Jain, A.K. (2011), "13 Bankers: The Wall Street Takeover and the Next Financial Meltdown", Critical Perspectives on International Business, Vol. 7 No. 3, pp. 281-283. https://doi.org/10.1108/17422041111149543
Emerald Group Publishing Limited
Copyright © 2011, Emerald Group Publishing Limited
The contemporary global financial and economic crisis has spawned an industry devoted to explaining the crisis. As is to be expected, these explanations dissect the crisis at different levels. The first set of explanations focus on what was clearly visible in the market – the mortgage‐backed securities that lost values due to declining house prices in the USA and triggered losses at the banks holding those securities. These losses caused some financial institutions to fail and others to withdraw from the borrowing and lending activities, causing financial markets to freeze. The second set of explanations – delving a little deeper into the financial system – examines incentives that led banks to invest heavily in high‐risk derivative products, ignoring the probabilities of costly catastrophic events and setting aside the prudence required to manage financial institutions. A parallel set of explanations examines the behavior of regulators – why they failed to recognize moral hazard situations in the markets and allowed banks to make investments that created systematic risks whose costs had to be borne by taxpayers while banks had enjoyed the excess returns from the investments.
At an even deeper level of analysis, we must ask what allowed financial institutions to become so powerful and strong that banks could operate almost without any controls and a disconnect could be created between the risks and the returns in the financial market. Such a disconnect was in violation of the prevailing idea of well functioning and efficient markets. Simon Johnson and James Kwak's 13 Bankers is an analysis at that level. They ask why the financial services industry became so powerful that policy‐makers, regulators and private investors all completely set aside their cautions and allowed financial institutions a free rein to collect unlimited rents from their control of the life‐blood of a modern economy – access to finance.
The main thesis of the authors is that oligarchic behavior that has been used to describe developments and crises in emerging economies can also be used to explain the behavior of the financial services industry in the contemporary USA. Oligarchs understand how they can enhance their economic power that may have been advanced through technical competence with power developed through political links. They use their power to extract excess rents from the economy during normal times and then use the same power to avoid bearing the cost of economic crises should things go wrong even when the crisis is caused by their own actions. Their political connections allow them to transfer the costs of mismanagement to the taxpayers. The first two chapters in the volume establish briefly that such behavior had not been uncommon even within the USA in the past, especially within the banking industry during the previous two centuries. There is ample evidence that enlightened political leaders in the past have recognized the potential damages of such behavior and have tried to control it.
Control and size of the financial institutions once again became an important issue for the current crisis. It is now widely known that the financial services industry's role in industrialized economies, especially the USA, has grown over the past few decades. The industry's size has grown faster than the GDP, its profits have risen faster than other sectors of the economy, and its share of the national output has risen faster than its share of national employment – resulting in higher income per capita in this industry compared to the rest of the economy. The authors have devoted the third chapter of the volume to demonstrate the rising power of this industry not only in terms of output and income data, but also in terms of its influence on the intellectual thinking within the country.
The most pernicious outcome of this process – intended or unintended – was an unwavering belief among the academic, the regulatory and eventually the political leadership that markets are perfect and one can subscribe unconditionally to what is the logical conclusion to that belief – the efficient market hypothesis. The authors argue that the financial services industry was an active participant in the propagation of this theory first within the academic world and then among the regulators. Their evidence for this assertion, unfortunately, is only one of “guilt by association”. This idea that markets are efficient and can take care of themselves ended up playing a critical role in the development of the crisis as well as in the growth of the industry for about two decades prior to the crisis.
A critical question about the power of this industry concerns the source of the power and the process by which the industry may have accumulated it. Was the growing relative size and the power of this industry a natural consequence of the growth path of industries, or did it represent an accumulation of monopolistic powers by the industry through means that undermine the market process? The difficulty of answering the question matches its importance. The power that the industry developed was at least not fortuitous. The political contributions of this industry have been well documented in this volume as well as elsewhere. No political party or legislator that had anything to do with the industry was to be ignored. The industry was also helped by the post‐Reagan climate of “government is bad and markets are good”. The industry took full advantage of the political climate that justified leaving decisions to the market and in turn contributed to nurturing that climate. “[T]he banking oligarchy […] used its political power to protect its golden goose from interference and to clear away any remaining obstacles to its growth” (p. 133). However, what is also clear are the consequences of the expansion of this power. The regulatory restrictions that had been imposed on the industry since the Depression were successively removed and the industry successfully neutralized any attempts to restrain the expansion of the industry either geographically, or in terms of scope or size. Regulators who urged caution had no choice but to leave (p. 136). Signs of systemic costs associated with unbridled expansion of assets (LTCM crisis) and outright greed and fraud (Enron crisis) were conveniently ignored.
Having laid the foundations for the build‐up of the financial oligarchy in the USA, the authors devote the subsequence two chapters to describe how banks, with unfettered access to users of funds and innovations in technology and financial modeling, multiplied their asset base and profits and in the process compensated their managers handsomely. The expansion was not always based on sound financial and economic principles. When risks could not be assessed, guesswork would do. If some financial institutions or investors seemed to be taking on too many assets, it could be assumed that they had enough capital to take care of small hiccups in the markets; large turbulences had been banned by the Federal Reserve Chairman Alan Greenspan. Regulators saw no need to worry about the growing exposures of financial institutions or systemic risks; the markets were supposed to be efficient and knew how to price the assets according to their risks. Properly priced assets do not create crises. There could not be incentive problems in such a market – banks could not assume that they should take excessive risks when payoffs were asymmetric – heads banks win and tails taxpayers lose. Systemic risks – should there be any – could be handled as easily as the dotcom bust in 2000‐2001. Unfortunately, events did not unfold as predicted.
In the last part of the book, the authors discuss what is perhaps the most important issue arising in the aftermath of the crisis – the problem of some institutions being too big to fail. Externalities associated with banking operations do not allow supervisory and political authorities to permit large banks to collapse when they get into difficulties. These institutions knew how important they were for the financial markets and could therefore assume that they would be bailed out in times of difficulties. This assumption allowed them to take bigger risks than they would have taken if implicit government guaranties were not available. While the regulatory changes being proposed at the present time attempt to prevent some of this type of behavior, the authors point out that the “too big to fail” (or TBTF) problem has still not been addressed adequately. The authors discuss the difficulties with proposed solution to this problem: increase in the level of supervision of large institutions, resolution authority over institutions in difficulty, or increased capital requirements. While the authors emphasize the importance of political contributions made by the financial services industry prior to the onset of the crisis, it is surprising that their solutions to address the TBTF problem do not include a ban on the large banks from making political contributions. If banks are too large to engage in certain activities or to expand beyond a certain level, it would make sense to prevent them from having political influence over the regulatory or legislative process.
Johnson and Kwak have not written the last word on the rise and the temporary fall of the power of the financial oligarchy in the industrialized world. Their work, however, is well documented, thorough and refreshing in that it recognizes that economic decisions are not made independently of politics. If the emerging regulatory reforms for the financial services industries around the world are not addressing the fundamental problems, the reason could be the politics. Reforms are being carried out by the same people who caused the problems. Certainly the policy makers have not shown a willingness to take the reform bull by the horns. The most serious problem – that of too big to fail – remains. Those who wish to pursue this issue further will do well to start with the Johnson and Kwak volume.