U.S. Banks, Financial Services Industry, and U.S. and Global Economy

As the U.S. awaits the stress tests of the banks, the debate on how to restructure the U.S. and Global financial services industry continues.

The restructuring of the U.S. and Global financial industry will probably be successful only when two major issues are reviewed. The first relates to (generally non-transparent and sometimes excessive) securitization of loans, and the second relates to (sometimes indiscriminate and unsound) integration of banking, investment and insurance activities under one umbrella. Lack of evident transparency, and serious moral hazard problems make these two issues major challenges.

There are two empirical and policy questions. One, does regulated and transparent securitization of loans help in the credit flow (with some multiplier effect) and business in general? Two, does regulated and prudent level of integration of banking and investment activities add more value to the economy?

The answers are not evident, and the policy and expert opinions appear to be evolving as the evidence is not clear.

The vibrancy of the financial services industry and the U.S. economy from about 1981 (when President Ronald Reagan encouraged deregulation and liberalization) to about 2007-2008 appear to indicate that securitization and integration of financial activities have helped the U.S. and global economy. What my have undone it are the excesses and complete dergulation. So the answer to the structural issues might be consideration and legislation of thoughtful regluation(s) and regulatory mechanisms. That's the approach of Secretary Tim Geithner, and President Barack Obama's economic team (they appear to tacitly agree that repeal of the Glass-Steagall Act, and the enactment of Commodity Futures Modernization Act may have accelerated such excesses).

The other view is that securitization of loans is empirically and theoretically unsound, and that banking and investment activities must be separated. No amount of regulation will help if these fundamental changes are enacted. Krugman says, "Underlying the glamorous new world of finance was the process of securitization. Loans no longer stayed with the lender. Instead, they were sold on to others, who sliced, diced and puréed individual debts to synthesize new assets. Subprime mortgages, credit card debts, car loans — all went into the financial system’s juicer. Out the other end, supposedly, came sweet-tasting AAA investments. And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and their magic turned out to be no more than a collection of cheap stage tricks. Above all, the key promise of securitization — that it would make the financial system more robust by spreading risk more widely — turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption."

Joseph Stiglitz observes, "In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option."