System must allow broken banks to fail

After the Fall

Saving Capitalism from Wall Street -- and Washington

By Nicole Gelinas

Encounter Books, 228 pages, $33

The credit crisis that precipitated the current global recession is often blamed on bankers' incompetence, with a healthy dose of greed thrown in.

Nicole Gelinas, a research fellow at the Manhattan Institute, argues in her first book that the flaws undermining American financial institutions are an unintended consequence of decades of poor oversight.

In a refreshing divergence from the conventional wisdom, Gelinas makes the case that market interference from right-of-centre governments insulated banks from the consequences of their actions, and unwittingly promoted irresponsible practices.

Republican presidents Ronald Reagan and both George Bushes all paid lip service to the notion that markets should and could regulate themselves, as did Democrat Bill Clinton, a "third way" moderate.

But all of them helped to create and grow a safety net for bankers and traders, which these actors used to take ever greater risks, secure in the knowledge that if they failed, the U.S. government would rescue them -- they had grown "too big to fail." And this, in practice, translated into an exemption from market discipline.

Until fairly recently, Gelinas explains, companies that performed poorly, whether by taking too many risks or too few to compete, were penalized by the market.

Banks before the 1930s were no different, but when account holders rushed to withdraw their balances at the start of the Great Depression, the collapse of finance helped to worsen and entrench economic failures.

In response to this, stringent controls were placed on speculation and lending, with rules about disclosure, and deposit insurance. Taken together, these measures made bank failures less likely, and also protected deposits, meaning that a run on banks would no longer follow reports -- or rumours -- of losses.

These reforms worked for half a century. As the world of finance evolved, though, oversight didn't. While straightforward lending transactions were regulated, bankers and traders developed innovations that allowed them to turn long-term debt, such as bonds and mortgages, into securities, further leveraging their investments.

Derivatives, a form of investment based on anticipating fluctuations in currencies and interest rates, grew in the space of a decade into a $95-trillion market.

The health of banks, insurance companies and investment became increasingly linked with speculation, and it was clear that, like banks before the Depression, the failure of finance industry giants could bring down an economy.

Rather than increase oversight, or tighten regulations about leverage and speculation, a series of bail-outs signalled Washington's new strategy: protecting finance from its own mistakes.

Wall Street took note of this. Soon, all major industries, not simply those in the financial sector, came to depend on securities and derivatives to keep their balance sheets looking healthy. Beginning in 2008, most taxpayers realized for the first time the consequences of the free insurance they had been unknowingly providing for the financial, energy and manufacturing sectors.

The bail-outs and debt-relief measures in the U.S., mirrored to a lesser extent in Canada, are effectively the bill coming due.

"When financial markets are too free," Gelinas writes, "they will eventually destroy themselves and damage everything around them."

Gelinas presents a history of financial regulation, a subject that could easily put readers to sleep, in a readable and accessible manner. She explains the causes of volatility and uncertainty in the housing and stock markets without relying on industry jargon or endless acronyms.

After the Fall doesn't explain how we can make an easy transition from "too big to fail" to "too broken to be fixed."

It does make clear, though, that this is a reckoning that must take place, and Gelinas sketches the outlines of how a rehabilitated system might succeed in the future.

Rebecca Walberg is the president of Winnipeg's Wakefield Centre for Policy Research.

Republished from the Winnipeg Free Press print edition February 20, 2010 H7