PREPARE FOR CHANGE ON WALL STREET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

Prepare for change on Wall Street

By Henry Kaufman

Published: Last updated: June 1 2010 22:03

America’s most important set of financial reforms in decades is coming to fruition. To be sure, lawmakers are still working out the details. But the broad outlines of the new US regulatory regime are coming into sharper focus every day. These new laws will affect financial markets and institutions in several important ways. But, as yet, neither investors nor managers seem fully to appreciate the change that is bearing down on them.

For a start, financial reform will help slow the growth of credit, which expanded at a spectacular pace in the decades leading up to the current financial crisis. As credit growth slows, so the profits of financial institutions as a percentage of total corporate profits will fall. The transition will be difficult; indeed, it began the hard way. But as new regulation and an overall slowdown of credit growth help shrink speculative debt, economic growth will become more sustainable. That, in turn, will go a long way towards maintaining the position of the dollar as the world’s key reserve currency. It will also give the US more time to address its own fiscal problems.

Meanwhile, top managers at many financial institutions will find themselves in unfamiliar territory. Their mode of operating, their business culture, has been to pursue aggressive growth targets for profits and market share by diversifying operations into new financial domains and by swallowing up competitors. Wielding generous compensation incentives, managers of leading banks encouraged employees to take big risks. As institutions grew and diversified, their activities became too wide-ranging and complex for senior managers to oversee effectively. At the same time, risk-taking came to rely more and more on quantitative risk-modelling, which tended to marginalise qualitative investment judgment. As we now know, econometric risk-modelling failed when it was most needed.

Perhaps ironically, the new financial legislation will challenge the Federal Reserve even more than it does financial institutions. Thanks largely to its poor record of limiting past financial excesses, most notably its failure to recognise or move against the latest credit bubble until it was too late, the Fed’s quasi-independence is already being called into question. Fiscal and monetary policies are powerfully linked; fiscal policies only become too lax when fuelled by overly accommodating credit markets – which in turn are financed by liberal monetary policies. Among other things, Congress is calling for an independent audit of Fed policy, for the US president to appoint the head of the New York Fed, and for greater involvement of the Fed’s board of governors in the selection of board members of the individual Reserve banks.

Actually, the central bank’s independence from political pressure is somewhat overstated. For one thing, the president appoints the chairman and the governors of the Federal Reserve Board, and Congress must approve them. For another, a close look at monetary history since the second world war suggests that only two Fed chairmen – William Martin and Paul Volcker – pursued policies that sometimes clashed with the near-term political aspirations of the incumbent president.

The immediate threats to the central bank’s independence come from other directions – two in particular. The first concerns its capacity for leadership, for genuinely taking initiative. Will the Fed step in when it sees evidence of abuses in financial markets? Will Fed officials be willing to tighten the bank’s monetary stance when financial markets become overly speculative, even if the economy does not seem overheated? Short of that, will Fed officials even be willing to use the bully pulpit to express concerns about excessive market speculation? Can the central bank attract and hold the kind of talent needed to maintain reasonable order in our financial system? Effective monetary leadership in the new environment remains, for now, an open question.

Another immediate challenge to the Fed’s quasi-autonomous status is the issue of what Congress will do about the too-big-to-fail conundrum. The central bank is likely to become more and more politicised, as its actions induce further concentration of the financial sector. This is because monetary policy decisions will fall most heavily on institutions that are not too big to fail. When some of these (small and medium-sized) institutions fail they will inevitably be absorbed by their too-big-to-fail counterparts. In this way, monetary policy will continue to foster a concentration of the financial sector into a shrinking number of players, as in recent years.

What America needs, to benefit from the proposed financial regulation, is a new economic philosophy that integrates economics and finance. The absence of such a philosophy has been a great failing. The weaknesses of economic libertarianism have been exposed. Monetarism was overwhelmed by financial innovations. Keynesianism was never practised legitimately: its expansionary tenets were embraced easily enough, but its restraining requirements too often were disregarded.

A look back over the past few decades of US history does not show mainstream economics in a good light. It is hard to be optimistic that today’s leading economists – whose distinguished careers have defined the status quo – will offer innovative ways of integrating economics and finance. Others must come to the fore. We urgently need economic minds with a broad analytical reach to rise to the occasion.

The writer is president of Henry Kaufman & Company and author of The Road To Financial Reformation

Copyright The Financial Times Limited 2010.