In Uncategorized on May 14, 2010 at 11:29

Senator Kaufman Was Right – Our Financial System Has Become Dangerous

Posted: 13 May 2010 02:54 AM PDT

By Simon Johnson, co-author, “13 Bankers: The Wall Street Takeover and The Next Financial Meltdown.

Senator Ted Kaufman (D, DE) is best known these days for arguing that, as part of comprehensive financial reform efforts, our biggest banks need to be made smaller.  His advocacy on this issue helped build support around the country and forced a Senate floor vote on the Brown-Kaufman amendment, which was defeated 33-61 last Thursday.

Senator Kaufman has also pushed strongly the idea that in recent years there was a pervasive “arc of fraud” within the mortgage-securitization-derivatives complex.  This thesis also seems to be gaining traction – according to the WSJ today, the criminal probe into this part of the financial sector continues to develop.

But the Senator’s biggest home run has been on a different issue: his warnings about the dangers of high-speed trading, involving “dark pools” of money, appear to have been completely vindicated – ironically enough, also last Thursday.

Think about it this way.  The US stock trading system, long-established and widely thought to be robust, crashed on Thursday afternoon.  Widely held stocks, traded with consistent liquidity, do not fall in value from $40 to 1 cent and then bounce back again – even in emerging markets, let alone in the United States.  It is true that complex systems crash, but given the infrastructure and back-up systems involved here, this is much closer to east coast air traffic control shutting down for 15 minutes than it is to your local cable company having a problem.

And here’s the most remarkable point – after 6 full working days (and top people do sweat this kind of issue on the weekend), we are still no closer to really understanding what happened.  To be sure, there are plenty of theories – and no shortage of proposals for avoiding a recurrence.  But, despite the evident resources thrown at this problem, we do not know what went wrong.

As Senator Kaufman points out, the SEC does not even routinely collect the data it needs to understand the actions and impact of large traders.

The Merkley-Levin amendment would also likely be a step in the right direction, in terms of reducing the socially dangerous casino nature of our financial markets.  But it is far from enough.

The rationale for organizing our financial system as we do is that this leads to a reasonable allocation of capital across the economy.  We can argue the merits of this proposition at various levels – but no one would suggest that the extreme volatility and breakdown of trading last week was anything other than completely dysfunctional.

The SEC is, without question, beginning to get its act together under Mary Shapiro.  But there is also no doubt that it needs to lift its game to a much higher level, if regulation is even to catch up with how markets have developed over the past decade – just look at this timeline of problem identification and policy response.

Senator Kaufman has flagged mortgage-related fraud, high-speed/dark-pool trading, and bank size as pressing issues to address.  He was completely right on trading and, based on what we know so far, also right on fraud.

How long before he is completely proved right on the dangers posed by excessive bank size?

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