These days nearly everyone agrees that the old regulatory structure clearly failed. Unfortunately, almost every proposal for reform is also destined for failure.
Take the proposal by NYU adjunct professor Ann Lee in the Financial Times. She warns against having regulation controlled by ex-bankers or their close associations. Instead, she wants to form a global regulatory board controlled by institutional investors to govern financial regulation.
“A more sensible approach to financial regulation would be to put the end-investors in charge,” she writes. “Investors who have a stake in the investment management industry should have a vote much like they do at shareholders’ meetings.”
Her argument is half-right. Hiring ex-bankers doesn’t make for good regulation.
“While those who defend the practice of hiring ex-bankers into government claim that ex-bankers are needed for the expertise they bring, I would challenge them to provide further detail of precisely what expertise these professionals offer that would make a difference in designing policy for the public interest,” she writes.
But the next part of her argument is wrong. There’s no reason to suppose that investors are better suited than bankers to run regulations. We would challenge her to provide further detail of precisely what expertise these institutional investors offer that would make a difference in designing policy for the public interest.
In fact, there’s plenty of evidence that investors would just seek to exploit financial institutions for short term gains, confident that losses could be passed on to taxpayers via government bailouts.
We’ve known about self-dealing, investor looting since at least this summer. That’s when a study showed that banks whose stocks had the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006. In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006.
This evidence shows that the attributes that investors valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. In other words, investors were demanding the worst banking practices of the boom. What’s more these intially over-performing and later over-failing banks were those that had the “best” corporate governance–meaning the kind that was most open to investor influence.
Let’s make this more concrete. For most of this decade, both Citigroup and Bank of America outperformed JP Morgan Chase in terms of stock price. Bank of America shares rose 102% from the end of 1999 through the middle of 2006. Citi shares rose 30% during the period. JP Morgan Chase shares fell 15%. Since then, JP Morgan shares have slid another 14%, while Citi’s shares have fallen 93% and Bank of America’s 71%. In short, investors during the boom were demanding that banks that were over-exposing themselves to the US retail market. If investors had been setting the rules for all banks, JPM would be in the same shape as C and BAC.
And these are the people Lee wants to put in charge of global banking regulations?
Look. We know the ideas of regulators about fair lending, risk and capital reserves didn’t work in practice. Bankers and regulators became too close, both ideologically and operationally. The bankers had too much influence in the entities that were supposed to regulate them, and the regulators were too much involved in banking practice.
Is there a way out? The Obama administration seemed intent on moving down the same path of failure, just a bit faster. As yesterday’s meetings between bank executives and White House officials show, the main regulatory idea seems to be to push bankers and regulators even closer.
But the answer cannot—must not—be to further empower irresponsible investors to force their ideas on every financial institution. Our financial crisis would have been far worse if the management of JP Morgan had not been allowed to resist the investor demand to be more like Citigroup.
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