The Street could help repair the trust it's broken from playing a part in heralding a "Great Recession" by funding and helping foster small businesses and entrepreneurs instead of ignoring them, according to panelists speaking yesterday at the New York Forum.
The predominant message at the forum, which is supposed to be a new, economy-focused, New York-based version of Davos, the annual summit held in the Swiss Alps town that draws the globe's top bankers, media moguls, economists, academics and press to discuss solutions to the world's problems, was essentially the following:
The key to transforming a moribund economy into a healthy, thriving one requires innovation. And the main engines of that innovation and dynamism are new, small businesses. So the financial markets should foster the incubation and growth of these entrepreneurs from the get-go, and public policy should supply the tools and space to let these innovators create and thrive.
That emergent notion aims to convince The Street to focus a larger percentage of their resources on incubating - financing and commercializing - novel ideas from entrepreneurs, as compared to how they expend the majority of their powers and time, making large companies bigger, and the already well-capitalized richer (including The Street themselves, trading for their own accounts and the like). Cash reserves minted by profits from those more traditional business lines might subsidize a new, reinvigorated entrepreneurial financing business, until it becomes more viably monetized.
Those calling for an increased supply of entrepreneurial financing are looking in part to The Street to step in and foster such creativity, because economists have marked a yawning chasm, or broken link, in the chain of commercialization in America, which disrupts instead of facilitates what should otherwise be a smooth conveyance of promising new ideas and inventions, to profitability. There is no clear nor unobstructed path of funding for new business ventures. Venture capital, the most obvious source, is too tiny a part of the solution to matter, these scholars say. They are not enough in number or funds to take up the task to the level required to make a difference, meaning restart America's economic engine. Plus, VC firms have been a demoralized or more risk-averse bunch for a decade, some say, since the tech bubble burst in 2000.
Venture capital investment fell from one percent of U.S. gross domestic product (GDP) at its peak in 2000 to two-tenths of one percent by 2003, points out Edmund Phelps, winner of the Nobel Prize in Economics (2006) and director of the Center on Capitalism and Society at Columbia University. Venture capital still hovers around 0.2 percent of GDP, according to the latest available (2008) numbers; it has yet to regain the level it reached in the mid-1990s (see endnote on Phelps' stock market cap and business output ratio he says indicates a weakening in business investment since, which, he reckons, foretells of dreary employment numbers ahead).
"Venture capital is tiny," agrees Richard Robb, CEO of Christofferson, Robb & Company, a London-based hedge fund. "It’s not as adventurous as its name would imply; it’s never been as big as all the propaganda suggests. Last year, institutional venture capital in the United States got $18 billion - there was about a third of that in Europe. Of that $18 billion, only 15 percent were an early-stage startup, only 25 percent of companies were less than three years old. You can call it venture capital, but it’s really leveraged acquisitions."
Smaller banks, meanwhile, although geographically closest to local entrepreneurs, are typically the most risk averse of venture funders: Local banks are not known for taking bets on whiz-bang new economy companies like discount gene sequencing firms or "social location gaming" application makers.So who are the real risk takers in this country? Wall Street, obviously. It's important to note that this includes the big banks, but also hedge funds and private equity firms. This is The Street as defined by the type of risks these firms are willing to take, not their locations anymore, which can range from Park Avenue to Greenwich, Conn. to Fort Worth, Texas, to Singapore. This really does also include well-capitalized venture funds, despite their dressing down above. It's these folks, importantly, who are sufficiently funded to both bet on entrepreneurial ideas and hedge that risk by also financing emerging companies with more proven track records. And here's the key to proponents of this theory: To forge breakthroughs, patrons have to allow for failure; such benefactors need to be well-funded and hedged enough to allow for failure, albeit within reason. This stems from the view that a risk-averse culture stifles growth. And from the common sense maxim that getting anything right requires many attempts and course corrections; applications of lessons learned. That essentially, we learn best from making mistakes: Consider the past, lest the desire is to repeat it.
(We venture that applying such caution to entrusting anything to The Street again given the lacerating pileups doing so has seemed to have tended to immure us would be considered just as wise, by many. And the amount of failure we're able to abide seems complexly "multi-polarizing," meaning tolerance for mistakes will likely seem overindulgent to those who view The Street's excesses as endemic and cyclical, just as it will to those who see its players as too big to fail; yet wholly insufficient to those who deem taxpayer bailouts of powerful private companies expropriation, reasoning it's taking average citizens' money and giving to the rich; other 'let-em-fail' folks finding said rescues antithetical to free market principles; and those claiming the public and government should post-crisis just let bygones be bygones and leave the market alone - three otherwise disparate groups that nonetheless all believe letting mistakes happen is natural and good. This is unless, of course, a big bank spurs government rescuing again. Then portions of the latter two could doff their principles in exchange for state protection, binning them more in the allergic-to-failure lot. There are also skeptical taxpayers we know who are willing to abide bailouts if they could prevent layoffs or buoy employment, despite experience which shows that job cuts come as part of any such emergency action: Strange bedfellows do cataclysms make. Given the brutality of our recent economic cudgeling, the degree of faith - that ephemeral, hopeful vagary - that lessons have been learned and are being applied sufficiently, seems diminished regardless. But remember, this is a call for leadership, one imbued with responsibility.)
Of course, the big banks will have to - some say significantly - reshape their traditional comportment to the markets to truly advantage (by financing) and take advantage of (by making money on financing) entrepreneurial small businesses.
How to make it work
Robb says it may pay for the market to look back to "the 19th century model of a merchant bank" to spark new small businesses and finance innovation, in which a broker might again become the polestar of private investment by funding the growth of emerging businesses sooner, like at the idea or planning stages, and incubating projects more locally and specifically: Merchant banks were powerful, but focused their financing might more narrowly on - albeit across a range of - individual projects in each town, trading hub, port or business locus where they might reside or have a temporary presence. Born from financing trade route ventures, merchant banks also lent and underwrote distribution far afield from the grain harvest or similar source of production of those to whom they originally and also gave credit. But they supported the whole of the economic endeavor at that time by lending directly to its pistons, whereas Wall Street, has by most accounts meandered far afield to shed such risk - that of direct, tailored venture finance.
Others say before shifting resources to some new or improved business model, Wall Street needs to first better understand what essentially is its leadership role - and responsibility - in boosting growth. That's foisting a lot on a group that individually are, like all other companies, dedicated to turning profits and sating shareholders. Let's leave aside the practice of showering executives with huge cash bonuses for the moment.
"You’ve described essentially this virtuous circle of innovation and ideas that one could foster," said Leo Tilman, president of consulting firm L.M. Tilman & Company. "Think about the sequence of the discussions from last night into today; business people, young people, inventors, creating new ideas, entrepreneurs launching new ventures, marketers and managers advising these ideas and new products, [and] last but not least, financiers financing these products. So the role of Wall Street and the role of the financial industry in that circle is absolutely essential, and the ability of Wall Street to create lasting value is part and parcel of this entire virtuous circle.
"What is the role of the financial industry? One: The financial industry must have strategic vision of what it should be," Tilman said. "Two: It must allocate resources to serve the business sector. And three: It must be able to create lasting value itself. We need to change the way we lead, and the way that we make strategic business decisions to erase the uncertainty and turn it into opportunity."
Yet some, including Robb, contend the banks are simply less capable of levering open the floodgates on the entrepreneurial giving waters, than say, hedge funds, like the one at which Robb works. But, he adds, private equity and "blue ribbon" venture capital are similarly equipped to do the job.
"Where does the money come from to fund truly innovative projects? Traditionally, [financing for ideas has come from] individuals rather than banks. And then private equity firms and hedge funds, both here and in Europe. I think that’s the financial framework. We’re here today to create a new paradigm for growth. We can’t look to the large financial institutions that the public is mad at to be able to fund this kind of innovation."
But hedge funds are just as untested and even less in the incubator game as venture capital funds. Hedge funds only began noticeably dipping toes in the venture space around 2006, and remain less than a significant percentage of it today. And the amount private equity dedicates to venture capital or "angel" funding, that which seeds ideas into working corporate structures, is similarly minuscule. The big game for "PE" firms resides further up the commercialization chain and remains in privately funding established companies or in taking public companies that are struggling private, by buying them, partly by issuing debt from these same firms, and then restructuring, or improving, PEs argue, these companies' operations so as to sell them later for a profit. Also, the risk profiles of private equity funds, based generally on what the industry refers to as a "growth equity" model, which the aforementioned illustrates, requires a high bar for proving long-term profitability, and hence private equity funds can be more conservative - meaning they countenance failure even less - than standalone venture capital funds.
What then? A government-aided skunkworks?
Depending on who you talk to, part of a potential systemic barrier to financing innovation could reside in the power of the big banks themselves, and the policy that allows them their largess, or that which boosts their capital and tax requirements. It's also possible that either of these structures could act separately or together to stealthily block the kind of innovation - large-scale small business financing - for which some pine.
"We have a public policy that tries to freeze dinosaurs in place in a variety of industries, sometimes even including financial services," said Glenn Hubbard, dean of the Columbia Business School and former top economic advisor to President George W. Bush. "The right way to get at that is really to step back and let things change. The way forward is to focus on entrepreneurship and innovation and it’s what I would boil down to diet and exercise. Slimming down the state, finding a bigger role for the private sector is the diet, and the exercise is really a growth agenda as a jobs agenda rather than a safety venture." Shrink government, "incent" companies.
Phelps generally agreed: "I think it’s magical thinking to believe that tackling social problems like health care, climate change and energy will somehow create jobs on the massive scale that we need."
If one detects a bit of an echo chamber regarding support of laissez-fare regulation and corporate tax policy, and skepticism of government spending, stimulus and deficits, it should be noted that Hubbard, Phelps, Robb and Tilman are all members of the Center on Capitalism and Society. Although they displayed range in their opinions of how they said it could best be applied, the center espouses a theory of economic growth that posits entrepreneurs and financiers as the key market catalysts in the aforementioned "virtuous" circle that, they claim, optimally boosts prosperity and increases employment. That from stimulating innovation via enabling new, small businesses - and their bankers - to thrive.
Skeptics counter that all this talk associated with Wall Street supporting innovation actually conceals a sub rosa effort aimed at convincing policymakers to keep capital and tax requirements low, lest the banks be constrained in how much they can put to work, for themselves and others. Regardless, both those on the more free market fundamentalist side of the spectrum, and those more concerned about applying risk management to a system that could better prevent the global economy from cratering, which it nearly did two years ago, have valid points in this debate: How to strike the appropriate balance between lending and credit (risk) decisions? Spending is needed; from whom can define your ideology. But, as we discovered, stimulus sourcing is not always a pigeonhole:
Note that government funding, what Phelps deems "chronic habit-forming Keynesian stimuli," which he calls a misstep, is exactly what none other than Rupert Murdoch, News Corp. chairman and CEO, said he favors when it comes to stimulating what is often lofted up as the next bubble of entrepreneurial innovation - alternative energy production - specifically solar, among businesses. This is what he said when he spoke during an opening panel of the forum the night prior. Although, it's important to note Murdoch had earlier emphasized it's his view that oil and gas will be with us for a "long while." And, in mentioning solar, Murdoch was actually responding to an audience member's question regarding a laugh-inducing comment he had made previously after saying that two huge pipelines could be run from Alaska through Canada to the states to "save this country, probably $150 billion a year..." because, wait for the punch line, wait for it..."We didn't buy Alaska to look after the moose!"
But, in responding to the audience member, who sought less comedy, Murdoch said: "Of course we should be investing in studying and building other forms of energy. And the alarming thing that I heard is that the Chinese are already ahead of us on solar energy - we ought to be working very hard on that. That is a legitimate area of the government to at least be subsidizing, or making tax deductions for people to spend money on that. We want to do everything we can, but in the end, we probably come back to saying we also need to have safe nuclear. You can't make a clean gas but you've got to have energy."
While Murdoch did not directly make the following connection, others that have, say that longstanding power structures that "freeze dinosaurs in place" are still chasing coal- and petrodollars. And what could well be preventing alternative energy - solar or otherwise - from becoming the next big engine of wealth creation fueled by entrepreneurial innovation and garnering larger private or public funding, is that banks are chasing and the government is enabling shorter-term, traditional profit streams using the excuse that emerging economies, particularly China, are serving their ever-growing energy needs by boosting exponentially their old-line energy industries, hard and fast and for the foreseeable future. Big banks chase such cash, internationally and domestically. There's easy, big money there behind all the protectionist barriers. So 'why fight or not make money on what you can't ultimately control?' goes the reasoning. This is despite China's dismal pollution and safety records, from which the U.S. is so obviously not immune, given BP's Gulf of Mexico spill and the Massey Energy Company's coal mine explosion in Montcoal, W. Va.
"China is starting up a coal-fired power station every single week of the year," Murdoch says. "And that's done a lot more damage than any good we can do here at the moment. We all have to be in this together. Luckily, the Chinese people are beginning to revolt against their own environment; the filthy air, the filthy water and so on. In a sort of democratic way, in China, they're forcing change, but it's going to be slow, because the Chinese government are relocating a billion people from the peasant farms into cities and finding industries for them. Whether they can do it, whether it's possible, I don't know. But that is their policy. I know people who are predicting a crash, but I have no idea. I don't know enough about it. I do know that they have a very real asset bubble at the moment. [But] they're doing everything they can to manage it."
For all we know, that management could involve even more coal-fired power plants to employ all those former rural citizens, financed by - if they're allowed well enough inside - the big, non-Chinese banks. Again, the globe's largest banks chase the biggest, easiest money. And that applies here. No one's disputing that. And, energy-producing natural resources like oil and coal, remain crucibles of power and cash. Such behemoths Wall Street recognizes well, and knows how to finance. These widely accepted constructs are in fact why turning banks more toward small entrepreneurial promotion may be difficult, and why alternative energy supporters continue to call for an old-fashioned government or public-private skunkworks, a first-man-on-the-moon style push to fund alternative energy production in the U.S. Because private funding has proved so inadequate.
We certainly have the know-how, goes the argument. Why not work on the technology?
There are many existing templates for jumpstarting and supporting creative thinking that leads to solving the world's thorniest problems. Funny we didn't hear much about them at the forum. But here are some that come to mind:
What about a three-legged incubator missioned to crack the world's most confounding challenges with commercialized solutions applied to medicine, energy and education funded and staffed by the Defense Advanced Research Projects Agency (DARPA), MIT and Goldman Sachs? Imagine the spike in blood pressure among the trilateral commission conspiracy theorists on that one! Or how about financiers tapping university supercomputers in knowledge-sharing programs to build more accurate financial models? The Washington, D.C.-based Council on Competitiveness deems University supercomputing centers untapped "national treasures" which should be harnessed to help firms innovate faster and compete better globally. Even the NSA works with industry, however indirectly (insert joke possessing varying stations of veracity here), via its own commercialization program. How about a hedge fund technology provider that supports the research and development of drug cures and treatments for cancer, Alzheimers and diabetes by selling supercomputing applications to alternative investment companies? Numerous such examples prove that finance and social responsibility need not be mutually exclusive endeavors.
Pretty talk, ugly reality?
Anyway, the response from the bankers, regarding them financing more new, small businesses and entrepreneurs: "Easy for you to say." They may have a point: It can be difficult to model the probability of positive (or negative) returns on investments in untried ideas or truly new businesses to any reasonable degree of certainty. One has to take an untested gamble - a flip of a coin, essentially - goes this view, because theoretically there is no similar existing company able to serve as a stand-in for the idea of the new one, so there is no historical data available to plug into the model.
Robb concedes the bigger risk: "The distinction between uncertainty and risk: In risk you know the probabilities; with uncertainty - we also call it ambiguity - the outcomes are fundamentally unavailable. The methods to finance ambiguity involve judgment - decision-making that can’t necessarily be justified to regulators or to institutional investors. Things that can be rated are not things that are novel."
Plus, Wall Street banks predominantly play at the end, or top, of the corporate commercialization chain, where risk is low, reward is high and business is generally steady, give or take the odd cyclical dip in corporate growth. Banks generally enter the picture when a once-novel company is mature enough to go public; they wait for years until there are enough revenues and profits - enough data - to pay the banks well enough to make it worth their while to sell and distribute the firm's shares to investors, and then even later, to facilitate the firm's access to credit in the debt markets by underwriting, issuing and distributing the firm's bonds.
Also, the advice to take new risks comes precisely at a time when risk-taking from financial firms is under skeptical scrutiny. Isn't outsized risk-taking by financial institutions, and individuals, however uninformed, what led us here, first to the financial crash and now economic anemia? Consider the past indeed.
Yet therein also lies the potential for growth, opportunity. A chance for hedge funds, big banks, private equity and venture capital to get smarter, find the innovative people and ideas earlier, finance them faster and compete even more with one another. Shucks, maybe even do some good, if we're talking greater innovation in the sciences, medicine or energy, or bringing education and technology to places where those resources required for growth are scarce.
Regardless, a battle between banks, hedge funds, private equity and venture capital for new markets appears pitched: While the banks' role in intermediating cash needs and requirements remains highly secure, the shared, open source nature of the Internet is empowering financial risk-takers to do-it-themselves, by fulfilling demand for services once the primary domain of the big banks: Tiny cracks have been seen to spider over the thick walls protecting the banks' core roles as middlemen in all things finance. Hedge funds, for instance, can more easily be self-seeding through online social networks which match funds with investors. There's even a low-cost blueprint for starting up your own hedge fund that's developed from renting spare computing power from online retailer Amazon.com.
Along those competitive lines, banks might do best to stem what's long been threatened as a brain drain to hedge funds and other firms by proving that, although they are too big to fail, they are not too big to innovate. After the titans of finance were found so clearly to have both contributed to and been victimized by the recent market crash and subsequent economic stagnation, they may find it difficult to convince the best and brightest talent emerging from American universities that the big banks are good, inspiring places to work, that they are not amoral or "evil" in the way Google tries not to be (and fails sometimes, such as in censoring Chinese dissident material).
Proving that Wall Street truly does good works (if not "God's work" as Lloyd Blankfein, CEO of Goldman Sachs claimed last year in a Times of London profile); that it's truly embracing of creative, self-actualization through intellectual stimulation and fulfillment; that it's actually competent enough to be entrusted to hold the reins of the economy, which sets the course for Main Street, to the large number of skeptics inspired by its huge recent failures, remains a high forward hurdle.
"The day Lehman Brothers failed represented a real turning point at which the whole model of capitalism and financial markets at its heart was challenged and found wanting," said Matthew Bishop, New York bureau chief and U.S. business editor at The Economist. He was moderating a panel at the forum called "Can we restore confidence in Wall Street?"
"I believe a new, more evolved form of capitalism is going to be needed [and] the role that Wall Street will play in that model is still to be seen," Bishop said. "I think prior to 2008 it was possible for someone on Wall Street to say with a straight face that what they were doing necessarily improved the state of the world, made us all richer and less exposed to risk. I think it’s evident that after September 2008, it’s no longer possible to say that with a straight face."
Bishop is the co-author with Michael Green of a book meant to elucidate how the economy can get its mojo back, called "The Road from Ruin: How to Revive Capitalism and Put America Back on Top." One way the book recommends doing that is through "philanthrocapitalism," which Bishop and Green define in marketing for a previous book as "rejecting the idea that business is about short-term profits, damn the consequences to society..." - a notion that requires tracking permanently “the means” to “the ends” onto the moral, ethical high road, so profit-making results always in good works spread society-wide. Last year's 400-strong Harvard MBA graduating class has pledged to do as much, though one wonders if enough of those ending up on Wall Street will be able to keep the courage of their convictions once mewed in the frenzied predatory bloodletting that too often seems meronymic to finance.
One problem, however, just as big for innovation banking, may be locating enough entrepreneurs to finance. Panelist Thierry Breton, the former French finance minister, now chairman and CEO of stock exchange technology provider Atos Origin, said he believes Wall Street should go back to its roots to "finance our dreams" again. But he added that finding the dreamers may have gotten tougher. Not one of his students, Thierry said, when he taught at Harvard recently, expressed an interest in starting their own business. "They all wanted to go work for a hedge fund or private equity firm." (Notice they were not remembered to have described "banks" as desired employers.)
Another thing standing in the way of entrepreneurial finance is the simple fact that The Street likes what it knows. Meaning, it's highly unlikely the banks will reallocate resources in any significant portion away from what's basically minted them money in the past. And most of the banks, when asked why they're not lending, say what needs stimulating most is one of their biggest money minting operations, what many say has become the power construct of our banking system: securitization, which is the pooling together of commercial, consumer or government loans - credit card and corporate debt, government borrowings and mortgages - from direct lenders packaged into bonds and sold to investors. The lenders sell off their loans with the help of the banks, which consolidate the loans from disparate sources, package them into big pools and distribute (sell) them as bonds to investors. The banks are called "underwriters" when they do this. The process is also referred to as our "shadow banking system," as it involves lending using indirect, non-bank methods, such as placing the bonds in offshore or "bankruptcy remote" vehicles or tax havens, with the banks or original lenders ("originators") often recording each loan as a "true sale" to those remote or "special purpose vehicles" (SPVs) - typically shell structures - versus recognizing them as an investment or a bet, which, if the "assets" therein are ever valued less than stellar or toxic, as many were during the recent crisis, is a potential liability to whoever can be said to own them.
Re-empowering securitization, the banks say - the business model the banks know - versus direct lending - the business model the banks left behind - is what the big bond underwriters cite most often as the requirement for reinvigorating the system, the main stimulus they say is needed to defibrillate the economy. Despite this being, none too few argue, part of what wrecked the whole enterprise.
Those weighting the rise of securitization as top player in both the boom, and the bust, of our recent economic thrill ride say history is essentially this: The banks rode a tidal wave of selling bonds and derivatives, a system of hot potato-style shedding of risks offered to consumers, companies, governments and the banks alike, via products the banks themselves created for same. This passing on of risk in what can amount to a high-stakes game of musical chairs, has come to the point over the last several decades to where now the banks arguably have become both the gatekeepers and keymasters for the entire lending system, and also therefore, our economy: The six largest banks in the U.S. now control assets that represent, even post-crisis, over 63 percent of the country’s GDP, compared to just 17 percent 15 years ago. That growth in big bank assets as a percentage of GDP roughly mirrors or tracks the growth chart/timeline of the securitization markets, except of course for the sharp dip in securitization volumes when the credit squeeze was at its worst and volumes began to fall from their peak in 2007. Before that, roughly half of the loans made in the U.S. were securitized.
Yet, despite all the hyperbolic talk and handwringing, news of securitization's late demise has been greatly exaggerated. They're hiring in Europe for a bond boom, for instance. And it remains, and will continue to be core to The Street's operating profits, at least according to, well, The Street.
Example: Vikram Pandit, CEO of Citigroup, when asked about lending, did not talk about the banks getting into a new business of direct lending to small businesses or entrepreneurs. Instead, he pointed to the need to fire up the old top-down power construct of securitization (the model which we know), to spur direct lending (the model left to the little fellas, the small retail lenders collectively known as "originators"). Pandit said the causes for the dearth in lending not only involve supply, which is constrained by a lot of uncertainty, he said, but also because securitization, the great modern Wall Street-run machine of American lending, remains broken. This theory says that when direct lenders like small banks and mortgage shops become used to shedding their credit risks through securitizing them - selling the various direct loans they've made to consumer and commercial debtors in pools to investors - they stop making those direct consumer and commercial loans, when they can't sell them off into the pools. (This of course discounts the entire other half of U.S. loans that usually do NOT get securitized, but either held on the books of creditors, or sold off to be held on the books of typically bigger banks or lenders. Such loan sales have flourished recently as many smaller institutions have sought, or been made, to shed risk.)
"The banks haven’t been lending to a lot of the activities that have been going on for two reasons," Pandit said. "One, the markets haven’t been working; the process of providing capital has gotten disintermediated. That capital has been coming from the bond market, the equity market, the private equity funds, the hedge funds, a whole infrastructure of people who are attuned to providing this sort of risk capital. Don’t forget that for the last 10 years in this country a shadow banking system, which was a non-bank financial system... The shadow banking system is a shadow of itself [and] shrinking because the capital markets are just not willing to lend through securitization or other activities for these kinds of entities. Well, that makes a big difference in terms of the amount of loans out there, not only in dollar amounts, but [because] these people had the infrastructure in place. They could find that business somewhere out there in Middle America that actually needed the loans. [Now] not only is the amount lower, but that infrastructure has been cut back. So even if you say ‘Here’s the money,’ how are you going to get it to these people?"
Robert Wolf, CEO of UBS America, and member of the President’s Economic Recovery Advisory Board, essentially agreed.
"The recent environment, it was pretty clear to me it was really one of extreme leverage," Wolf said. "Financial services, households, consumers, across the board: Everyone took advantage of the low interest rate environment and easy credit. Our industry moved away from our normal cycle. We moved from being in the moving business to the storage business. And we got away from our core competency, which is how to serve the client. I think that one of the most important things we don’t want from reform is you don’t want to restrict capital. You want to make sure that capital is fungible across the globe; that capital markets are buoyant."
Wolf conceded that the big banks are a major part of the GDP - "maybe too much" - and added that it might be good if America went back to making things again, or perhaps "green" or alternative energy should be the catalyst to make our economy freshly robust. He also admitted a need for self-reflection in the industry. "We have to look ourselves in the mirror and exude humility and make sure products are suitable for our clients." (That word "suitable," he used, versus "best" is key: Securities brokers have no fiduciary duty to their clients, meaning they don't have to protect their clients' best interests when giving customers investment advice. Brokers need only make certain that the products they are selling are "suitable" to the type of investor who might be buying them.)
Yet it also stands to reason that the aforementioned synopsis of the crisis, what amounts to a ‘you guys were junkies too’ defense of the status quo, lacks an important element required for making it convincing: A junkie needs a dealer. And, given that, which, the junkie or the dealer, should be expected to have the responsibility for possessing some type of moral code or ethics? Neither? Who, after all, is best equipped to take advantage of the other when there's an imbalance of power or information in this relationship, the junkie or the dealer? The consumer or the bank? Which led us here?
Here's Phelps essentially supporting just such a systemic critique, in which one sector of the securitization mechanism is being shown to have sucked up resources that otherwise could have gone to financing small, entrepreneurial businesses, although Phelps mentions only the federal government's role in this scheme, which leaves out the role of the banks in creating, operating and profiting profusely from the securitization machine:
"You’re bringing this discussion back to the financial crisis," Phelps said, "but we had this dynamism before the financial crisis. What I was saying in my opening remarks was that the stock market capitalization in real terms was just about flat from the end of 2000 until the end of 2006. The American economy would have been stagnating except for the fact that we… the government, manufactured this housing boom, which generated some nice stats in terms of employment, but business investment was pretty anemic over the entire decade. So I don’t think we had a great structure in place before the financial crisis. I think the rot was developing all this time, but it was being masked by the housing boom."
Some say what's needed to best strengthen our broken financial sector is to bust up the existing system into more moving parts - increase competition - by breaking up those that control it, the world's biggest banks.
"We need drastic change," said Amar Bhide, visiting scholar at Harvard University’s Kennedy School of Government and author of "A Call for Judgment: Sensible Finance for a Dynamic Economy," due out in October from Oxford University Press (USA). Bhide's prior book was 2008's "The Venturesome Economy: How Innovation Sustains Prosperity in a More Connected World." He is also a member of Columbia's Center on Capitalism and Society.
"The five CEOs of the five largest banks in the United States, they collectively have $200 trillion in derivatives sitting on their books," Bhide said. "They don’t know what risks lurk in these derivatives. Nobody knows. Nobody, I believe, has read a derivative contract. We have gone over the last 30 years, not just in the last four or five, to an increasingly Soviet-ized system in which credit decisions are made by three credit rating agencies, four or five investment banks and underwriters, instead of tens of thousands of lending officers looking around making specific judgments about credit. This is a dangerous system because… you have three credit rating agencies all using the same models making mistakes that weigh down the system. It also leads to massive misallocation of capital. This whole mass produced finance, the mass production that allows derivatives to go six-fold [in the last decade] to $600 trillion. What this does is it also short-changes real business. Once the derivatives business is so hot, and it is hot, who the heck wants to get their hands dirty doing credit analysis and so forth? This mechanistic system of short-changing real business, it’s giving mortgage loans to people who shouldn’t get loans versus perhaps the people who should get loans. It’s something that’s been fundamentally wrong for 30 years and remains wrong. We still have the shadow financial system."
Bhide's advice? "Break up the banks," he said. "I would go for a much tougher version of the Volcker rule [banning banks from trading for their own account]. I would go back to a rule that was in place in 1835 that says 'you should do this, this and this, and nothing else.' Say, ‘You can only make loans to businesses of the sort that an average lending officer and an average bank examiner can understand, and nothing else.' And then let the rest of the firms do what they want, as long as they do not have recourse [taxpayer bailouts] to the depository system. We need to have a very simple solution."
Breaking up the big banks, many would say, is politically untenable, and therefore discounted, regardless of the level of merit it may hold as a fix that could work to sufficiently reduce risk while optimally spurring enterprise.
Most agree that change is needed. And many say the type of change that needs to come is that which can better support sustainable economic growth from those which have traditionally been seen to have levered and exited flush, up top from what amounts to a financial seesaw: The Street, which is seen to get out at market's peak through either insight or sweetheart deals, while consumers are left gasping from being slammed into the ground for loss of the counterweight once controlling, pumping the ride.
"The onus is on Wall Street itself to articulate what its role is in society," Bishop said. "It also seems pretty clear to me that it hasn’t risen very well to that challenge. We seem to be in an era where regulation seems to be much more necessary, [when] Wall Street’s leadership including its finest firm, Goldman Sachs, has been found wanting, at least in its public statements, in which the public doesn’t really have much confidence."
That's likely because the role Wall Street is too often seen to play in society remains one where the banks help "clients control their risk by introducing them to a zero-sum game that [the banks] win," as Martin Mayer, guest scholar with the Brookings Institution, recently pithily put it in Securities Industry News. This image of Wall Street, although partially representative of the reality, is not wholly inaccurate. And it's partly a self-induced problem. It's why changing to a modus operandi that favors responsibility and leadership for growing an economy that's more steadily and sustainably ascendant from the bottom up - so as to support the story of Horatio Alger, in which everyone has a fair shake at bootstrapping themselves from rags to riches - may prove too heavy a burden. Or, dare one say, too noble a task? Are we naive to ask?
That is up to The Street.
Know that perception always trails reality. The perceived trend to shackle risk-taking, such as with the financial reform legislation about to be agreed upon by Congress: Many in the industry have long deemed the bill as benign to their bottom lines, especially once rules get promulgated from its language, which lacks specific definitions, despite the hype from industry lobbyists claiming otherwise.
Here's Bishop on how reporters and editors at The Economist have found a generally sanguine attitude among industry toward the financial reform bill: "People on Wall Street who we privately found to be very alarmed a few months ago seem now to be pretty comfortable with what’s coming. Which, as journalists makes us feel that something’s gone terribly wrong, because this is supposed to be sorting out what’s happened on Wall Street. And if Wall Street’s happy, maybe the problems aren’t being sorted out."
The industry satisfaction alluded to matched what Robb had earlier said about the regulation of hedge funds, private equity and venture capital firms in the bill, which he called "pretty benign," adding that the resulting "SEC regulations are not going to stand in the way" either.
Given that, ought naught there be a bit of 'careful what you wish for' counterbalance applied to the call for renewed vows between bankers and entrepreneurs, lest the "innovation" sought results in The Street getting busy filling small business coffers full of derivatives and structured products, for which the U.S. reform bill arguably paves the way?
Regardless, it would seem wise to be wary of conventional wisdom - that for instance, conservatism now rules the day in finance - because it belies the fact that the "smart" money always moves quickest, meaning by the time you read about risk rising again in the markets among its players - on which a bit of ink has lately been spilled - the bets have been increasing on whichever trend's just been publicly tipped, for months or longer. Also, let's be real: risk-taking rises again. It always has. More boom and bust? A new bubble? The probability for such outcomes is more strong than it is weak. Whether bubble-chasing need be pathologized as endemic folly to human nature is perhaps another discussion. Maybe a new bubble is what we need. Maybe that's what all this smart talk is really saying, sotto voce.
But what the proponents of larger private funding of new small businesses seem to us to be saying is, not necessarily. That is, if the market can be built on many tiny bubbles and therefore stay reliably, rationally frothy, we can continually crest an ever-rising swell, versus teeter down the other side and plunge into the abyss. This "effervescent" premise again goes thusly: While growth is often observed from the roots-up - with small business and entrepreneurs supplying the engines that drive the overall economy - the stimuli for these sapplings breaking ground often comes from the top-down, with small business playing the role of "green shoots" and Wall Street "starring" as the sun. The Federal Reserve, our central bank, is cast as the water god of overlord liquidity, as it supplies easy (low-interest) money to the banks, to fund their credit operations, don't forget. (Or maybe the Fed is anti- or dark matter; perhaps the banks are too: not always seen, but always there, enabling the endeavor. Whatever. The banks, central and otherwise, are ultimate givers of life of sorts, in their power to lend.)
But consider if such power of liquidity, Wall Street financing, was made available earlier, and less concentrated on one "hot" emerging sector and its brightest, most recognized stars, like it has been with certain Internet retailers and more lately in Chinese real estate and alternative energy? What if that big money was more evenly spread among a multitude of entrepreneurs whose ideas are truly diverse, some in disciplines perhaps not even or easily classifiable, yet? What if the fools rushing in where the angels fear to tread spread their risks around better on multiple burgeoning entities, from the idea for a diet-based candy store to groups of tinkerers testing ways to shrink the size but boost the storage, power and safety of lithium batteries? Would such bets lead to more sustainable, less volatile, but just as robust, growth, versus the spikes and chasms we've had to deal with so much in the past? Proponents for increasing Wall Street's involvement in financing innovation seem to be saying 'We don't know, because it remains untested. But perhaps we ought to give it a shot.'
Endnote: Phelps and Tilman have called for the creation of a government-sponsored "First National Bank of Innovation," which could lend at attractive rates to a network of merchant banks that could in turn invest directly in novel enterprises across a range of entrepreneurs and small businesses. Fueling growth in American business this way, they say, could engender a more steadily ascendant economy, based on analyses said to show that creating more diverse new ventures boosts employment and sales while dispersing risks better, thereby increasing the system's vitality and stability.
Here is Phelps describing his stock market cap and business output ratio, which he says indicates a weakening in business investment over the last 15 years, and strongly points to, he says, a less than cheery employment outlook going ahead:
"Stock market capitalization in the U.S., adjusted for inflation, ended the year 2009 about 40 percent up from where it ended in 1995, but that’s out of context: What about the real economy? Business output rose nearly 50 percent over this same time span, owing to productivity growth... So the ratio of stock market cap to business output is down about 10 percent compared to the mid-1990s. And this ratio is a relatively good predictor of business investment. So the 10 percent behind this ratio suggests a significant weakening of business investment. Such weaknesses in business investment is going to drive weaker employment. Our rough estimate suggests that the 10 percent drop in that ratio means that the natural unemployment will go up from about five and a half percent to something like six and a half percent. The disappointing behavior of this ratio lies in the stagnation of the market cap in real terms from the end of 2000 to the end of 2006. About the same time that Silicon Valley was running out of steam, investors were pulling out of Silicon Valley, venture capital investment fell from one percent of the GDP in 2000, to two-tenths of one percent by 2003. The economy ran out of steam and ran out of dynamism in those years."
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