Thanks for your response. Of course banks deserve a lot of blame, but a regulatory environment designed to foster competition (a development that began in the investment banking industry in 1976) without actually removing the main cause of overcapacity: lack of credibly uninsured bank liabilities. Allowing banks to compete with investment banks and under a widely criticized regulatory regime (Basle ! and 2), was stupid. I should add here that the alternative to a (bad) international regulatory standard would have been some form of protectionism. If commercial banks would have been unable to sponsor conduits and trade in commercial paper,and insurance companies unable to make commercial oans or write credit derivatives (except with capital requirements at least at the commercial banking level) the investment banking community would probably be reduced to firms operating on an agency and short term trading basis. Protectionism would then come in if foreign banks would make US domestic loans from their US agencies at terms clearly unfeasible for banks subject to US domestic regulation. That would, of course, have made the international business of US moneycenter banks much more difficult, leading to two influential interest groups (moneycenter banks and investment firms) to support the regulatory regime that contributed to the present mess.

And a situation like that does not reward the virtuous: you either play or fold..

No, but close enough for the sake of this discussion.

observer: You like to think that the financial industry as a whole is ethical, productive and good for everyone and it is a few bad apples that give everyone else a bad name.

No, I don’t believe that at all. I believe that if you give people lots of money to do the wrong things, the wrong things things will happen, so you have to set up the incentives so that people end up doing socially productive things, and that there were all sorts of horrible incentives that encouraged bad behavior.

I don’t think that people in finance tend to be better or worse than any other large group of people, and you get your mix of saints, and crooks and everything in between. Focusing on the personal ethics of people misses the point, since if you replace everyone, you end up with another group of people with moral quality which is about the same.

Also whether or not there are a few bad apples or not is sort of irrelevant. If a few bad people can cause this much damage, then something is very, very wrong with the system.

observer: But you are hopelessly blinded by your insider’s perspective. In short you have drank the kool aid.

It’s interesting that you assume that I believe things that I simply don’t, and then call me hopelessly blinded.

The fact that I work on the inside does change the way that I view the world, but I do try to see beyond my little silo.

Observer: I have no doubt that you are an honest and industrious person yourself,

This makes no sense. If I’m a person that willingly works for an industry as bad as you say it is, then I can’t possibly claim any sort of honesty, and I don’t see why you want to claim that I am anything other than corrupt.

It’s not as if I’m forced to do the work that I do. It’s not as there could be lots of corruption around me, without my noticing.

Observer: but sorry to break it to you, the industry you work in is rotten to the core. It’d help a lot for insiders such as yourself to acknowledge the scale of the rottenness and corruption.

I just tell you want I see. If it’s not what you think I should see, then I’m sorry. I actually don’t see that much rottenness and corruption, probably in large part because I intentionally and consciously avoid situations where there is rottenness and corruption.

Observer: and think about how you’d create a better financial system.

The problem is that if you start with the premise that the industry as a whole is rotten and corrupt, then I should be punished quite severely, and I don’t see how you can avoid that conclusion. If I’m going to get strung up by the lynch mob, then it’s unlikely that I’m going to cooperate irregardless of whether or not I deserve to be strung up.

I dunno. Maybe the fact that I try to surround myself with decent people, is precisely I don’t personally know anyone that makes as much money as FollowTheMoney’s friends.

observer: Oh please. Name one person or organization who is getting “unfairly” blamed right now.

Twofish: Me.

I don’t know who you are. From your comments on this blog, I can guess you are some sort of derivatives trader at Goldman Sachs.

You like to think that the financial industry as a whole is ethical, productive and good for everyone and it is a few bad apples that give everyone else a bad name.

But you are hopelessly blinded by your insider’s perspective. In short you have drank the kool aid. I have no doubt that you are an honest and industrious person yourself, but sorry to break it to you, the industry you work in is rotten to the core.

It’d help a lot for insiders such as yourself to acknowledge the scale of the rottenness and corruption, and think about how you’d create a better financial system.

though i fully agree that they whole buildup of risk couldn’t have happened without non-market inflows from china and other central banks.

It’s not clear to me that these statistics mean much. In the 1960′s, a lot of resource allocation decisions were made by middle managers in large companies. In the 1980′s, a lot of these large companies were broken up, and now you had the same sorts of decisions meaning made by people in finance.

Larry: And I think you’re confusing Wall Street with venture capital and angel investors.

No I’m not. It’s all part of one big system. VC firms get their money from hedge funds or are hedge funds themselves, and the money to the VC firm usually flows through an investment bank. Angel investors use private banking in order to keep money available for investment. And the goal of these firms are get large enough so that they can IPO or get bought out at which the investment bank is necessary so that the founding capital can exit.

Larry: I do agree that the value is added by efficient allocation of resources. Unfortunately, efficient is what’s missing.

In some ways US finance turned out to be too efficient. One characteristic of US corporations is that they are completely dependent on financial markets to satisfy cash needs, and having lots of cash lying around is generally considered a sign of incompetence. The problem is that when the markets start to fall apart, then things get very bad, very quickly.

The analogy is that most companies in the US don’t have big diesel generators, because they can rely on the power grid, but when the power gets knocked out, things get very bad, very quickly.

Larry: Maybe that’s what the financial industry needs, a dose of Wal-Mart.

Wal-Mart wouldn’t be possible without Wall Street, since they need investment banks to handle things like letters of credit, bond and stock issuance, and treasury services.

In particular, it’s important to point out where Wal-Mart fits in with the system of securitization, which has gotten this reputation as this evil nasty thing with no redeeming social purpose.

Wal-Mart has about $7 billion in cash and cash equivalents. It doesn’t put that $7 billion in a checking account. What it does with most of that $7 billion is to purchase short term securities such as repurchase agreements and money market funds, and since that cash is not in a checking account, for that money to be put to work, it has to go through the securities market.

The problem is that the financial industry has been allocating most of the resources to itself. By most metrics from wages to the share of the S&P 500 earnings (source: Paul Kedrosky’s blog), finance plus insurance and real estate just got too big.

And I think you’re confusing Wall Street with venture capital and angel investors.

I do agree that the value is added by efficient allocation of resources. Unfortunately, efficient is what’s missing. Maybe that’s what the financial industry needs, a dose of Wal-Mart. Hell, even the two Bobs would be an improvement.

What is the point here? Banks are pretty well defined entities in most jurisdictions. Bank fragility was well understood and the intrusion of practices that well managed investment banks (the ones with management capital at stake) would ban in their own firms was also well-observed, criticized, but not opposed. Without the Chimerica fuelled US housing boom, things would have been different.

And without the root problem of the financial services industry: overcapacity and ambiguous agency (who does management care about? shareholders, depositors? the captive taxpayer?). For some reason no one did something about it. Do not blame the banks. Banks that would not play the musical chairs game would not play at all. The ones that did knew that some would lose. No one expected that the chairs would disappear during the game.

1. The GOP’s version of reality – which has a strong libertarian streak – in which self-regulation of both companies and markets works better than government regulation. You’d think that would be self-evident but people defend these failed ideas daily.

2. The GOP version of market capitalism. No one seriously attacks the concept of capitalism – which has become misused and distorted – since no one wants to replace private ownership on a large scale and outside limited and temporary exceptions. This core failure is more at issue politically because the GOP now cries “Socialism!” at every turn and, frankly, if I read one more ridiculous, distorted comparison to Europe I’ll barf.

3. The idea that one can compete without creating cost. As you’ve noted, Brad, many of the information issues trace to London’s light-touch regulation – including, it seems, Treasury’s and the Fed’s ignorance of the extent to which Lehman’s demise would cause a dollar shortage for European banks. That light-touch was set up by Britain to attract business and the competitive edge brought in massive capital, drove up real estate prices, pumped money in London financial firms – and apparently enabled AIG’s CDS group. Such an edge also has a cost and now the bill has come due. We can’t delude ourselves into believing actions don’t have consequences.

I strongly disagree (and maybe it’s the people that I hang around). You have $X billion and lots of great ideas. Correctly deciding which ideas get funded and how much and doing it correctly creates value. Getting those decisions wrong destroys value.

You can see how important finance is by seeing the mess that happens when it gets done badly. If we had a system that spent less money on stupid real estate and more money on factories and municipal bonds to build schools, roads, and hospitals, that would have generated a huge amount of value.

If you look at every major social problem in the world, hunger, poverty, war, disease. Most of it comes down to issues of money and finance, and if you get money and finance *right*, then there is no end to the amount of good that you can do. Get it wrong, well just look around you…..