Finance: Cleaning Up After the 'Perfect Storm'

Amid all the illusions that led to today's financial catastrophes, regulation got lost amid ideological struggles. Time to fix what's broken

By Eric K. Clemons

This is the first of two parts.

In an interview more than two decades ago, the chairman of the New York Stock Exchange, Richard Phalen, noted that the financial community "makes money in the dark." It is the job of regulators and investors, said Phalen, to "drag us back into the light." At roughly the same time, Saul Hansell wrote an illuminating story on derivatives traders for Institutional Investor. The gist of the story: "You tell me how you pay them, and I'll tell you what they really do when you are not looking."

I've never forgotten either of these, the "profitability of darkness" and the "law of the wallet," as forces in the evolution of the financial services industry. Indeed, these two conditions—the decrease in transparency and lack of oversight in the financial industry, and the law of the wallet gone wild—do much to explain our current financial crisis.

But there are other conditions—changes in the structure of the financial services industry and in our attitude toward financial services more generally—that also contributed to the "perfect storm" now battering Wall Street and Main Street. These four are the most crucial:

1. Transparency came to be seen as an evil, not a good. Yes, Sarbanes-Oxley no doubt created enough administrative burdens to reduce the attractiveness of serving on the board of public companies or of launching IPOs in the U.S. But it also contributed to the evolution of an entire industry based on the premise that you could get wealthy fast by investing in companies that were not obligated to observe the legal niceties of reporting to investors. Complete and accurate financial disclosure is the investor's last line of defense.

2. Regulation was replaced with ideology, on both sides of the party divide. This was especially true in the case of the belief that home ownership was not only desirable, but almost a right, to be encouraged through regulatory policy. This was followed closely by the belief that markets automatically police themselves. Former Federal Reserve Chairman Alan Greenspan's partial mea culpa of October 2008, now seems absurd; how could he—how could anyone—have thought that the market would correct immediately for abuses that were not visible? At the same time that the American economy became increasingly dependent on nonbank lenders and the "shadow banking system," regulation of nonbank financial institutions lessened or in some instances almost ceased to exist. Derivative instruments, such as securitized mortgages and securitized credit-card debt, greatly increase the efficiency of our capital markets. But when innovation and a significant portion of the markets' activities are not regulated, we now know this can create systemic risks that are unacceptable.

3. Financial and nonfinancial institutions grew more dependent on one another. In our newly interconnected financial services industry, the connections among banks, shadow banks, and nonbanks are difficult to observe and poorly understood, but when part of the structure begins to fail, for any reason, the ripples turn into cascades of collapse.

4. The financial freeze-up reinforced itself. As lenders deal with their own capital problems, they tighten credit to legitimate institutions downstream, reducing their ability to lend in turn. Much of this has been automatic, like the power grid failing when one station overloads and the others around automatically react inappropriately: A bank stops lending because it has to mark its portfolio to a market that has collapsed, which causes another bank to reduce credit-card limits, which automatically reclassifies the credit rating of some customers, which increases their interest payments and reduces their purchases, which causes yet another retailer to fail, which then has its own ripple effects.