The Banks We Need
The 2008 crash and its consequences proved beyond a doubt the need for stronger and smarter regulation of banking and finance. Getting this right remains a challenge, but there's been progress. One worsening obstacle to intelligent rule-making, though, should be cleared away before it becomes a bigger nuisance than it is already -- and that's a lazy, ill-founded prejudice against the finance industry and its workers.
Seven years after the worst recession since the 1930s, anger at Wall Street, the City of London and other financial centers is hardly surprising. Although there is plenty of blame to be apportioned -- to government, regulators, ratings companies and a public that refused to recognize some basic risks -- the harm caused by the industry's errors was enormous.
Banks had woefully weak internal controls. Documentation for mortgage lending was sloppy at best, willfully negligent at worst. Companies rating securitized loans were woefully unprepared for a black swan event. There were investment professionals who certainly should have known that higher returns come with higher risks. Tragically, innocent bystanders saw their careers destroyed and their savings devastated. And the complaint of "private profits, public losses" became a surefire sound bite for pandering elected officials.
Up to a point, in spurring needed reforms, popular anger has also been productive. For all its defects -- and it has plenty, to be sure -- the Dodd-Frank Act has begun the work of strengthening the U.S. financial system and making it safer. Stress tests, stronger capital requirements and moves to provide for orderly liquidation of failing banks are a start. The same goes for similar measures in other countries, and for efforts to improve international coordination of financial rules.
Political resistance had to be overcome to get those initiatives passed. Populist anger served a purpose. The danger now is that the anger is hardening into a kind of complacent bigotry. This mood may continue to serve the purposes of politicians seeking election -- but it doesn't advance the public interest.
Count on one thing: There will be another crash. That's how markets work. Urgent vulnerabilities need addressing. The post-crash financial system is more concentrated than before; the biggest banks more, not less, dominant. Subprime lending is making a comeback. (Have we learned nothing?)
At the same time, the next phase of regulatory reform must strive for simplicity; keep compliance costs in check, especially for smaller banks; guard against micromanaging and rule-making for its own sake; and place regulatory powers with the agencies best suited to use them. That's a difficult balance to strike, and anger only makes it harder.
Federal Reserve Chair Janet Yellen told an audience last week, "It is unfortunate that I need to underscore this, but we expect the firms we oversee to follow the law and operate in an ethical manner." It's a fair point. Here's something else that needs underscoring but shouldn't: Banking and finance are crucial drivers of any nation's prosperity, not branches of organized crime -- as the banks' more careless critics seem to think.
Moving capital to its most profitable and productive uses is wealth-creating in its own right. Matching risk with the willingness and capacity to bear it isn't just a matter of shuffling money to and fro: It creates new value, just as surely as growing a crop, building a house or designing a smartphone app.
In any modern economy, financial expertise is a core competence. Look at the world's poorest and most backward economies to see what financial underdevelopment does for living standards. In a way, the global recession proves the point: The financial paralysis that followed the crash, requiring dramatic government interventions to keep the system operating, demonstrated the centrality of finance in the most brutal way. Without banks and financial markets to keep the wheels of commerce turning, economies seize up.
Related to the view that finance is parasitic is the notion that financial innovation is a kind of scam -- an idea popularized by Paul Volcker, the eminent former chairman of the Federal Reserve, no less. (The automated teller machine was handy, he quipped, but that was about it.) Volcker, for once, was wrong. Innovations such as credit cards, indexed mutual funds, financial derivatives and securitized lending have widened access to valuable financial services and made the world better off. Nobody who gives the matter a moment's thought would wish to uninvent these products, supposing that were possible.
Further innovation, moreover, may be the best way to make finance safer and more productive. It's a theme stressed by Robert Shiller, Nobel laureate and author of "Irrational Exuberance." Shiller foresaw the stock-market crash of the early 2000s and the bursting of the house-price bubble, and he's no cheerleader for the finance industry -- yet he emphasizes the role that new financial instruments (such as more sophisticated retirement annuities and mortgages with built-in insurance against economic contingencies) could play in protecting ordinary savers.
Better regulation is essential. Particular attention has to be paid to the dangers of excessive systemwide leverage, and banks and other financial instructions need to be better capitalized. In this and other respects, aligning tax and regulatory incentives with the public interest is no simple task. But the guiding principle in this work shouldn't be the idea that finance is a fraud on the public and Wall Street a nest of vipers. The purpose of regulatory reform shouldn't be punishment.
Rather, the aim should be to promote prosperity. A vibrant, innovative financial sector is a vital economic resource. Talented and hard-working people are well deployed in such an industry, and deserve to be well-rewarded. Anger has had its day, and it's time to move on.
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