". Instead the $700 billion bailout has been carried out through "late-night back-room dealing, pure and simple . . . The money was used to recapitalise banks, buying shares in them on terms that were grossly favourable to the banks themselves."

The big banks, warns Johnson, have only gained political strength since the crisis began because with the financial system so fragile, the damage that a major bank failure could cause is much greater than it would be during ordinary times. The solution? "The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalise troubled banks and break them up as necessary."

Professor Johnson explains that nationalisation would not imply permanent state ownership, but simply a government-managed bankruptcy procedure for banks. But he says it will also be necessary to put an end to the oligopoly that the financial community presently represents. This means breaking up the oversized institutions that tend to have unreasonable influence on government policies.

"Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail . . . Anything that is too big to fail is too big to exist."

For good measure, he also suggests an overhaul of antitrust legislation that was drawn up more than a century ago to combat industrial, rather than financial, monopolies. He also calls for caps on executive compensation to help restore the political balance of power. (This measure was made more urgent following a report in late July by New York Attorney General Andrew Cuomo showing that US investment banks have continued to pay their executive billions of dollars in bonuses even as they asked for enormous public handouts to prevent collapse.)

Although Professor Johnson says that at present the political will is lacking to take the necessary steps to end the existing finance oligopoly, he believes that faced with the prospect of a national and global collapse, minds may become more concentrated: "If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite," he says. "Let us hope it is not then too late."

Bill James is a Sydney-based freelance journalist. This article is an edited version of two articles first published in Perspective magazine.