In the US, the healthcare bill has passed and general attention is shifting back to the economy and financial industry regulation. As in healthcare, the stakes are high, for both the general public and the financial industry. As in health-care business interests are fighting hard for every inch and as in healthcare they are defending the indefensible.

Only, the subject matter seems much more complex for outsiders and politicians. The public’s lack of knowledge on finance is being brutally abused to engender fear and control the outcome. Even if more and more politicians seem to resist the power of the lobbyists, we are all stunned by the President’s insistence that the old guard determines the agenda (Paul Volcker aside).

Often we hear that this old guard, including the bankers we bailed out are the only ones who understand the issues. Are we really that gullible? There are enough financial professionals outside banking who understand the issues, almost certainly a whole lot better than the overstretched  leaders of our  “too big to fail” banks.  What’s more is that they should have great interest in speaking their mind in opposition of universal banks that have crowded them out during the boom and made a mockery of market mechanisms, literally destroyed it.

The necessity of serious structural changes in the financial industry is blatantly obvious, it seems, to everyone I speak to, even the bankers among them. Yet, there is a sense that the focus in the debate continues to be biased towards hedge funds and a so-called shadow banking system. Fact is that it was our large “Blue Chip” commercial banks, each larger than the global hedge fund industry combined, who spiraled themselves and our system out of control. The global top 20 of them doubled their balance sheets from 2004 to 2007 to $40 trillion, close to global GDP. Even if painful for those involved, the $50 billion Madoff scheme seems trivial.  

How did the banks do it? Simply put, they started to use their triple A rated commercial banking balance sheet (which is generally a very low risk business) to underwrite more adventurous business units. Their triple A ratings allowed them to raise funds at the lowest possible rate and invest in every kind of arbitrage opportunity, anywhere. Little surprise, their expansions were breathtaking and as a “lucky” byproduct risk premiums in their models collapsed in “virtuos” reflexivity with their self-created and increasing leverage.

No independent business or hedge fund would be able to beat these banks’ muscle and capital costs. Banks took over leadership across finance and in the process crowded out a diverse and multifaceted financial industry. The crowding out and loosing market share may have not hurt so badly since the cake was grown so fast and so large, even a much smaller slice of it felt very gratifying.

However, universal banking and its success has eroded the market’s raison d’etre, the efficient allocation of risk and capital. How did our global commercial banks, now universal banks cum Super HedgeFunds convince us that they knew how to integrate and effectively manage a myriad of businesses and risk structures across finance? They never had to convince anyone, not a regulator or a client, they just did it and increasing profitability was their proof of ability.  

Now, they have walked us into a financial crisis and based on the facts their businesses and their risk models have failed. To call this crisis a black swan event is good marketing but disingenuous. This was not a surprise nor an outlier nor an accident. According to many esteemed observers it was inevitable. Banks used a stable and low risk business to leverage themselves into unknown territory with doubtable tools and insufficient understanding. It is clear and had been discussed along the way that risks exploded, quite the opposite what banks’ models portrayed.

We can observe from the debate about compensation packages, our universal banks had huge trouble aligning interests and risks of decision-makers.   Their size and diversity of functions are an important factor but, I would like to suggest that false application of risk models made it impossible.  By now almost everyone in the financial world has come to understand and simplify the complex world of risk with one simple concept: price volatility and relative price volatility. Price volatility is a more or less workable proxy for risk for short term risk evaluation.  Banks however ignored longer-term risks, implicitly assuming that every long-term investment will become a short-term investment at some point.

Price volatility as a concept and its formulaic application are one-dimensional and make it easy to dissociate oneself from the real economic risks present in any investment. Add to this the fact that decision-makers mostly did not own nor were they directly tied to the capital underwriting these risks. Further take into account that price volatility is negatively correlated with liquidity and credit expansion. While increasing leverage obviously increased risks, applied risk measures collapsed having everyone believe risks were well managed.

Equally it was impossible for banks to use and structure derivative instruments properly. However, instead of focusing reform on the inadequate institutional structures the regulatory discussion remains on the instruments themselves. Throughout history financial crises always produce the instruments deemed most damaging, in hindsight. However, their particular characteristic matters not. Once the market is granted latitude to expand liquidity too fast and by too much the legal contract to package the deals to make it happen will always be found.  Let us be fooled into punishing the tools that have improved our lives and possibilities in many ways. We neglected transparency and oversight and expanded too fast; the exact instrument used is hardly the culprit.

If we have the goal to maintain systemic stability and avoid future financial crisis, it seems much easier and more effective to avoid excessive expansion of money and/or concentration of risks than to curtail and control financial innovation. As such the FED has to be ultimately responsible for not reigning in the extraordinary credit expansion, as this is its main purpose. The FED’s structure, focus of responsibility and transparency need addressing. 

Let me summarize: commercial banks took over inherently entrepreneurial niches in finance with their large scale bureaucracies and propagated and built a consensus towards a risk model that over time degraded the market’s ability to recognize and neutralize risks in small and digestible doses. Risk and capital became to be concentrated in the least capable institutions and the market failed. Ironically, Banks’ reliance on the assumption that markets are efficient directly caused market efficiency to break down.

Maybe Mr. Krugman is right in that we don’t have to break up our universal banks, maybe a sensible regulatory framework will do the trick all by itself and disintegrate these “too big to fail” businesses. But, in order to achieve any form of satisfactory reform, the perspective of the discussion needs to change. As long as the old guard, the largest and most powerful bankers along with the Fed, determine the agenda, there is little hope of restoring an efficient and sustainable market mechanism.

The issues are complex and of global nature.  It is time to get the non-banking financial industry leaders involved at the highest level. Today they have an opportunity to level the playing field, restore the integrity of their industry and help make ‘too big to fail” a thing of the past.