By Andy Xie, board member of Rosetta Stone Advisors Limited
 
The global financial crisis has triggered an outcry for more regulation. European governments are calling for Bretton Woods II to govern international finance. Be careful what you wish for. It is dangerous to rush through changes in the heat of a moment. We must think through what went wrong and what is needed to safeguard the global financial system. What we must not do is kill all risk taking.
 
I want to start by giving you my conclusions. What went wrong was the dismantling of the regulations that governed finance after the Great Depression. Mr. Greenspan personified the change. He believed in self-regulation on the part of financial institutions. The painful lessons from the Great Depression led to the conclusion that moral hazard was the biggest threat to financial stability. When someone is taking risks with other people's money, his freedom must be regulated. Hence, the urgent change is to restore the necessary safeguards that were dismantled in the past ten years.
 
The global nature of the current crisis has exposed a major weakness of globalization. The WTO framework is the vehicle for regulating global trade in goods and resolving disputes among countries. However, there is no comparable mechanism for the globalization of capital. Major financial institutions have assets and liabilities in many countries. When they go burst, how should governments deal with the consequences? Lehman Brothers transferred billions of dollars from Hong Kong and London to New York right before its bankruptcy, hurting other countries' interests in favor of the U.S.'s. As capital flows just far as goods and much quicker, a global regulator in some form is probably necessary for financial stability in the future. Globalization without such a safety lock may fall apart.
 
The Bretton Woods system was an exchange rate arrangement that emerged after the Second World War. Mainly, it pegged other currencies to the U.S. dollar and the dollar to gold. The International Monetary Fund (IMF) was set up to monitor balance of payment. As capital flow was minimal, it was really about monitoring trade balance. When a country ran out of foreign exchange reserves, the IMF would provide dollars to support it and arrange a devaluation to decrease its trade deficit. The World Bank was set up for financing long-term development, initially in Europe and then in developing countries.
 
Today's problems are very different. The challenge comes from capital flow, not the flow of goods. When cross-border capital flow is so large, it is impossible to go back to a fixed exchange rate system. Indeed, the system of flexible exchange rates has worked quite well in coping with the crisis. We haven't seen the total collapse of currencies in the crisis countries. In 1997 and ’98, the currencies of Asian economies collapsed as their pegs to the dollar broke. This demonstrated the weakness of a fixed exchange rate system. We must not go back to a fixed exchange rate system to manage the global economy.
 
The remedies to prevent future bank crisis are (1) to restore regulations that check moral hazard and (2) to establish a global regulator to supervise cross-border flows and handle bank failures that involve multiple countries. The crisis has not spent the end of free market system at all. It merely shows that the system needs to learn new lessons and sometimes relearn old lessons. Regulations are needed to check the imperfections of a market system, not to replace it with government planning.
 
Mr. Greenspan says that this is once-in-a-century crisis, implying it is a natural disaster like a big earthquake. This is not true. If anyone is responsible for it, it is he.

I wrote for a decade documenting Greenspan’s management of the U.S. economy by creating one bubble after another. When many analysts pointed out the risks of a property bubble and massive growth of hard-to-understand derivatives, he claimed repeatedly at congressional hearings that a nationwide property bubble was unlikely, because it hadn't happened before – which was not true – and self-regulation by financial institutions was effective at controlling risks from derivatives. The gross negligence on his part bordered on criminality.
 
Of course, Mr. Greenspan is not solely responsible. So many worshiped him like a god. Senator Phil Graham once mentioned that, if the Great One had died, he would keep the body standing up in the Fed Chairman's chair to calm the market. From academia to the popular press, so many lauded Mr. Greenspan for finding new tricks to manage monetary policy. His effectiveness really came from his impact on asset prices. Rising asset prices juiced up demand quickly, making his policy seem instantaneously effective. It turns out those was just old-fashioned asset bubbles. But people wanted to believe, so the dissenting voices were disregarded, and the dissenters were treated as sour grapes. All the people who heaped praises on Greenspan, meaning most people, are responsible for this crisis.
 
Wall Street greed is another factor in the catastrophe. Investment banks depended on fee businesses like taking companies public, advising on M&A deals, and providing research to institutional investors in exchange for commissions from buying and selling securities in secondary markets. After the tech bubble burst in 2000, these businesses shrank. Their rallying cry afterwards was ‘taking risk,’ i.e., buying risky assets for appreciation. The so-called proprietary trading income gradually rose to dominate their ‘earnings.’ In this game, of course, no one on Wall Street was going to lose. They all pocked fat bonuses on their ‘successes.’ Most were fools and just followed the heard. Some, especially senior managers, knew it was all a scam. They went along for the ride to enrich themselves.
 
The third reason for the crisis was that American workers wanted to sustain their living standard through borrowing, as the globalization kept their wage down. American politicians knew that the wage was stagnating or even declining in real terms for most American workers. When American workers suddenly ran into competition from Chinese and Indian workers who were paid less than tenth of what they were paid and ten times as numerous, they would lose out. That stark reality came into conflict with the American optimism. That optimism is normally a positive force that keeps people trying, but it can delay painful actions when retrenchment is really needed.
 
To sustain the fiction that American workers would enjoy ever rising living standard, there was political tolerance for deregulations that would make borrowing easier, i.e., with less equity or collaterals. The political expediency made it easy for the Wall Street to push for tearing down the regulatory infrastructure erected during the Great Depression to control moral hazard inherent in the financial system. The Glass-Steagall Act that separated commercial banking from investment banking was taken down to pave the way for the merger of the Travelers Group and Citibank. That kicked off the wave of commercial banks pushing into investment banking.

Lacking the credibility of long-time investment banks, commercial banks relied on their ability to leverage their balance sheet – a euphemism for extending cheap loans to their clients in exchange for their investment banking business. Their competitive edge from subsidizing their investment bank business with a commercial banking arm put great pressure on traditional investment banks that didn't have a deposit base, and, as the Fed guided interest rates down, the traditional investment banks issued commercial papers to source cheap money to compete against the commercial banks.
 
The traditional investment banks have been more vulnerable than the big commercial banks in this crisis. As their assets become illiquid, the market refuses to roll over their debts, which makes their collapse self-fulfilling. Some view merging with a commercial bank as a way out. The thinking is that it would provide a stable source of funds from deposits. It was shocking that no one challenged this notion. How could regulators allow investment banks to use government guaranteed deposits to own high-risk assets?

The problem is not a source of funds but the high risk they take on their asset side. The cure is stopping gambling with other people's money, not to shift from commercial papers to deposits for funding them. Commercial banks should be commercial banks, and investment banks should be investment banks. The former lend government-guaranteed deposits and, hence, must be regulated on how much risk they can take. The later earn revenue from services, not gambling.
 
Another important change happened in 2004. The U.S.'s financial sector debt was growing twice as fast as GDP. It was much quicker at investment banks. They ran into capital constraints for taking on more debts. The solution was to change the rules. They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on, which was designed as cushion against losses on their investments. The freed-up capital could then flow up to their parent company for investing in mortgage-backed securities, credit derivatives, and other exotic instruments. That change played an important role in the expansion of the subprime and derivative market. It allowed them to put these opaque assets on their balance sheets, use booking revenues for manufacturing these assets and selling them to themselves, and it allowed capital gains on the supposed appreciation of these assets. Essentially, they used their capacity to expand balance sheet for financing self-dealing and manufacturing profits.
 
The excessive deregulation was partly justified by the argument that financial institutions could effectively self-regulate. That was a huge mistake. Large financial institutions have no dominant shareholders and are controlled by management. Their top managers are interested in bonuses that are linked to their accounting profits. They are motivated by maximizing short-term accounting profits. Most senior managers didn't understand the risk their firms were taking but didn't care because of big bonuses. But like good CIA operatives, they insisted on the formality of risk control to ensure that their bonuses would not be taken back for gross negligence. Some government agencies are trying to get their bonuses back. You can be sure that they will use some of their bonus money to hire good lawyers to keep their ill-gotten gains.
 
The catastrophe of today's financial crisis is largely self-made. Half a century after the Great Depression, no one with that experience was left in the power structure. Greed pushed the politicians, regulators, and financial institutions to try their luck again. Financial crisis is inevitable because human beings forget the past lessons and want to believe in free lunch again.
 
The transnational nature of financial institutions on both asset and liability side has presented new challenges to handling a financial crisis in two ways: First, the crisis spreads very fast across the world. Many trades are multi-country and multi-asset in nature. When one market fails, others follow quickly. The systemic risk in today's world is global in nature. Second, when one country bails out a financial institution, it may be bailing out investors and depositors in many countries with its taxpayers' money. Politically, it becomes difficult for a government to act early in a financial crisis. Only when the crisis is intense enough that governments become willing to act. In order to handle the next financial crisis better, some sort of global system is needed to define who is responsible for what. Of course, when a country uses its taxpayers' money to bail out foreign investors and depositors, it wants a say in how the global financial system is supervised.
 
European governments are leaning towards a global financial regulator. The U.S. still wants each country to regulate financial institutions and activities within its borders like before. The U.S.'s current position is clearly untenable. Financial institutions have been undertaking regulatory arbitrage across countries, exploring the differences in financial supervision across the world to hide their risk taking. The status quo is not acceptable. Major changes will happen one way or another.
 
A global financial regulator is an extreme solution. It requires countries to give up a considerable part of their sovereignty, a sensitive issue in most countries. If all the major economies buy into this plan, they can reorganize existing multinational organizations like the IMF and Bank for International Settlements (BIS), e.g., combining them to form a global regulator. Its responsibilities would be to set up rules and supervise financial institutions that operate in multiple countries. Its disadvantage is that such an organization may be required to do too much and may be too rigid in setting up rules.
 
I think that the global community is not ready to embrace a global super regulator. Most countries are not ready to give up so much sovereignty yet. The acceptable changes are probably (1) to agree on some global standards for financial regulation and supervision, and (2) to set up a global body, possibly through combining IMF and BIS, to coordinate national regulators and provide early warning signals on excessive risks that financial institutions are taking in cross-border activities.

Would such an outcome prevent future crisis? Probably not.
 
A financial crisis makes another crisis less likely in the near future, as governments and investors become more cautious after being burnt badly. Overtime, the wounds are forgotten. Greed again takes over and drives people to do crazy things again.
 
Financial crisis, however, doesn't make market economy a less desirable system for economic activities. The world has not found a better system. The market system motivates economic agents, workers and businesses to exert their best efforts and take calculated risk. Without risk taking, there would be no progress. Financial crisis represents an extreme form of volatility in a market economy. Volatility is not good in itself, but it is a necessary byproduct of a market economy. Stability is good but is not the most desirable goal. Primitive societies may be most stable, but they stabilize at a low level of economic activities.
 
Financial crisis will always be with us. We need to set up the best system to decrease its frequency. It would be wrong to stop risk taking in order to eliminate financial crisis, which would lead to stagnation. In the moment of panic, we shouldn't throw out the baby with the bathwater.