- The Washington Times - Tuesday, February 8, 2011


Last month’s much anticipated release of the Financial Crisis Inquiry Report proved to be disappointing - not because of the report’s findings, but because of its lack of breadth. The majority on the commission chose to follow the populist tides and delivered a politically popular but not inclusive report. This raises an important question: Are policymakers sacrificing an opportunity to remodel financial markets and revitalize the banking sector?

Unless policymakers carefully review our capital market structure and incorporate the necessary changes, they may again squander an opportunity to right the ship, leaving the global financial system vulnerable. An inaccurate diagnosis or a misinterpretation may lead policymakers and business leaders to neglect the infrastructure reform on which the entire financial system’s welfare may depend.

The prevalent thinking seems to be that our current financial crisis is a once-in-a-lifetime event. However, viewing the current crisis through the prism of conventional wisdom may prove to have dangerous consequences. Policymakers as well as Wall Street should know the perils of depending on historical norms as a guide to the future. Prudence suggests that the escalating severity of consecutive crises signals a need to recalibrate risk models to a new financial paradigm of higher volatility.

Although America’s archaic regulatory structure needs repair, it doesn’t need an added layer of more intrusive government regulation. Rather, an attempt to identify and assign risk is needed, which will require a higher quality of supervision of our financial system, coupled with an expanded authority to intervene. Those who shoulder the cost, including the taxpayers, should reap the markets’ rewards for such risk. When the taxpayers’ money stands behind bets, risky behavior is encouraged and illusory performance is rewarded. Allocating capital efficiently is not accomplished by using taxpayers’ money to guarantee against solvency. The term “free markets” should not be interpreted to mean “without cost.”

The American public knows that reverting to the risky behavior of “heads I win, tails you lose” is irresponsible. It should be unacceptable that taxpayers are saddled with the risk of subsidizing purchases while others stand to reap most, if not all, of the profit. This not only is rigged, but will not stabilize the banking system. A bolder reworking of the risk-reward balance would be prudent.

As Lehman Brothers‘ failure has shown, bankruptcy as a resolution for financial entities causes widespread economic havoc and immeasurable harm to the taxpayer. In the aftermath of Lehman’s more tragic than predictable demise, the Federal Reserve and other central banks had to take aggressive policy actions to help the financial system mend itself. The Fed lowered the federal funds rate to near zero, provided capital and expanded the volume of its balance sheet via the capital markets. Most notably, it purchased long-term securities and introduced lending programs to restart the flow of credit. For the moment, it appears that these actions by the Federal Reserve, the U.S. Treasury and other world central banks collectively averted a more vicious financial crisis and augmented the functioning of several key markets.

Yet still, policymakers today have two unpalatable choices: Allow large financial entities like Lehman to go into bankruptcy and then, collectively, the country can hold its breath as the financial system races toward the abyss, or put it on the taxpayers’ tab. Neither is appealing. In fact, both should be unacceptable.

Lawmakers and regulators need to think more radically than in the past. There are no “Back to the Future” sequels with time machines or Marty McFlys to bring back an almanac detailing future overheated markets. History cautions us that not even the financial institution’s management has been able to identify potential bubbles or implement changes to thwart them. The policymaker’s quest should not be to find a system that predicts, but rather one that prevents irresponsible risk-taking that requires taxpayers’ money. Even staunch laissez-faire promoters concede that allowing self-interested traders to reap the bounty from risky bets while losses have the potential of being borne by the taxpayer does not support a sound financial system.

Long-term sustainability of our financial system requires more substantive changes that isolate, or at least contain, the risk at a cost to those responsible. This may be at the holding-company level, within business units, on individual desks or with all of the above. Not that long ago, partnerships understood the concept. Establishing secure capital levels - some of which belong to the risk-takers - among divisions to ensure each has its own source of liquidity in a crisis may prove to be a far easier task than ascertaining the suitable size or appropriate functions for our financial institutions.

What would such a structure accomplish? Like a partnership, it would create wealth on realized profits - net dollars realized in disposition over the price paid in acquisition - not interim marked-to-market gains. It would give investors and regulators details about capital levels and make monitoring leverage clearer. It would make it easier to identify systemic risk and to segregate conflicting duties. It would create a meritocracy that better corralled risk and retained the most effective talent.

Most important, it would end the Fed’s practice of rescuing trading desks from ill-advised risk-taking and give supervisors a credible way to enhance market discipline and close units without breaking up or disrupting the fundamental commercial or utility bank. The benefit that large, integrated banks with a worldwide footprint provide in today’s diverse global economy would be retained. Should lawmakers solve these structural problems, the world may find a more stable financial system that allocates capital more efficiently and effectively.

Stanley J. Dziedzic Jr. is author of “Lehman Brothers‘ Dance With Delusion: Wrestling Wall Street” (CreateSpace, 2010) and former managing director of Lehman Brothers, 1996-2005.

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