Wall Street’s New Game

If he were alive today, the great economist Mancur Olson would recognize today's financial conundrum. A crisis this fundamental calls for a complete rethinking of how Wall Street and other financial centers are regulated. But that's not happening, nor is it likely to happen. Even the dramatic regulatory scheme for derivatives laid out this week by Treasury Secretary Tim Geithner—a vast improvement on what he initially proposed in March-doesn't get at one of the central problems: "regulatory arbitrage." Faced with a plethora of different agencies, many of them weak, Wall Street's giant firms do business in the shadowy cracks between the regulators. The classic example is AIG, ostensibly an insurance company. Because AIG bought a small savings and loan at one point, the giant parent company managed to place itself under the supervision of the tiny Office of Thrift Supervision-the financial equivalent of a gnat watching over an elephant. The result was that AIG's London finance unit went virtually unmonitored and wreaked disaster by selling credit default swaps worldwide. Countrywide Mortgage, one of the biggest peddlers of bad loans, used a similar strategy by also designating itself a thrift.

Geithner's proposal calls upon Congress to enact laws that will lay down tougher restrictions and monitoring for "over-the-counter" or privately negotiated derivatives. Sensibly, the Treasury secretary is now talking about regulating not just trading but also the firms that conduct the trades, and tackling fraud and manipulation. But for the most part the plan, as well as other legislation Congress is considering, seems to leave intact much of the regulatory landscape, with its alphabet soup of regulators from the SEC to the CFTC to the OCC and OTS. For Wall Street's recovering giants, this will mean a challenging new game of regulatory arbitrage that will no doubt regain its dizzying pace before long.

All of which brings us back to Mancur Olson. In his groundbreaking work, the late University of Maryland economist explained why it is so difficult for advanced democracies to reform. He described how the accumulation of vested interest groups and bureaucracies in free societies causes a kind of sclerosis in the system over many decades. After a while you can't do "blue-sky" reform, starting from scratch, as Congress did in the early 1930s with Glass-Steagall. From 1932 to 1934 the Senate banking and currency committee held exhaustive hearings on the 1929 crash and found that commercial banks had misrepresented to their depositors the quality of securities that their investment-banking sides were underwriting and promoting. The result was the separation of commercial from investment banks and a new regulatory framework that endured for nearly 60 years. But that was possible in large part because up until then there had been virtually no regulation apart from the Fed (itself invented only in 1913). Today there are too many entrenched agencies and too many congressmen vested in keeping them (because their particular committees oversee them). The banking and financial lobby is too dug in. Jonathan Rauch, an early popularizer of Olson's work, called the problem "demosclerosis" and defined it as "government's progressive loss of the ability to adapt."

Something similar happened in the national-security realm in the early years after 9/11. During World War II and the early Cold War, America built the intelligence apparatus it needed to win from scratch. That was successful-though of course questions persist about how much the CIA ever really accomplished-in part because on the eve of World War II, the U.S. government bureaucracy was tiny. The Interior Department was bigger than the War Department, believe it or not. Today, by contrast, every intelligence agency is a glandular monstrosity left over from a half century of world war and cold war. The FBI, CIA, NSA and other agencies spend almost as much energy defending their own turf as American turf-all of which has made true reform nearly impossible.

Geithner and many in Congress know that new regulation always begets new kinds of arbitrage, and they will try hard to close the loopholes. For example, one of the big unmonitored trading practices involves "customized" (which are unregulated) swaps between two or more firms. Geithner's proposal calls for all contracts that go through his new clearinghouses to become automatically "standardized" and therefore regulated. But that will only increase the incentive for firms to define even more contracts as customized and to trade them outside of clearinghouses. Former Treasury Secretary Hank Paulson was worried about similar problems:

As early as March of 2008, he called for giving the Fed more power over all markets and instruments so as to "de-segmentize" them, and the possible merger of the SEC and CFTC.
Those merger discussions are still going on, as is the debate about enlarging the Fed's authority. But none of it is very far advanced. The healthier Wall Street gets, the less likely it becomes that either Geithner or the Congress will muster the will and power to break through the vested interests. "Overall the regulatory landscape makes zero sense," says Marc Lackritz, who recently retired as president of the Securities Industry Association. "It's outmoded." But Lackritz says Geithner can only do so much at a time, in pieces. "It's not that different from health care reform. The Clinton administration said it would take care of the whole thing at once, but it died of its own weight because it was too ambitious. But gradually bits and pieces have been enacted." Too gradually, if the current health care crisis is any measure. It will be a sad concession to Washington's ways if the same thing happens with Wall Street.