The US Financial Meltdown: A sign of systemic failure of the capitalistic system? Peter Lye-28 September 2008

As the financial crisis unfolds itself over the last 14 months starting with the sub-prime mortgage crisis and cumulating to the recent almost complete annihilation of the once mighty investment banking community with Merrill Lynch selling itself out to Bank of America that once vowed never to step into this arena of banking, Lehman Brothers folding into chapter 11 bankruptcy and the last two remaining pillars

of the industry, Morgan Stanley and Goldman Sachs giving up the freedom under investment banking into the regulatory arms of the Feds by metamorphosing itself into a bank holding company to tap a larger source of funds not available to them as investment banks. The need to separate investment bank into separate entity was created by the Glass-Steagall act of 1933 partly to prevent a conflict of interest from arising between the differing activities as well as to protect the smaller depositors from the relatively higher risk propensity of investment banks. Has this act served its purpose in the light of today’s crisis or has it helped to provide the fertile environment for brewing this crisis by exchanging greater business latitude with narrower source of funding? Are there lessons that we should have learnt from the hedge fund crisis in its handling of derivative instruments that resulted in the frightful demise of LTCM and a near panic in the financial markets then? Are all these a sign of systemic failure of our capitalistic system and deludes a trumpet call for shift in course away from capitalism or a major re-engineering of what defines capitalism for it to function healthily as no system is perfect?

The Glass-Steagall act of 1993 was enacted to prevent private banks whose main activities is investment business from owning deposit taking banks and thereby protect the depositors from being exposed to the more risky stance of investment banks. It also sets out to limit the type of related transactions that can be done between bank holding companies and investment bank to plug potential loop holes from being exploited. This was how most of the investment banks ended up as private entities until the recent decade or so which witness many of them going public to tap a larger source of capital. The last major investment bank to go public was Goldman Sachs amidst much fun fare on its stock market debut. This has the effect regulatory wise in placing these publicly traded investment banks initially from the Feds to full autonomy following the Glass-Steagall act and onto the arms of the SEC on their debut on the stock market. What dimension does regulation have on the behavior of these entities?

First of all, in my mind, regulation is like all things in life besides death and taxes for there is no absolute surety. The business arena is like the battle field that soldiers fight on. We can and must expect casualties. However, there must be enough safeguards in place to prevent catastrophic events like the 2 nuclear events that resulted in systemic wide failures or its financial parallel of the massive run on banks leading to a near collapse of the banking system in 1930s. Regulation is there to provide a framework to facilitate the business of risk taking and equitable risk reward for market participants.

Secondly, regulation is there to ensure an acceptable level of market transparency to facilitate business transaction. Chief amongst these is perfect price information as the Holy Grail underlying the capitalistic system. Even in today’s advancement in telecommunication that enables almost instantaneous dissemination of information worldwide, total transparency is still very much like a mirage in the desert; it seems to be there but it is not there. Some of the impediments to total transparency are product and supplier/customer differentiation, sufficient market liquidity in terms of having sufficient market participants in the product, human behavior and regulation itself which sometimes impedes transparency in the interest of achieving it by narrowing the conduits by which information can be released. Human behaviors like insider trading and market cornering is very anti-thematic to fair play and there are legislation in place to discourage such behavior by punitive measures when caught including jail time and leveling discovery and prosecution process through things like burden of proof, and rule of evidence as such crimes are not only difficult to discover but also difficult to proof beyond reasonable doubt as the gold standard required by our legislative framework. There is an ongoing joke that an acquittal does not equal innocence but that there is insufficiency evidence to proof guiltiness beyond reasonable doubt.

Thirdly, regulation is there to provide orderly clearance of trades executed in the market. This is done differently to suit the differing markets. On one end of the spectrum we have exchange traded products like stock and shares to provide almost perfect certainty in trade completion and payment without any concern about counterparty risks as the exchange and clearing house sort of provides the buffers. At mid-point where most physical trades take place, we have non-exchange traded products that uses currency as a value proxy of the product exchanged for. Stability of currency exchange rates and a good legal framework for dispute resolution is important to create market certainty. On the opposite end of the spectrum, we have the age old barter trade that does not involving any currency. A poignant observation about this financial meltdown is a partial breakdown of the trade execution resulting in a very fast downward price spiral of unprecedented velocity as most of these instruments are not even cleared through an exchange and ability to complete the trades is dependant on perception of counterparty risks one of the major factor in selectivity over counterparty and thereby narrowing the market and price in the process. We should re-examine whether an exchange should be setup for some of the instruments that are traded on a bilateral basis to avoid a repeat of such incidence.

Fourthly, although much has been argued about governmental rescue plans like the US$700 billion dollar life line proposed by US Treasury Secretary Paul Hanson and seconded by Fed chief Ben Bernake could create a wrong precedent in the future for companies that view themselves as being too big to fail like banks and insurance companies from behaving responsibly, I believe that the rescue is not likely to perpetuate such behavior if done with enough punitive measures on current owners and managers. However, I do have a concern over the equity of such a life line as it tend to favor the richer who has reaped the benefits and now want someone to help pay for their loses. This could be an inevitable situation as a collapse of the economy will inadvertently affect the poorer sector of the population. As to who would ultimately shoulder the cost of the lifeline, in the case of the USA, I believe that it is more likely to be under written by almost everyone world wide as the direct or in-direct holding in the dollar is so widespread that US will be tempted to monetized the debt in more ways than one. You could argue that you do not hold any US$ but whichever currency you are holding, your central bank is likely hold part of their reserves in US$ to back the currency. We are lucky that in the past decade of so, we have an additional reserve currency in the form of the Euro which is less open to manipulation being controlled by many financial secretaries within EEC.

I tend to conclude therefore that the recent ongoing financial meltdown is more of a regulatory failure than a failure of the capitalistic system and therefore it is not time to resurrect the Berlin wall as such.

  

Peter Lye aka lkypeter

Safe Harbor. Please note that information contained in these pages are of a personal nature and does not necessarily reflect that of any companies, organizations or individuals. In addition, some of these opinions are of a forward looking nature. Lastly the facts and opinions contained in these pages might not have been verified for correctness, so please use with caution. Happy Reading. Peter Lye