Survival Of The Unfittest?

"Greed is good," is the phrase that most comes to mind when thinking of the infamous villain Gordon Gekko in the movie Wall Street. I am not naive or crass enough to believe that greed is good, however Gekko did say another phrase that is much more relevant in today's world. He spoke about survival of the unfittest, and in recent history our nation's breakout of bailouts is creating a culture that is bringing to life Gekko's nightmare. Or at least that is the way an article within the Economist describes the culture, and not just in the US.

But the dramatic changes in the pecking order mask a lack of more profound change in the system of finance itself. Lehman aside, no big firms have been allowed to fail (as they would have done, unaided). Thanks to state aid, the law for big firms today is what Gordon Gekko, the red-blooded villain of the film “Wall Street”, dubbed “survival of the unfittest".

Don't jump to conclusions too quickly. The article is not a total advocation of complete free markets within the banking industry. The article makes some great points on why some government regulation is necessary, but warns of the dangers of setting a precedent of state guarantees.

Removing the explicit side of the state’s commitment is relatively simple. Some guarantees are still plainly needed now, but a firm deadline of, say, five years for the final expiry of the governments’ various crisis-induced pledges should be set globally. With the world economy in better shape, this looks more realistic than it did six months ago. But even then the implicit assumption will linger that banks will always be bailed out. This is the core problem. There are two possible responses to it: regulate banks to try to make them safer, and attempt to limit the implicit guarantee. Both approaches are now needed.

No one should pretend that banking is an industry where pure natural selection takes place. But as guarantees, both explicit and implicit, are withdrawn, the hope is that self-discipline will be imposed on banks, not just swathes of new regulation. There are signs that riskier banks are already paying more to finance themselves. This differentiation must be promoted, so the weak and reckless are gradually forced to shrink and live within their means—and not off taxpayers’ largesse.

I really like the article because it talks about some of the consequences of providing an 'implicit state guarantee' to the banks. The described guarantee is a fancy way of saying that we are starting down the slippery slope. I have blogged about the unforeseen consequences that can arise out of government deities deciding who lives and who dies, and this article illustrates some that are being to take shape. A good read from a good source of information.

Banks and Balance

Not sure I agree with everything in this article in Forbes, but there are some good points made. I think when it comes to banks it is a little trickier because people don’t act rationally when banks start failing. Banks are only required by law to maintain but a portion of the cash on hand that is managed within their institution. When people start pulling money out en masse banks don’t have the ability to get all the people their money. That reason alone makes it a little trickier to say that banks should be allowed to fail. However, I love how he illustrates the slippery slope of the 'too big to fail' mentality that I have blogged about numerous times.

For the institutions supposedly lucky enough to be tapped by our federal minders as too big to fail, the much remarked upon "optimistic" scenario is one in which their cost of capital will drop for them being protected by Washington. This ensures that the many financial institutions not important enough to fit under the Fed's umbrella will be weakened for having to lend in an environment distorted by larger institutions profiting from their tight relationship with Uncle Sam.

I also like how he spoke about profit and loss being the real regulators. Legislation is flawed and people will always find the most profitable approach given new guidelines, and undoubtedly new problems will arise from new legislation. What remains unchanged though is the desire to make a profit and avoid a loss.

For banking institutions more broadly, the Obama plan involves raising their capital requirements while putting rules in place to make sure they're got more exposure to the loans they securitize and sell. What's forgotten here is that without investor capital there are no banks, so while it may be comforting to think that the federal government can rearrange the path to banking profits, if investors don't agree, they can surely take their money elsewhere.

Along those lines, the beauty of finance is that it is fungible. If the stringent capital requirements make it difficult for stateside banks to operate profitably, the dollars that fill their coffers will move offshore along with myriad financial jobs. Almost to a man politicians worship at the altar of "job creation," but if the new capital requirements prove problematic, the creation of financial jobs will occur in London, Frankfurt and Tokyo--not on Wall Street. "Systemic risk" will simply find a new address.

A truly free market economy does not and will never exist, so to state simply that total free market policy will be a cure all is a little unreasonable. However, I feel that when the choice is the free market or government legislation and intervention I believe we should always err on the side of the free market. People look to blame the free market and capitalism for the mess we are in today, but the free market was only free within the boundaries that were set by legislation. Lobbying and legislation have contributed as much as, if not more than, greed has to fueling the build up and eventual downturn we are facing today. I guess like most things in life it is about balance. What is the lesser of two evils? Letting banks fail unconditionally or going down the dangerous road of the too big to fail mantra?