The Federal Reserve is not part of the federal government. Regrettably, most Americans are ignorant of this fact. Since the members of the Board of Governors of the Fed are appointed by the president, the assumption is that it is another agency of the executive branch, but nothing could be further from the truth. It is owned primarily by private banks that are shareholders and appoint two thirds of the members of the boards of directors of the twelve regional Federal Reserve banks.
In this context, the expanded powers of the Fed that are being proposed by the Bush administration (and the weakening of the powers of the Securities and Exchange Commission) presents an interesting event in what passes for risk management these days in the financial services system. Barney Frank, the chairman of the House Financial Services Committee, has, in effect, signed on to this plan following an epiphany some time ago that occurred during his conversation with Charles O Prince III, the former chairman of Citibank. According to the New York Times, Mr. Prince was explaining that “structured investment vehicles” were kept off the balance sheet so that his bank could compete with investment banks. Somehow the practices of commercial banks using archaic accounting to keep investments off their books led to the conclusion that regulation should extend to investment banks and hedge funds. There doesn’t seem to be any mention of getting those “structured investment vehicles” back on the balance sheet.
Regardless of that tortured logic, let’s be clear: Regulation does not have any effect on preventing crises – at least not any more. Regulations come after the fact and they are almost always based on some shred of common sense. Are we to believe that every CEO and CFO woke up the day after the passage of Sarbanes Oxely to be shocked and surprised that they should have controls in their financial processes? Some may have been shocked to discover how out of control they were, but none were ignorant of the fundamentals of sound business practices.
And so it will be with the regulations and agency reorganizations that come out of this latest crisis. It reminds me of my experience dealing with general contractors during the commercial real estate projects I had the opportunity to work on in the late 1980s and early 1990s. I established an agreement with these folks early on that if I caught them attempting to increase their profits through a particular form of deception, they would agree not to use that form of deception in the future. We both understood that some level of shenanigans was part of the process. The tacit agreement to control it meant that the general contractor was assured of some opportunity to increase profits and the owner could manage the resources devoted to detecting fraud.
The scale of the current crisis, however, turns that example on its head. We have an unregulated market in credit default swaps (in essence the insurance policies on debt instruments that have been turned into securities themselves) that has twice the face value of the US stock market. JP Morgan Chase, currently touted in some corners as a savior of the financial system for not letting Bear Stearns go into bankruptcy, has tremendous exposure in this swaps market, not to mention its problem home equity loans and corporate debt defaults. So a bail out of the savior holding the bucket could be in the cards. What has come to be known as high risk behavior is the predominant behavior and dwarfs the activities of companies producing products and services for consumption.
No matter how many assurances we get from sober faced financial experts that the Summer or perhaps the Fall should mark the end of the current crisis, we need to understand that the dimensions of this deception (or rather self-deception) – that there does not have to be an underlying value in economic transactions – is going to result in significant pain. We can attempt to address that pain with more esoteric and unregulated financial “products” or we can address the underlying issue of what drives us all to participate in behavior that results in calamity.
Last week my suggestion that the emergence of ethical behavior based on the premise of the common good was, to put it mildly, categorized as the musing of a Pollyanna. Certainly the most difficult thing in the world to change is one’s mind, one’s opinions. Often, unfortunately, some level of suffering is a prerequisite. I would suggest that that suffering is on us, whether or not we are in the direct line of fire of a foreclosure or a personal bankruptcy. The separation between the reality of our daily lives and the machinations of the financial markets is a gulf so wide that we can’t see the shores any more.
The root of the word “risk” comes from the Old Italian risicare, which means “to dare” (not "omigod" what will happen if I do dare). Daring to do something is different than placing a bet on the spin of a roulette wheel. It has to do with envisioning a goal and deploying a strategy. It is the basis of commerce, and the behavior that makes it all work is ethics.
Ethical behavior is not a mysterious, unachievable set of standards. It is a direct result of the simple acts of paying attention and accepting responsibility. If those are hopelessly simple ideas let me suggest that we might do with a little less of the sophistication that got us into this mess in the first place.
COMMENTS
I have been operating for six months or so in the political arena in a small town in Oregon, where there is a huge absence of ethical behavior in our town's government. Risk management is non-existent, and the city's floodplain is in jeopardy of losing all federal assistance. A handful of us have worked tirelessly mounting newsletters, blogs, town meetings, etc. in an attempt to motivate our 2500 or so citizens to step up and be counted so we can bring some change to this situation, all without significant result. I see this as a microcasm of the problems Mr. Sharon is addressing here, and I think it's predictive of what we can expect in the country as a whole. The pain hasn't gotten nearly bad enough for a signficant enough percentage of citizens for any mobilization of effort. I don't know what the tipping point is, but I doubt we're anywhere near it yet.
Jane Hagan 04/02/08 11:01 am ET
I concur with Bill Sharon's admonition that ethical behavior applied liberally would help to avoid calamity in financial as well as most other domains. Alas, my professional training as a psychologist also leads me to concur with his observation that ethical self reformation typically is preceded by personal suffering attributable to precipitating ethical lapses. His insight that regulation almost always will be ineffective in preventing future hardship is a stinging rebuke of Capitol Hill reactions to such financial train wrecks. It is indeed evident that governments seldom legislate to safeguard against future calamities, and instead react to emergent ones. After all, the latter have voting constituents, whereas there are no constituents for catastrophes avoided. Naive as it may seem, what recourse comes to mind except exercising ethical behavior?
Let's be nice and play fair 04/01/08 01:05 pm ET
"Regretably, most Americans are ignorant" -
Be careful here. Are people in Mexico or Canada "Americans"? What about those in Central or South America, are they Americans? If the quoted line refers to US citizens, then I agree.
Comment Posted 04/01/08 11:23 am ET
Forgive me for being ignorant on this subject, please explain the "structured investment vehicle" reference you've made in this article.
There is much to be said about ethical behavior especially in the government of people. Whether it's Federal, State, or Local government-it's working for the people. Not to hurt the people but to help the people help themselves.
That's where America has gone a stray, I feel.
We've forgotten to help all the people, we've
helped select groups that in turn helped us
to someone else's demise.
True, there are people that do not wish to be helped and can bring the rest down with ignorance and disobeyance to rules and regulations. That's a tough one. We have to
help and police them to keep the whole population safe and secure. No different than in the animal world.
Yet, when we the people strive to break the rules and hide the unethical behavior...we lie,
we cheat, we steal. That is wrong, that can be in a gray area where judges have to decide what is right. We hope the judges are ethical, too.
Government for the people and by the people...ethical and just...no other way.
Thanks for inspiring me today, I enjoyed your article.
Tania Caillouet 04/01/08 11:19 am ET