Transactions: March 23, 2009

Wise man Paul Volcker has exhumed the long-dead carcass of Glass-Steagall and wheeled it into the room. Now what do we do with the bugger? Well, it's not really the same old Glass-Steagall laid to rest in 1999. Volcker may be getting up there, but he's aware that stuff has happened since then, like proliferating hedge funds, private equity shops and techniques such as securitization. So he would split finance not into the outdated dichotomy of commercial and investment banks, but between firms that can take risks because they're not systemic threats and those -- call them banks, whatever that means these days -- that are either too-big-to-fail or that have some sort of federal safety net slung beneath them, like deposit insurance or TARP moolah. Since Volcker made those comments, a debate has simmered among souls who care about such matters, as opposed to whatever home-brewed claptrap Rick Santelli is winging around. Much of that has swirled around which products would fall into which camp -- Volcker was sketchy on details -- and whether this disposition of functions would relieve or exacerbate managerial "conflicts."

But conflicts (like compensation) are a secondary issue; not irrelevant, just not fundamental. Conflicts are bad, sometimes dangerous, certainly managerially challenging. But the conflicts of the universal bank did not get us into this mess. To eliminate conflicts may be impossible, short of mandating that firms sell just one product or service, which would be, to say the least, absurdly inefficient. In fact, regulatory reform has two foundational considerations when it comes to industry structure -- safety and viability -- and one big issue in regards to process: governance. Both involve tradeoffs, which are so nasty that we've grown accustomed to kicking them forward, indulging in fantasies (hang 'em high) or fixating over symptomatic, not causative, issues.

Here's the thing. Safety is meaningless if the "bank" makes no money. Viability is meaningless if the "bank" burns itself, and us, down. If getting that tradeoff right is tough, and it is, one reason is that governance is about as intractable as human nature. Regulatory governance is grounded in the fact that regulators camp in a no-man's-land between economics and politics. Regulation, particularly as we get more aggressive, shapes the real economy. The questions always come down to: What kind of economy do we want and who gets to decide? Do we want a consumer economy, one based on industry and exports, or a Jeffersonian wonderland of doughty farmers? How much leverage should banks get to juggle? Who's a systemic risk, who's not? And who is going to decide these elemental questions, a regulator, a mechanism like the free market or a gold standard, or, this being a democracy, voters and politicians? All three have flaws. All three tend to be "captured" by short-term gratification. And the most powerful decider is the most inexpert. Voters seem to approve the stimulus, which is, in a sense, the very disease that brought us down (yes, I know, it's an emergency and probably necessary). Will voters demand a return to easy credit when the crisis recedes, or will thrift persist? Have we, the most change-happy nation on earth, permanently changed? What about in a decade? How will those desires shape regulatory control, no matter how finance is divided up? There seems to be no ultimate solution to this problem, short of scaring up Plato's philosopher kings, who are, alas, off working for hedge funds.

And there is a deeper problem: the fiercely competitive nature of global finance. Over the past decades, finance has been on evolutionary overdrive, and not just because regulatory fetters have loosened. Technology, innovation, globalization, and affluence have driven fantastic change; indeed, part of what we're seeing today is that firms occupying the "wrong" evolutionary niches are dying in great waves (see the independent Wall Street firm). This is not an argument for "progress." Survival of the fittest, like market winners, involves a lot of luck, which is one of those ideas latter-day Social Darwinists never grasp. But what we know is that finance was shaped in response to relentless commoditization, in which lush profits are quickly arbitraged away. Was there greed? Were mistakes made? Was there a moral hazard? Malfeasance? Yes, yes, yes, probably. But it's also true that high-end finance evolved, or devolved, into public multi-line megaliths engaged in a daily war for shareholder affection while constantly at risk of succumbing to utility-like profits. Before we move businesses around into various bins, we should ask whether they can survive a harsh environment. Or we can ban all change, build walls, and drown in the nostalgia that old Glass-Steagall can still dance.