Public Service or Private Enterprise? Banks and the risks they ought not take

In the aftermath of the financial crisis, much has been written on the increasing risks banks took to grow profits, and the collateral damage that was caused.  Hard questions have been raised on the true role of banks within the economy. Are they operating a public service - enabling the efficient flow of capital? Or is their primary responsibility to shareholders – justifying concentration on more lucrative activities?

Three bestselling authors have examined this dichotomy: Suzanne McGee (Chasing Goldman Sachs [1]), Michael Lewis (The Big Short [2]) and Andrew Ross Sorkin (Too Big to Fail [3]). All enjoyable to read, these books provide us with detailed insights into the crash, but from very different perspectives.
Chasing Goldman Sachs recounts the changes in the industry that led to an increased willingness to take on risk.  It explains how investment banks were originally limited partnerships, protective of their own capital. Their focus was introducing corporate borrowers to potential investors via the “money grid” (just as energy utilities connect generators to the consumers of electricity via the power grid). As these banks went public, they began to pursue riskier, short-term strategies to achieve a higher return on equity. McGee argues that this was at the expense of their duty to the overall economy.
The Big Short covers a slice of recent history, following those who successfully bet against the subprime market in 2008. It explains how they back-traced CDOs to the underlying debt, uncovering an actual risk far greater than the instruments’ credit scores implied. Investors should have been able to rely on the credit rating agencies, but Lewis contends that the latter were among the bad guys. He describes the downside of their lack of analytical resources, together with a business model where fees come from the very firms whose products they rate. This begs the question: is credit rating also a public service with a fiduciary duty? And if so, how should it be funded?

The most pro-Wall Street of the three authors, Andrew Ross Sorkin describes the period from the collapse of Bear Sterns to the TARP bill. In the spotlight is Hank Paulson (US Secretary of the Treasury) and his fears of economic meltdown should one of the institutions "too big to fail" collapse. Sorkin shows Wall Street working together with the US government (albeit under duress!) to prevent such a failure, as a utility should. This tale emphasises the need for government backing when private companies provide essential services. Up for debate is how much regulation is acceptable in exchange? And to what extent should it impact a bank’s operations and incentives?

A utility business is by nature low risk and low margin; whereas the search to maximize profits typically assumes the opposite. All the authors above acknowledge the conflict in financial services between public responsibility and private profit. The truth is that during economic growth and stability, the two models appear to coexist. The crisis brought to light the shortcomings of that assumption. In this author’s opinion, governments and banks must now cooperate to define the financial system they need and want, and what frameworks will allow that new model to succeed.

[1] Chasing Goldman Sachs: How the Masters of the Universe Melted Wall Street Down . . . And Why They'll Take Us to the Brink Again, by Suzanne McGee, 2010
[2] The Big Short: Inside the Doomsday Machine, by Michael Lewis, 2010
[3] Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System--and Themselves, by Andrew Ross Sorkin, 2010

Comments (1)
  1. Monty says:

    Excellent analysis of the financial crisis.

    Hope the Government and the Bankers take heed of your observations and bring stability to our economy.

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