The front pages now are full of tales of woe from the higher reaches of the financial stratosphere. Old rules for both financiers and regulators have been ignored as confidence in quantitative models and the smarts of those who run them spiraled ever higher.
Now the sin of pride is proving expensive, not to mention embarrassing. It may not, however, be the only failing in the financial industry caused by high-flying expectations.
A cautionary tale from beyond the Beltway, while anecdotal, may be a troubling indicator of other problems looming for the industry if self- regulation does not quickly step up to the challenges created by the twin phenomena of rapid diversification and sudden market downturns.
A friend owns a medium-size business that is the grateful-not to mention dependent-recipient of a large loan from a major regional bank. This line of business, like many, relies on a constant stream of credit to finance its operations, and it therefore has a deep and long-standing relationship with its lead bank.
Like many others, that bank is seeking to diversify. It recently bought a regional investment house. So far, so good.
Now the tricky bit. Last week the bank loan officer called the business to suggest that it go public and liquidate its debt. The underwriter of the IPO? Its new investment bank, which just happens to like deals like this.
Also, it just happens that the investment bank needs deals right now, given what is going on with IPOs.
If one looks back to the origins of the Glass-Steagall Act, allegations that banks used their market power to convert their own loans into equities sold to the hapless public were perhaps the single most compelling reason Congress intervened.
This is no quibble outdated by subsequent events.
When the Fed first authorized Section-20 affiliates, it mandated a strict separation between lending and underwriting. These barriers are far more porous now, but supervisors are still concerned that the proceeds of an underwriting not be used to pay off the balance of a loan made by an affiliate.
Neither the Glass-Steagall Act nor Fed regulation factors in the new element: expensive holding company acquisitions of investment banking operations, still only imperfectly understood at the top.
In the 1930s bank management came of age during a period in which commercial and investment banking were often indistinguishable. If they are again to become inextricably intertwined, as the incident outlined above suggests, then regulators must define a more uniform regulatory framework to protect both borrowers and investors.
Of course this small, sorry story is not an isolated incident. It is writ far larger in the tragic saga of Long-Term Capital Management.
In that case, commercial banks acted as investment banks, and vice versa. In the end, the mixture became so thick that the Fed was forced to put its considerable institutional prestige on the line to rescue all concerned.
Though some public comment suggests that it was the unregulated hedge fund that caused the crisis, one could argue, at least as persuasively, that it was the misregulated banks and securities firms.
The bank regulators were looking for credit exposure, and the securities regulators for net capital compliance. Some of the commercial banks were investors and the securities firms creditors.
The regulatory wires were crossed.
The financial modernization bill, now on Congress' cutting-room floor, would have created an explicit framework for the integration of the securities, banking, and insurance industries. It included a far less clear regulatory structure for identifying and isolating the risks that can rapidly redefine themselves in diversified companies, popping up and spreading in ways traditional regulators may fail to recognize.
The bill was similarly light on the information consumers of various financial products will receive, relying on the current set of regulatory guidelines.
These should suffice in the short term, but a more comprehensive understanding of all the risks diversified companies will run is essential if the "modernized" system is to stand through what is starting to look like a post-modern financial market.
