Will we ever learn?

Last week I was chatting with one of my friends who is based in New Jersey. He is a senior executive of a multinational bank and a key player in the high-stake game of Wall Street. (Like many members of this club, he often pretends to know all the answers and I am willing to listen to him!) The topic of discussion turned to recent financial market turmoil and how the survivors are surviving. The record quarterly profit of Goldman Sachs and huge bonus they plan to payout naturally popped up.

“The turmoil has kicked out many players. The bailout package has ameliorated extreme trauma of the remaining few. Now with reduced competition to feed the demand, the surviving bankers are up to their same old tricks. They even enjoy better margins these days” My friend explained to me. I was a bit surprised. So soon? Is the memory so short? Don’t we learn some lessons? Is it just a cynical remark of a jealous banker?

I logged onto the net to see what more renowned experts had to say on this. The following quote from Paul Krugman in the article "The Joy of Sachs” he wrote in the New York Times summarised it all. (Do take the pain to read the whole article. It is illuminating.)

“First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

Second, it shows that Wall Street’s bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.

Third, it shows that by rescuing the financial system without reforming it, Washington has done nothing to protect us from a new crisis, and, in fact, has made another crisis more likely.”

This brought to my mind a completely contrasting story. The story of Darbary Seth of Tata Chemicals. Soda Ash, the chemical that his company produced and marketed was under price control and one day the government removed the price control. Instead of trying to take advantage of the freedom that this decontrol offered and increase price, he actually reduced the price. To the surprised colleagues and frustrated competitors he quipped, “When there is decontrol, we should have self control”

These are two ends of the spectrum. On one end we see the corporate governance that limits itself to being technically correct and compliance to the letter of the law. On the other end we see a visionary leadership who recognizes the larger role played by every business enterprise. The world around us is a mixture of both and what lies in between. The balance keeps shifting from one extreme to another. Sometimes the crisis, that was triggered by the excesses lead to stronger shareholder activism and trigger correction mechanisms as new acts and regulations.

In the last few years the pendulum appears to have been more to the side of ‘profit at whatever costs’. More so in the areas of financial innovation or rather the how these innovations were exploited.

How do we ensure that the balance tilts more towards more responsible corporations? Is there a need to bring about some regulatory intervention? Will it help?

I agree the rules cannot be the solution. But when the financial innovations significantly expanded product options and as Krugman noted “directed vast quantities of capital into the construction of unsellable houses and empty shopping malls which increased risk rather than reducing it, and concentrated risk rather than spreading it” there appears to be a definite case for some tweaking of regulations to ensure that the checks and balances are built with no/ minimum conflicts of interest. (Refer to my posting Checks and Balances - Who checks and Who balances” for some thoughts on this)

Don’t get me wrong. I am not advocating a return to license and control raj. My limited point is that we need to strengthen our institutional framework further and the regulators should improve the quality of their team so that they can clearly discern what is right and what is fair and don’t let the political expediency rule their judgement; especially when the market participants get caught in a spiral of short-termism and incentive structures that could be disastrous to the society in the long term. On the other hand a little more of introspection in the board rooms and among managers could also help.(Take a look at "Devastation of world financial markets - A case of Policy Reversals in India?” for some different perspectives on this)