Michael Lewis and what does it take to reform Goldman Sachs and its ilk

In writing a review of Greg Smith's book, Why I left Goldman Sachs, Michael Lewis raises the issue of what does it take to reform Goldman Sachs and the other Too Big to Fail banks.

Stop and think once more about what has just happened on Wall Street: its most admired firm conspired to flood the financial system with worthless securities, then set itself up to profit from betting against those very same securities, and in the bargain helped to precipitate a world historic financial crisis that cost millions of people their jobs and convulsed our political system. 

In other places, or at other times, the firm would be put out of business, and its leaders shamed and jailed and strung from lampposts. (I am not advocating the latter.) 

Instead Goldman Sachs, like the other too-big-to-fail firms, has been handed tens of billions in government subsidies, on the theory that we cannot live without them.

The theory that we cannot live without them is simply an extension of the policy of financial failure containment.  A policy effectively written by and for the banks during Robert Rubin and Tim Geithner's time at the US Treasury.

Under financial failure containment, global financial regulators stop engaging in activities like ensuring that market participants have access to all the useful, relevant information in an appropriate, timely manner that prevent a financial crisis.  Rather, after the financial crisis occurs, they turn to the taxpayers to pay to clean it up.

Naturally, taxpayers had to be called on to absorb the losses incurred by Goldman and the other Too Big to Fail banks.

They were then permitted to pay politicians to prevent laws being passed to change their business, and bribe public officials (with the implicit promise of future employment) to neuter the laws that were passed—so that they might continue to behave in more or less the same way that brought ruin on us all.

Mr. Lewis describes one of the ways that Jeff Connaughton says Wall Street always wins.

And after all this has been done, a Goldman Sachs employee steps forward to say that the people at the top of his former firm need to see the error of their ways, and become more decent, socially responsible human beings. Right. How exactly is that going to happen? 

If Goldman Sachs is going to change, it will be only if change is imposed upon it from the outside—either by the market's decision that it is no longer viable in its current form or by the government's decision that we can no longer afford it.

Mr. Connaughton would argue that because of the Blob (aka, a group comprised of politicians, economists/lobbyists and Wall Street) the government will never make the decision the we can no longer afford Goldman or any of the other Too Big to Fail banks.

That leaves it to the market to decide that Goldman and the other Too Big to Fail banks are no longer viable.

There is a bizarre but lingering aroma in the air that the government is now seeking to prevent the free market from working its magic in the financial sector-another reason that the Dodd-Frank legislation is still being watered down, and argued over, and failing to meet its self-imposed deadlines for implementation. 

Regular readers know that the Dodd-Frank legislation is simply the substitution of the bankers' preferred combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

Our current financial crisis shows that the combination of complex rules and regulatory oversight doesn't work.  Specifically, during the financial crisis the financial system continued to function where there was the combination of transparency and market discipline and collapsed where there was the combination of complex rules and regulatory oversight.

The areas of the financial system that had the combination of complex rules and regulatory oversight were all opaque.  Think banks and structured finance securities.

Why did Wall Street support Dodd-Frank (other than it was written by Wall Street's lobbyists for Wall Street's benefit)?

First, it protects Wall Street from the market.  So long as the Too Big to Fail remain 'black boxes', the market doesn't really know what is going on inside the banks.  This limits how effectively the market can impose discipline on Wall Street.

The only way the market can effectively discipline even the largest of the Too Big to Fail is if the banks are required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this disclosure, market participants could independently assess the risk of these institutions and impose discipline by properly linking the Too Big to Fail banks' cost of funds to the risk they are taking.

But the financial sector is already so gummed up by government subsidies that market forces no longer operate within it. Could Goldman Sachs fail, even if it tried?...

Currently, Goldman Sachs could not fail if it tried.  That is because it is on life support from the Fed.

So long as the Fed is willing to keep all the Too Big to Fail on life support (and every policy the Fed has adopted since the beginning of the financial crisis has been to clean up after the financial crisis while keeping the banks on life support), it is impossible for the market to exert any discipline on the Too Big to Fail.

However, it is the very fact that the Fed has all the Too Big to Fail on life support that makes it possible to require these banks to provide ultra transparency without worrying about the financial system collapsing.

Once ultra transparency is required and provided, investors can adjust their exposures and then the Fed can end its life support.

Along with the other too-big-to-fail firms, Goldman needs to be busted up into smaller pieces. 

Better to do this by the market exerting discipline rather than to rely on either legislation or the global financial regulators to do the job.

Under market discipline, bank managers will shed risk as quickly as possible without disrupting the financial system (its bad for the value they receive on the positions/businesses they shed if they cause too much disruption).

The ultimate goal should be to create institutions so dull and easy to understand that, when a young man who works for one of them walks into a publisher's office and offers to write up his experiences, the publisher looks at him blankly and asks, "Why would anyone want to read that?" 

The only way these banks are going to be easy to understand is if they provide ultra transparency.  Without this information, they will always be 'black boxes'.