That post discussed to what extent regulation, per se, is really possible, or even desirable, in the current context of our financial system.
Other passages in Kaufman's thought-provoking editorial include these,
"As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.
But the destruction of financial silos that once separated brokerage, commercial banking, investment banking, insurance, mutual funds, and other financial businesses has made fragmented state and federal regulation obsolete.The Federal Reserve System comes closest to performing the role of financial system guardian. Its central mission is to implement policy that will encourage sustained economic growth. But its monetary tactics are asymmetrical. Leading Fed officials periodically acknowledge that the central bank knows what to do when a financial bubble bursts (ease monetary policy), yet it lacks the analytical capacity to identify a credit bubble in the making. How, then, can the Federal Reserve hold inflation in check in order to encourage economic growth while at the same time restraining financial markets within prudent limits?
Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade."
While he doesn't explicitly state it, I get the sense from Kaufman's remarks that he believes the integration of the 'silos' of financial activities such as brokerage, commercial banking, investment banking, insurance and mutual funds to have perhaps been not an unalloyed good thing for our financial system.
Whether or not Kaufman meant to imply this, or really believes it, isn't material to my point. I'd like to explore it for its own sake.
It seems to me that two salient differences between our financial system circa, say, 1960, and 2007, are: provision of more financial services to more consumers, and; provision of more instruments which allow risk to be bought and sold, at prices determined by freely-operating markets, among sophisticated, vetted parties.
Think back to the world of 1960, and my first contention is obvious. Credit cards, apart from retail store charge cards, were the exception, rather than the rule. Investing directly in equities or fixed income securities was expensive, the former enjoying (for brokerages) a 7% fixed commission structure. Capital, at the retail level, in the form of savings, was sticky, rather than liquid. Financial performance information was scarce, if not virtually unavailable.
Now, the changes in retail brokerage alone has resulted in massive changes in investment flows. Information abounds, for free, about equities, mutual funds, and all manner of investment vehicles. Trading and investment is much cheaper, and includes direct, electronic access via trading one's own money at costs which were totally unforeseen in 1960.
The process of buying a home is now cheaper and faster than it was 47 years ago.
In the process of their evolution, various financial systems came to increasingly on technology. This reliance, as it has in other industries, drove two important structural changes. First, the rising costs of technology made size profitable, driving consolidation in businesses such as credit card issuance and processing, as well as mortgage loan origination and servicing. Second, concurrent with this consolidation came lower fees for the same services.
In business after business, save, perhaps, for boutique services such as high-end private banking and investment banking M&A activities, scale has become important for driving costs down and making financial services ubiquitous to those who need them, be they retail consumers, investors, or institutional investors or credit customers.
Along the path to 2007, substantial businesses were built by standalone companies in asset management, credit card lending, mortgage banking, and various capital markets activities.
As recently as 1996, when I was Research Director for then-independent financial services consultant Oliver, Wyman & Co., which is now the financial consulting division of Mercer Management Consulting, there were five independent credit card issuers (First Card, MBNA, Advanta, and two others whose names now elude me), a number of mutual fund companies, and several mortgage banks (Countrywide & Golden West, to name two), and retail discount brokers (Schwab, Quick & Reilly).
In the decade since, commercial banks, contrary to accepted financial theory that an investor can diversify his/her own holdings better than a company can do it for him/her, sought these types of businesses to attenuate variation in their reported earnings, as well as pursue the mythical 'cross sell' opportunity amongst various retail businesses.
The results have not been impressive, as I noted in this post two months ago. Thus, Kaufman's concern regarding money center bank opaqueness to regulatory scrutiny may be only a passing issue. Even now, there are calls for Citigroup, the most diverse of the money center banks, to begin unraveling itself into more manageable, standalone units. The financial supermarket model originally pioneered by Jim Robinson III at American Express has never outperformed the S&P500, anywhere, for very long.
Consumer behavior remains stubbornly resistant to profitable cross-selling of financial services, while their provision by giant, diversified financial entities results in difficult-to-manage, loss-making financial companies which never seem to function smoothly for very long. For more on that, read these posts, here, and here.
And, contrary to Kaufman's typical gloomy outlook, perhaps, as I observed here, in a post echoing an article appearing in the Wall Street Journal just this past September, we are observing a pendulum of credit creation that is swinging between securitzation and portfolio lending. Right now, it's swung far to the securitization pole, but appears heading back toward the center, and, probably, beyond.
My point is that, over time, financial conglomeration does not, in fact, lead to consistently superior shareholder total returns. In fact, the only currently, or, for that matter, historically frequently-appearing large financial institution in my equity portfolio is Goldman Sachs. It's not a widely-diversified financial services company. Rather, it tends to specialize in two areas- institutional businesses, such as underwriting and trading, in which superior knowledge, modeling and risk management matter, and asset management, which shares the same salient characteristics.
The price that US consumers have paid for financial services innovation and cost reductions over the past five decades has been the concentration of many financial services into fewer, larger entities, which concentration has increased risks to the banking and credit system.
Failures such as First Pennsylvania Bank, Continental Bank, SeaFirst, and numerous banks weakened by loan losses, which were acquired during the 1980s and '90s, such as BofA, Shawmut, First Interstate, and a clutch of Texas energy-lending dependent banks, provide examples.
Perhaps the most serious threat to the US financial system in the past decade was the 1998 collapse of Long Term Capital Management, a Connecticut-based hedge fund founded by former Salomon Brothers partners, led by John Meriwether. However, that entity doesn't fit Kaufman's warning of a diversified financial conglomerate bringing down our system through complex, opaque dealings among its many tentacle-like businesses.
No, LTCM managed to do that with just one business- asset management. It complied with then-existing hedge fund regulations. No problem with concentration of financial service businesses and risk in that case. Yet, it is generally regarded as the worst single-firm example of excess in recent memory.
The US financial system weathered the LTCM situation, and the prior crises involving various insolvent banks.
So, in conclusion, I'm not at all certain that Kaufman's warnings are even correct. Most of our financial system's largest failures have been committed by non-diversified banks or financial services companies.
In fact, one of the few benefits, besides technological innovation, that recent consolidation affords is larger capital bases with which to absorb the effects of mistakes.
Looking back over nearly 50 years of US financial system innovation and evolution, I think one could fairly say that the benefits we have enjoyed have far outweighed the realized risks that have accompanied such changes.
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