Frank talk about rules
Wall Street's investment bankers hate any kind of talk about regulation. They're about to get an earful.
This week's dramatic actions by the Federal Reserve - backing up the sale of Bear Stearns Cos. with billions in loan guarantees and opening its lending discount window to dozens of securities firms - amount to a bailout putting taxpayer money at risk. Emergency steps like that get people talking about regulation.
US Representative Barney Frank, chairman of the House Financial Services Committee, is one of those people. He's on the schedule to speak to Boston's business leaders this morning, and it's no secret what's on his mind. The Newton Democrat will lay out the case for greater regulation of investment banks, if not a specific plan for how to do it.
"There needs to be some discipline on their activities," says Frank, who will speak before the Greater Boston Chamber of Commerce. His top priorities: some kind of capital requirements and more transparency.
Capital and clarity are two important issues today. Investment banks have borrowed heavily against a limited amount of capital to maximize their potential profit. That also elevates risks to serious levels. It also has been difficult to tell exactly who owned what at any given time.
It doesn't take a rocket scientist to see that the way government tries to protect the economy by regulating financial institutions has fallen way behind the times. The Fed does this principally by regulating commercial banks that make loans and take deposits. In return, it gives those banks important benefits, such as nearly unlimited borrowing privileges.
Wall Street bankers who underwrite and trade securities were different, working in a world of heightened risk and reward. They made huge fortunes in good times and had every incentive to take big risks, usually by betting with lots of borrowed money. Today, they have unprecedented power to drive the economy into a ditch when those risks go bad.
Frank recounts a recent visit from Chuck Prince, when he was still the chief executive of Citigroup, the giant commercial banking company. Frank asked why Citi kept some assets off its own balance sheet with the use of structured investment vehicles, funds known as SIVs. The answer: That would put a banking company like Citi at a competitive disadvantage with investment banks. "That's when it struck me. They do the same things with different rules," Frank says.
I'm pretty sure Frank was onto that distinction a long time ago. But the story illustrates how difficult it can be to reel in excessive financial market risk with supervision and regulations.
Citigroup ran into dire trouble of its own, writing down billions of assets and suffering huge losses as a result. The company lost more than half its stock market value. Before long, Prince was out of a job.
At about the same time, the investment banking firm Merrill Lynch & Co. also suffered massive losses thanks to the same kinds of mistakes. Merrill chief executive Stan O'Neal lost his job, too.
Both Prince and O'Neal left, but they both walked out the door with fortunes in their final paychecks. So exactly what did regulation accomplish in that case? One commercial bank and another investment bank went down much the same path.
There are many other problems that come with regulating investment banks. For one, markets operate around the world, and money moves among them every day. How do regulators account for that?
Of course, there are many other kinds of investment firms that made big and highly leveraged bets in the markets. Are hedge funds next on the regulation list?
Frank says Congress will get to the investment banking business later, once it tries to deal with the home mortgage crisis. Treasury Secretary Henry Paulson is working on a plan to reorder financial regulation himself. Frank suggests it would be best to wait for Paulson and debate the subject then. But Frank's core interests, capital and transparency, are key issues for anyone worried about a system exposed to dramatically more risk.
Steven Syre is a Globe columnist. He can be reached at syre@globe.com.