I remember the two bullies who studied with me in high school. They intimidated poor souls like me quite often; had no shame in forcefully taking nice goodies from our lunch boxes, flick our chocolates, force us to let them copy from our assignments and what not. Absolute rascals; but they were good athletes. They bought honour to the school in every district and state championships and so they were darlings of the faculty. Every once in a while they got caught for their transgressions; will get few raps on the knuckles, may be few days of suspension and then they were back in action. I am sure many of you would have had similar experiences.
I remembered these bullies when I was reading comments by Hank Paulson (US treasury secretary July 2006- Jan 2009) in 2006. “If you look at the recent history, there is a disturbance in the capital market every four to eight years; savings and loan crisis in the late ‘80s and early ‘90s, the bond market blow up of 1994 and the crisis that began in Asia in 1997 and continued with Russia’s default on its debt in 1998. I was convinced that we were due for another disruption” (Referred in his book “On the brink”). He was proved right within few months.
The same book also refers to a remark by John Mack CEO of Morgan Stanley in 2008 on the cause of the melt down. “Greed, leverage and lax investor standards; we took conditions for granted and we as an industry lost discipline”
This is not just the cause of 2008 melt down; it is the cause of many melt downs. Such behaviour appears to be normal in this line of business. Take a look the civil case filed by Securities and Exchange Commission (SEC) against Goldman Sachs in April 2010 charging ‘fraudulent misconduct’. This is not just an isolated incident as we can see from the following.
“NASD fines Citi, Merrill, Morgan Stanley $250,000 each” The America's Intelligence Wire July 19, 2004” (i)
“On June 6, 2007, the NASD announced more than $15 million in fines and restitution against Citigroup Global Markets, Inc., to settle charges related to misleading documents and inadequate disclosure in retirement seminars and meetings for BellSouth Corp. employees in North Carolina and South Carolina.” (ii)
“Merrill Lynch & Company said yesterday that it would pay $100 million in penalties to New York and other states and change the way it pays stock analysts to end an investigation that its chairman said had damaged the firm's reputation. “ (iii)
Citigroup Inc. agreed to pay a $70 million fine for practices in its Baltimore consumer finance unit, including raising the cost of loans to poor and credit-starved customers by requiring them to have unnecessary cosigners” (iv)
“Morgan Stanley, the second-largest U.S. securities firm by market value, was fined $10 million by the Securities and Exchange Commission because it failed to guard against insider trading for at least eight years. The fine was the biggest ever for a violation of surveillance rule” (v)
These are just a few samples. Do a Google search with the word ‘fine’ along with the name of any of the large investment banker; you will be surprised at the frequency of serious transgressions which are not just fines on technical violation but fines on substantive charges. We will wonder aloud “Will we ever learn?”
Compounding such practices is the frequent roll out of complex financial products which are often too complex for the investors to understand. Hank Paulson’s (who has been the CEO of Goldman Sachs before taking over as the Treasury Secretary) reference on the proliferation of product innovation is quite blunt on this. “In theory this was all to the good. But there was a dark side. The market became opaque as structured products grew increasingly complex and difficult to understand even for sophisticated investors”
This is why we need innovative regulation to match with the innovations in market place. In his blog post on regulating the new financial sector, Prof. Willam Buiter has given a very interesting suggestion “the same rigour used by US FDA for pharma and medical products should be insisted for introduction of financial products to broader market does not look out of place in the context of the recent history”.
We also need to think innovation in the checks and balances that we build in the system. Quoting Paulson again; “The regulatory structure, organised around traditional business lines had not begun to keep up with the evolution of the markets”.... it had led to counterproductive competition among regulators, wasteful duplication in some areas and gaping holes in others”
We in India have few important lessons to learn from all these.
To prevent run-away innovation that is rash and irresponsible, we need to put in place the right regulatory establishment to avoid the same kind of mistakes that has been laid bare in front of us. If we expect responsible behaviour and self regulation collectively from the guys running financial markets we are asking too much. We have not seen such industry wide responsible behaviour anywhere in the world.
Regulation does not mean micro-management of day-to-day functioning. Regulator’s role is to set the rules of the game and keep a watch whether the players are playing as per the rules. He also has to keep a look at the impact of changing structure of the game and modify the rules. If I give an example, the rules of T20 is not exactly the same as in the case of test cricket though both are cricket. To make this possible the regulators will have to be able to attract people who have the right experience, the right domain knowledge and most importantly the right attitude who can establish appropriate processes and use the modern technology tools and match or better industry strengths. This is the challenge of governance.
One of the major suggestions on regulation we often hear is to curtail all innovations; I don’t agree with this. We have enormous potential for modernising the markets with innovative products. If we say that we will be insulated from the turmoil on account of lack of market sophistication, we are not being very bright. It is like saying that I never fell because I never rode. A sophisticated market is a prerequisite for growth. In this journey we will make mistakes; and these mistakes will trigger better controls and that is the democratic process of growth. To go into hibernation is not the solution. Look at our favourite sport, cricket; from leisurely five day test matches we have progressed to one day internationals and now to 20 over matches keeping pace with our life. Notwithstanding, the controversy of IPL, the innovations have only improved the game on multiple dimensions.
“ We should and can have a structure that is designed for the world we live in, one that is more flexible, one that can better adapt to change, one that will allow us to more effectively deal with the inevitable market disruptions and one that will better protect investors and consumers.” Hank Paulson
(i) http://www.accessmylibrary.com/coms2/summary_0286-22046900_ITM
(ii) http://en.wikipedia.org/wiki/Citigroup
(iii) May 2002, New York times http://www.nytimes.com/2002/05/22/business/100-million-fine-for-merrill-lynch.html
(iv) Washington Post, 2004
(v) Bloomberg 2006
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