The SEC’s suit against Goldman may make good political theater and it may give us a “teachable moment” about the intricacies of securities law, but it also threatens to distract regulatory reform from the most important issues. Assume that tomorrow someone from ACA publicly stated “Whoops! I found an e-mail from Goldman telling me Paulson was shorting the deal.” Would it dampen the reformist zeal in Congress? Absolutely! Should it? No.

Think of it this way. Even if the Abacus deal never happened, even if Goldman and other broker-dealers owed fiduciary duties to their clients, the financial crisis likely still would have happened. And that is not to pass on the merits of a case (two weeks old) at all. If we subtract out the securitizations in which investment bankers didn’t believe in their own marketing, we’d still be facing a pile of defaulted mortgages and mortgage-backed securities gone south.

The investment bank conflicts of interest story – like Rolling Stone analogizing Goldman Sachs to a vampire squid – is appealing because it is easy to understand and fits within our increasingly stilted political debate in this country. It also appeals to lawyers and law professors; “conflicts of interest” sits squarely in our wheelhouse. It also is in keeping with our national tradition going back at least as far as the Pecora commission of focusing on conflicts as the heart of financial crises.

That’s not to say there weren’t conflicts of interest at the center of the crisis. It’s just that the more important ones were likely elsewhere. For example, potential conflicts of interest at rating agencies do deserve careful scrutiny. “Conflicts of interest” are just a subset of a larger problem of misaligned incentives – for example, how securitization perverted the incentives of originating lenders to check the creditworthiness of borrowers.

Sachs education: Banking in the shadows

What the Goldman case is, however, useful for casting a harsh light on a more central factor in the crisis – the role of shadow banking. Shadow banking is an evocative label that describes how the network of securitizations and credit derivatives came to serve as an alternative to our traditional banking system. Instead of banks borrowing from depositors and lending to customers, shadow banking connects borrowers (like home buyers) to capital markets investors through a web of complex financial products – ranging from simple mortgage-backed securities, to CDOs, to credit default swaps). This system combines the old economic function of banking by funneling credit back to borrowers with the theoretical advantage of more efficiently spreading concentrated risk to a large number of investors in bond markets.

The big financial conglomerates like Goldman Sachs played a key role in the shadow banking. As the Goldman employees testified before the Senate, they were “market makers.” In other words, they were the hub where the various players in the shadow banking network – hedge funds, banks, bond insurers, mortgage originators – came together.

Shadow banking may not look like a bank, but it quacks like a bank, and it can suffer runs like a bank. That is, various institutions in the shadow banking network can sink quickly if investors panic and can demand redemptions en masse. Shadow banking institutions can suffer from not only liquidity crises, but solvency crises, as well. They can take on excessive risk and pose systemic dangers.

Finally, by taking on more leverage, they can increase the effective money supply; the same money multiplier effect that occurs when banks lower their reserve requirements is mirrored when credit derivative counterparties must post lower collateral or when investors can borrow to buy asset-backed securities. Leverage is leverage is leverage. The more leverage, the more credit that is pumped back into housing and securities markets (Now, as I noted in an earlier post, the synthetic CDO in the SEC v. Goldman case is a bird of a slightly different feather; because it was a pure bet, the leverage of the parties to that bet did not necessarily translate into more money flowing back into the housing market. But excessive leverage did seem to put the Abacus investors and insurers -- and potentially some of their creditors-- in mortal jeopardy.)

Regulating Shadow Banks

If it quacks like a bank and poses some of the same risks as a bank, perhaps we should consider regulating it like a bank. That’s not to say we require that securitization vehicles have banking charters, but that we consider using of the same conceptual tools already in our banking law tool kit – liquidity requirements, insurance, prudential regulations etc. -- to address the same types of functions and risks.

Arguing that we don’t need any regulatory reform in the wake of the crisis strikes me as completely wrong. Even Adam Smith and Milton Friedman saw a potentially valuable role in regulation addressing banking runs. That is not to say we need to ask WWMFD (that’s “what would Milton Friedman do?”). The fact is that shadow banking institutions – even supposedly safe bastions like money market funds – suffered runs and received bailouts by virtue of extraordinary federal intervention.

We may disagree on whether bailouts were appropriate, but that is water over the dam. They happened and it is hard to believe that the market would completely buy any governmental oath (even one sealed in the U.S.C.A.) that “we’ll never do it again.” If the government provides insurance, it needs to regulate. We can have a good debate on what regulation ought to look like. And it is completely legitimate to ask whether we should focus less on creating new statutory powers and more on ensuring that regulators use the powers they already have. (A mountain-biking hedge fund friend asked if I am now rethinking my earlier writing on the perverse cycle of deregulation during boom times and and re-regulation after crashes. Not at all. We need more than ever to think about re-designing regulation to escape this cycle and withstand political short-termism).

Unfortunately, it seems that the current proposals on Capitol Hill are only nibbling at the edges of shadow banking.

Why lawyers need a voice: creatures of legal arbitrage

Economists have had a central role in talking about the causes and cures of the crisis. Legal scholars less so. But lawyers do need to speak up. Shadow banking is in large part a creature of regulatory arbitrage – of lawyer crafted work-arounds of banking regulations and accounting rules. For example, many credit derivatives are functionally the same as bond insurance. But they are crafted so as not to qualify as “insurance” so as not to trigger regulatory rules. Future legal arbitrage and ensuring that regulators can keep informed about its consequences is one of the least-discussed topics of financial reform. We also need to make sure that we have more than just a bill on Capitol Hill that addresses shadow banking in broadbrush strokes, but is dumbed down in the details.

# # #

Let’s let the SEC v. Goldman wind its way through the Southern District. Let’s analyze whether proposals to impose fiduciary duties on broker dealer on their own merits. But if we expect to prevent another crisis, let’s cast a light into the shadows of banking.

Finance, Financial Crisis, Securities | Bookmark

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d8345157d569e20134808d0354970c

Links to weblogs that reference The Goldman Distraction: It’s the Shadow Banks, Silly: