Editorial: Three weeks like no other

Extraordinary things now happen every other day in the world of American finance. In less than a week, the US government has effectively taken over the country’s largest insurance firm (American International Group, or AIG), provided guarantees for money market mutual funds, signalled the death of investment banking as it has been known after Goldman Sachs and Morgan Stanley decided to become bank holding companies, and asked Congress to write out a $700 billion cheque at the cost of the American taxpayer, so that distressed assets can be taken over by the government. Together with the drama of the previous two weeks, which were no less notable for decisions like the takeover of two giant mortgage companies, the merger of Merrill Lynch with Bank of America and the bankruptcy of Lehman Brothers, this has been the most extraordinary period in the history of American finance.

What does it all mean? First, the US government and the Federal Reserve have acted quickly, given up all ideological positions with regard to markets, and focused on crisis management. Observers are agreed that this needed to be done, because the alternative would have been infinitely worse. Second, the world of American finance has changed for good, and will not be the same again. The era of highly leveraged investment banks (Morgan Stanley had capital adequacy of barely 3 per cent!) is over. Third, some regulatory oversight of the world of complex financial instruments, and that could include hedge fund operators, is now certain. Fourth, investigations have started into whether there was abusive short-selling in the market as one firm after another keeled over; prosecution should not, therefore, be ruled out.

Finally, this is not the end of the story, because follow-through action is now required. Goldman and Morgan Stanley have to either raise more capital or shrink their balance sheets in order to get to sensible capital adequacy ratios (9 per cent is the accepted minimum). This could mean that they merge with or buy up commercial banks that have better ratios. Also, since the assets of firms like Lehman and AIG have to be sold, there will be destruction of value as sales take place at a discount. The discount may be reduced after the government gets the $700 billion cheque from Congress, which is why markets reacted with relief at the announcement — but that raises questions about a conflict of interest between the taxpayer and the owners of the distressed assets, with the government being the intermediary.

Two questions need to be answered. First, are some of the solutions being hammered out today, under pressure to manage the immediate crisis, good for the long-term structure of the financial sector? For instance, one observer has characterised the marriage of an investment bank with a traditional commercial bank as hitching together a casino with a utility. There are differences in attitudes to risk and to deal-making in these two worlds; there are also conflicts of interest between fee-based merchant banking and fund-based investing because the Chinese walls that are supposed to exist between these two activities don’t exist, or are porous. Whether this universal banking model is superior to the separate silos created by the Glass-Steagall Act of the Great Depression, three-quarters of a century ago, is a question that should be debated.

The second question concerns the nature of reform that is needed. Advocates of the freewheeling financial system that has just collapsed argue that it delivered gains in productivity and, therefore, faster growth; and that the cost now being borne by the taxpayer of a trillion dollars or more is well worth the benefits that have accrued. Against this, those who argue that the system mostly benefited a few thousand operators in the financial centres — the profits of US financial firms had grown from 10 per cent of all corporate profits in the US in the 1980s to 40 per cent — would question the supposed benefits of such a system to the rest of the world, considering that the two fastest growing economies of China and India have had no part in it. Also, while the benefits of the system have gone to a few, the bill is now being picked up by the taxpayer. This is the ideological debate that will shape the new financial order.