Archive for November 22nd, 2010

John Cassidy has another great piece in the New Yorker, “What Good is Wall Street?” in which he argues that most of what investment bankers do is socially worthless, and yet the finance industry booms and salaries for top bankers skyrockets:

Most people on Wall Street, not surprisingly, believe that they earn their keep, but at least one influential financier vehemently disagrees: Paul Woolley, a seventy-one-year-old Englishman who has set up an institute at the London School of Economics called the Woolley Centre for the Study of Capital Market Dysfunctionality. “Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas?” Woolley said to me when I met with him in London. “It is like a cancer that is growing to infinite size, until it takes over the entire body.

An interesting aspect that Cassidy touches on has to do with financial innovation:

Because trading has become so central to their business, the big banks are forever trying to invent new financial products that they can sell but that their competitors, at least for the moment, cannot. Some recent innovations, such as tradable pollution rights and catastrophe bonds, have provided a public benefit. But it’s easy to point to other innovations that serve little purpose or that blew up and caused a lot of collateral damage, such as auction-rate securities and collateralized debt obligations. Testifying earlier this year before the Financial Crisis Inquiry Commission, Ben Bernanke, the chairman of the Federal Reserve, said that financial innovation “isn’t always a good thing,” adding that some innovations amplify risk and others are used primarily “to take unfair advantage rather than create a more efficient market.”

However, he does not seem to quite get to the “race” that goes on between regulators and the regulated. Throughout the history of finance, it is a recurring theme: after a crisis, the government passes regulation to maintain stability, and soon after the regulated go to task innovating financial instruments that will circumvent that regulation. In time, another crisis occurs and the cycle happens all over.

The lesson for today is that we need a new set of regulation. But will it look like Glass-Steagall? Probably not. The economy and our society has changed significantly since the 1930s. A 21st century regulatory reform will need to address a deeper international environment and the new avenues for financial innovation which include asset backed securities, credit default obligations, structural investment vehicles, and credit default swaps.

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