No one had been able to untangle the Gordian Knot. It was so complex. Just like our financial system today. How to come up with a new approach that would legitimately make the system healthier? Is it pay? Is it capital? Is it leverage? All? More?
Alexander the Great, when confronted with the Knot, thought for a bit and then pulled out his sword and cut the knot open in one thrust. I think that such an approach may work here. I speak not as an outsider but as a person who was in the forefront of deregulation in the 1980's. I was part of the effort to tear down the architecture that had preserved the system and the world since the 1930's.
Here is the hint. The great break between a productive financial system, one that bridges the world's savings into the worlds projects and an unproductive one - where most of the financial activity is "playing with money" happens of course in the 1980's when deregulation took place.
Of all the steps taken the sword is found in just one area.
Up to the "Big Bang" the only capital that the investment banks had was their own. So the risk that a single trader might take was limited by his share of the capital and his partners' willingness to support the trade. In the UK partners were exposed to unlimited liability. So they could lose everything.
The really big deals were both done as agents - meaning that you had to have a really great sales team who were really plugged into the buyers. Being done as agents, the price could not be guaranteed up front. Which meant that the firms who got the deal were the ones that knew and worked best with the clients. Really big deals were also always syndicated among many other firms. This also promoted good behavior. For firms that could not place were punished.
At Goldman Sachs, and many other firms like my old one Wood Gundy, the big payout was made not with annual bonuses but in partners shares that were accumulated over the active working life of the person and then sold in the last 5 years. The loans were serviced by the dividends. So again, the risk of the firm was tied into its long term health.
Because investment banking was prohibited in deposit taking banks, Investment banks were small. Goldman would have had less than a 1,000 people in 1980. If one failed it would be bad but not the end of the world.
This was a ecosystem that did not need outside regulation - it defaulted to being sensible. Sensible in every area.
Post Big Bang - the Investment Bankers had access to vast sums of capital. They raised it themselves such as Goldman or they borrowed it from large commercial banks who either became their "Owners" or who had themselves set up investment banking operations.
The Risk and the Penalty for failure was removed from the Investment Banker. Now Trading, that had been the Barrow Boy Service to the Elite Client Men on both the Buy and the Sell Side, became the key power men in the firms. Again the key was the Balance Sheet.
Now instead of acting as an agent - with leadership resting on knowledge and relationships on both sides - every deal was now only a big trade. The "Bought" deal, where the bank bought it all from the client at a fixed price came into play. Soon, if you could not play here, you were left behind. Capital and Trading were it.
So Investment banks became huge. Huge in capital, in people and in impact. They became the dominant activity in business - sucking up the best people and creating a financial sector that was no longer the servant of the economy but its master. Many became too big to fail just as the risk that they were taking would ensure that they would fail.
With the vast resources of capital under pinning the trading, a trader now could take huge bets that he could never have taken before. When they worked out, he could claim to have made the money. But of course the real money was in the size of the deal and that was only possible because of the access to capital.
There was also no downside for the trader. Bonuses are paid no matter what as we are seeing. To attract and to keep "talent". If you had a bad year, you were fired but most, like pro athletes, would find another job somewhere else soon. No one would be wiped out by a bad trade.
All the discipline of real and shared risk has gone.
Worse, Banks no longer served the real interests of the client. The populace were sucked into being sucker investors - like the slot machine players at the Casino. They were "sold" worthless paper by hucksters. Engineering rather than legitimate investments was the rule on the other side. No Suez Canals only Credit Card Backed Securities.
Worse, in the bailout, the government now is the lender of last resort. There is no way that these firms can fail now. Huge before, the survivors are massive.
Traditional attempts to regulate will either be watered down or gamed.
The only thing that will work is to reset the system to the Glass Steagall rules. Separate the two types of banking.
Regular banking should be boring. Our money as depositors is at risk. If you make more than 15% ROI over time, the bank's management is taking too much risk. A safer number might be 11%. A bank that is doing that is doing a good job - being the bridge between people who have deposits and regular borrowers.
Investment Banking should, be what it has always been, for the riskier and larger stuff that largely finances large capital projects - say a new high speed rail system in the US or new green energy projects - or governments.
Trading should serve all of this and provide liquidity in real things.
What all the derivatives have done is to create a gigantic bubble that has nothing to do with life as it is lived in the real world. This type of "Innovation" has only been a distraction and a destructive thing.
But how will this be regulated you ask? If you limit the capital of those who play, you have regulated it! It has only been the availability of endless capital that has created all of this.
Banking is the world's second oldest profession. The principles of sound practice have been known for millenia.
The thinking that created Glass Steagall was born of the mess that was the 1920's. It was sound then and is sound now.
Sadly my bet is that we will have to wait until a cataclysmic event that mirrors 1933, until we have the political will to impose it back. For those that do not know. The market roared back after the crash in 1929. Green Shoots were seen all over the place. The Hoover administration talked up all the sensible things they were doing. But unemployment and ongoing bank failure - the reality - caught up in the second blow. The second blow that made any sense of muddling through impossible.
We get confused. Roosevelt took office not in 1929 or 1930 - but in 1933. All the earlier efforts by a very clever man, Hoover - the man who had saved Europe from starvation after WWI - had failed.
In the end we will get our 1933 - maybe sooner than we think.
Then only cutting the Gordian Knot will do.
