From the earliest days of capitalism, those skilled at making money have proven creative at evading the regulators.
In the Middle Ages, when usury laws banned lenders from charging interest, savvy merchants lent in one currency and took repayment in another, thereby profiting without incurring the wrath of the Catholic Church. So much has happened over the ensuing centuries — a blur of financial ingenuity spanning the creation of stocks to the mortgage-backed investments of the present day — yet history remains unbroken: Time and again, financial innovation finds a lucrative path around regulation.
As Congress and the Obama administration now enter the endgame in an effort to temper the dangers that delivered the worst financial crisis since the Depression, experts assume that this historical narrative will hold. If anything, swift advances in technology — computerized trading strategies unleashed on a global landscape — have made it harder for watchdogs to simply recognize the risks building within markets, let alone deliver effective action.
“The financial industry always finds ways to stay ahead of the regulators,” says Kenneth S. Rogoff, a former chief economist at the International Monetary Fund and now a professor at Harvard. “Whatever law they design today, if it’s not updated in 15 or so years, it will be completely ineffective, completely irrelevant.”
Not that regulatory efforts are futile. The history of finance is full of crises that spawn regulatory steps, snuffing out trouble before a new variant pops up. The wildcat banking era of the 19th century, when banks in multiple states issued their own (sometimes worthless) currency, spurred the creation of a national bank supervisor. When opportunists and charlatans sold stocks to the public without disclosing the extent of their debts, culminating in the stock market crash of 1929, the federal government created the Securities and Exchange Commission.
The New Deal reforms imbued traditional banking with a sense of safety, but also encouraged financiers to seek out greater profits by taking risks in areas beyond regulatory purview. The resulting shadow banking system that emerged over the last quarter-century — the murky world of unregulated corporate insurance contracts and other flavors of so-called derivatives — nurtured the recklessness that ultimately metastasized into today’s global crisis. The government had effectively tamed the traditional banking business. Wall Street expanded to more adventurous terrain, erecting frontier-style casinos beyond the edges of regulation.
This shadow banking system came to specialize in innovations that created the illusion that risk was being responsibly managed; in crucial cases, they actually intensified the dangers. For many years, this felt like prosperity. American International Group sold insurance policies (credit default swaps, in industry parlance) that supposedly backed up now worthless pools of mortgages extended to homeowners with sketchy credit. That emboldened financiers to pump trillions of dollars into now empty empires of housing. There were jobs for home builders, landscapers and furniture dealers, and property values rose for all.
Financial innovation helped Greece mask the extent of its debt troubles, leading European banks to keep lending. That generated jobs for German autoworkers, whose creations landed on the streets of Athens before reality trumped illusion and crisis washed across Europe.
The very concept of financial innovation now seems compromised. Some derivatives have sown stability, enabling global companies to hedge against fluctuations in currency exchange rates. Yet many innovations with forbiddingly inscrutable names — collateralized debt obligation, structured investment vehicle — are now implicated in a ruse designed to convey a sense that risk was being diluted when it was really being amplified and spread worldwide. When the insurance policies failed and the losses piled up, ordinary people lost trillions of dollars in wealth, homes and jobs.
Some argue that regulators were effectively duped into complacency by financial institutions skilled at managing the perception of risk (even as they proved less skilled at managing risk itself). Others accuse the watchdogs of looking the other way as dangers mounted, whether out of ideological reverence for unsupervised markets, fear of angering the people who control money, or a desire to please banks that might soon employ them for considerably more than a government salary.
Some argue that the investments at play became so complicated and intertwined that even the money masters who built them no longer understood their creations, as if Frankenstein’s monster had melted into liquid and seeped into the drinking supply. The marketplace may be so vast and elaborate, its tentacles reaching from Sarasota to Singapore, that it simply beggars human understanding.
“Technical advantage has far outstripped our capacity to manage it,” says Andrew Lo, a finance professor at M.I.T.’s Sloan School of Management.
The most fundamental challenge to effective regulation may be the stark inequality of the forces at the table. The latest effort to defang the financial system relies on many of the same institutions that failed to intervene in the run-up to the last crisis. The people inside regulatory agencies serve at the pleasure of the Congressional budget process. The people they are supposed to be watching pull down bonuses reaching seven figures. Their companies employ armies of top-flight lawyers on the prowl for new ways around meddlesome rules. Members of Congress and their staffs may soon be courted by the very institutions whose profits they may constrain through legislation.
“There’s all this innovation going on, and if somebody gets particularly into it, they get hired away,” Mr. Rogoff says.
The revolving door that sends denizens of Capitol Hill to highly paid jobs as lobbyists and bankers while turning Wall Street executives into Treasury officials has long been proffered as a reason to be skeptical of regulation. Yet given the impenetrability of Wall Street, some argue that we have no other option but to rely on financial insiders to staff regulatory agencies: When you need to defuse a bomb, you hire someone intimately familiar with explosives.
“If we take the view that only people who come from an academic background, people who don’t have any experience, can serve in regulatory agencies, we will have an impoverished government,” says Eugene A. Ludwig, comptroller of the currency in the Clinton administration and now chief executive of the Promontory Financial Group. “These human foibles are going to be with us forever.”