As we await the stress tests, here is one perspective on what we need to do to remedy our economic challenges.
(1) De-finance the economy: US and even the global economy has come to depend too much on financial services industry. At the peak i.e. in the last few years, the US financial industry services contributed about 8 percent to nation’s GDP (compared to long held stable number of 4 percent). So the contribution to GDP doubled in the last 20 years meaning that the size of the financial services industry is almost one trillion dollars now. While about 20 years back, it was less than 300 billion dollars. In the last few years, the profitability of the US financial services industry has constituted 41 percent of the total profitability of the private sector. That is an astounding number.
The increase in the size of the financial services industry has come largely through integration of the activities of investment banks, commercial banks and insurance companies. This integration has raised moral hazard and transparency problems. This trend of deregulation began in the late 1970s (President Jimmy Carter era) and culminated with the elimination of the Glass-Steagall Act. The value in the financial service industry has come from commissions which have incentivized the participants to enhance the value of assets, loans and credits not always based on sound principles.
(2) Prudent Regulation: Excessive and unregulated securitization of loans, and credit default swaps have created major challenges. For example, the derivatives and credit default swaps, which in 2002 were worth $1 trillion and today are worth $33 trillion. It appears that derivatives undid AIG, a company that had 116,000 employees in 120 countries, and many other financial institutions and other companies.
The challenges of securitization of loans, and derivatives and credit default swaps can be categorized thus. First, it has become impossible to do honest accounting and estimate the real value of assets because the securitization and swaps have created a chain of transfer of values. Such transfers have occurred without clear accounting, assessment and/or record keeping at each stage. So what is needed are a set of well-thought out accounting and financial regulations and rules that would produce more realistic and clear assessments and record keeping. For example, what should be the level and mechanism of regulation of hedge funds? Should we continue to permit the banks to operate at thirty-to-one leverage (In 2004 SEC allowed banks to go from ten-to-one leverage to thirty-to-one leverage).
Second, the compensation and bonus structure in the financial industry services is largely based on commissions on the volume of transfer of perceived wealth. So, essentially, there is an incentive to inflate the value of financial instruments and to encourage as many swaps and transfers as possible. Therefore, the immediate need is to review this compensation mechanism and examine what portfolio of norms, requirements of reporting, and regulations would discourage blatant inflation of the financial instruments and their excessive swaps.
Tags: AIG, Credit Swaps, Derivatives, GDP, Glass-Steagall Act, Hedge funds, Insurance Companies, Investment Banks, SEC, Securitization of loans, Stress tests, Tim Geithner, U.S. Banks, U.S. Economy, Wall Street
