In the war on terrorism, it was easy to trace the original sin back to a single figure, Osama bin Laden, if difficult to eliminate him. In thinking about the financial crisis, it has not been so straightforward. We have had confounding problems discriminating between primary, secondary and tertiary causes; of arranging those causes in a hierarchy; and of assigning blame. That is, the original sin remains elusive, and we run the risk of dealing with symptoms rather than causes. And yet for all that, we must act, making arguments, offering up policies. And every one of these policies, from Basel III capital requirements to Dodd-Frank reforms to the recent Vickers report on banking out of the U.K.
, contains an implicit, deeply embedded set of presuppositions, some explicit, some lurking quietly, others beneath the level of consciousness.
If we had to offer up a chain of causation, how far back would we go? Well, we could argue this until they close the bar. We could travel back to the New Deal and look at the creation of the modern mortgage with the Federal Housing Administration and Fannie Mae spawning the government-sponsored entity problem. True, that system, like the Glass-Steagall split in banking, worked quite well for decades until it morphed into something quite toxic. You could go into the '80s and the beginning of bank disintermediation and financial deregulation. You can fixate on the repeal of Glass-Steagall. You can look at bank consolidation, the end of partnerships on Wall Street, the rise of universal banks. You can point to financial innovations like derivatives.
But in all this speculation there is one group that generally gets left out: institutional investors. At some level, this makes perfect sense. Institutions are ubiquitous in the financial economy, but mostly they are big, quiet and passive. They did not actively blow up anything; their involvement in mortgages was, at best, at a distance. True, they clearly flubbed their role as monitors; and there is evidence that on issues like compensation, size and risk, they were partying with everyone else, albeit from the back of the room. But institutions, from mutual funds to pension funds to sovereign wealth funds, offer very nonthreatening, nongreedy profiles. And probably most importantly, they are the one segment of finance that has the greatest identity with the public, whatever that means.
But we are not looking here for the person who pulled the trigger; we are looking here for the set of events that shaped the large, speculative financial system that we seem to both need and fear. What we know historically is that the reforms of the New Deal held up fairly well until the '70s. True, there were strains. The aversion to stocks famously faded in the '60s. Economic affluence generated savings and wealth that increasingly sought go-go performance. Wall Street, which mostly served individual buyers of stocks and corporations, was small, rigid and closed; it was the famous Wall Street club -- nepotistic, inbred, cozy, if relatively safe. But the affluence of the post-war years produced a major new power center, the institutions, which were growing rapidly and adopting new techniques of modern portfolio management developed mostly in academia. The institutions were unhappy with the hidebound ways of Wall Street, which in turn viewed them with a combination of trepidation and interest. And as institutions became larger political forces, they drove a series of reforms that essentially deregulated finance (helped along by Wall Street's own failures) and ushered in an era of increasing efficiencies, lower prices, greater competition, consolidation and, increasingly, speculation. Finance boomed. The world cheered.
The fact is, nearly any fair-minded person saw what had occurred in the '70s and accepted that institutions were progressive forces for good. After all, their ultimate customers were, even before 401(k)s, ordinary Americans. And so, like free trade, the reformation of Wall Street propelled by institutional investors brought a new world of lower commissions, more sophisticated products and superior execution. As early as the '60s, the institutions installed "performance" as the measure of all things financial. Although the junk bond-fueled hostile raids of the '80s made some institutions nervous, they were generally happy to profit from a deal and walk away with a premium. And, of course, it was no coincidence that the apotheosis of the institutions led to the decisive shift to shareholder governance, abandoning the old stakeholder model as ineffective, inefficient and too easily manipulated by boards and managers. The financial world that was created after 1975 was, for all the opprobrium tossed at the banks and Wall Street, one designed for and by institutions. One narrow example: Institutions all but created the two-tiered system of sophisticated (accredited) and unsophisticated investors. Wholesale firms like Goldman, Sachs & Co. learned to play that game with elan, but institutions sought and won certain freedom on disclosure and risk that came with being accredited.
So was the financial crisis the fault of institutions? No more than you can blame any other interlocking economic actor, from banks to house flippers to politicians and regulators. But the point is that the financial system, which so many decry as far too large, far too leveraged and overpaid, and far too powerful politically, is really the creation of an institutional investing mindset.
Simon Johnson's notion that big banks represent an oligarchy has elements of truth; they certainly can lobby effectively. But throughout the last four decades, the institutions, with their benign image, their consumer constituencies and their association with democracy, have had far more clout. It is a mistake to conflate institutions with Wall Street, as if there was one overriding self-interest. Their interests are sometimes complementary, but for decades the two have as often gone their separate, antagonistic ways (stock exchanges were often a battlefield for these struggles, from the '70s reforms to the Dick Grasso affair). And when push comes to shove, the institutions tended to win. By institutions here I'm not referring to hedge funds, for all their size and scale. Hedge funds are investors, but they lack, so far, the identity with consumers and the public good of institutions. On governance matters, some hedge funds do seem to be accruing some identification with the public or with shareholders.
Again, this is not an attempt to demonize the institutions. It is an attempt to illuminate an often opaque, if pivotal, aspect of financial history that is often overlooked. Institutions often get a pass, certainly at the Securities and Exchange Commission, which was set up to serve "investors," and in Congress. It is also extremely difficult, for all the glib talk, to imagine the financial system before the emergence of institutions. Their postwar growth and their emphasis on performance, often in stocks, channeled vast amounts of new capital to the economy (through a reformed Wall Street) that was a major factor in the creation of the post-'70s prosperity that lasted until 2008.
The questions become then: How would we unravel all that to try to create a smaller financial sector, a less performance-driven investment segment? What's the relationship between large institutional investors and overmighty banking? In forcibly shrinking banking or Wall Street, would we also ratchet back the size and power of the institutions? Would a more fragmented, restrained and prudent finance fail to cater to the desires and needs of large institutions boasting large, complex and increasingly global portfolios? And is it wise to automatically assume that what's good for the institutions is good for either individual companies or the nation?
Now it may well be, as defined benefit plans fade and public employee unions come under fire, that the institutional era is ending. That may be right; or it may be wrong. (I suspect the latter.) The world keeps changing, however, and the institutional segment has grown in complexity, with the proliferation of hedge funds, private equity shops and other private capital players, some with great bulk. Institutions, particularly sovereign wealth funds, are now a powerful reality around the globe. But that continuing dynamism makes the argument for returning to an era somewhere in the murky past even more complex and difficult. But whatever we do, leaving the institutions on the sideline as innocent bystanders is probably a big mistake. - Robert Teitelman