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Inside the Wall Street Journal's Future of Finance Initiative

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Last week I was a participant in the Wall Street Journal's Future of Finance Initiative in England. WSJ has written a summary of the conference highlights, and missed some key points. Allow me to fill in the blanks.

Paul Volcker, former Fed Chairman and current Chair of the President's Economic Advisory Board, made the most worthwhile comments. Moral hazard was not discussed in the open forums, so Volcker reminded the assembly. Yet even Volcker did not broach the topic of fraud.

Alistair Darling, Chancellor of the Exchequer, spoke on the opening evening. I asked him why massive financial fraud remained unaddressed. Darling appeared momentarily confused and seemed to suggest this was exclusively a U.S. problem to be handled by the courts. I pushed back on this notion. By the time one needs a lawyer, it is too late. I noted that we, the middle aged financiers in the room, are responsible for taking action. If we don't face this issue head on, we will never restore trust in the financial system.

Ana Botin, Banesto's Executive Chairman, suggested that the risk manager should report to the board. Then she blew it with the assertion--made several times--that the CEO can also be Chairman. (Ken Lewis defended his dual role as CEO and Chairman of Bank of America at a Fed conference in 2003. How did that work out?)

I didn't challenge Botin's assertion, because I used my two minutes (literally) during the "Too Big to Fail" breakout session to (unsuccessfully) try to carry the point that when banks fail, we should allow shareholders to be wiped out, and debt holders should take losses. (Under that scenario, most of the current managers would be booted out.) Instead, the group posted the need for a "living will" to be designed by the managers that made life support during our recent crisis a debatable necessity.

Elizabeth Corley, CEO of Allianz Global Investors in Europe, presented conclusions from her panel's discussion of the "Regulatory Frontier." The panel's idea of upgrading regulatory resources was to deploy senior financial institution officers to regulators for two or three years and vice versa. Meanwhile, the financial institutions should chip in to maintain the regulators' former high pay. Howard Davies of the London School of Economics saved me from having to explain the concept of regulatory capture. After he spoke, I was the only one to clap. Apparently everyone else thought the panel was titled the "Predatory Frontier."

Robert Diamond, president of Barlcays PLC, sounded like a financial holocaust denier. He seemed to think that the idea of breaking up banks has only to do with the threat to the financial system, if they fail. The point is that some of these institutions threatened the financial system--and continue to threaten the financial system--because they are too big to manage.

Diamond seemed to dislike the term "socially useless" to describe recent financial innovation and defended Barclays' proprietary trading. Since Barclays has dropped its suit involving its total return swap with Bear Stearns' imploded hedge funds, Diamond may have already forgotten this relevant example of financial innovation gone wrong. Hedge fund investors were wiped out, the hedge funds' dodgy assets landed on Bear Stearns's balance sheet, and later on JPMorgan Chase's balance sheet, after it acquired Bear Stearns. Our past crisis taught us that hedge funds are not independent of the banking system. This transaction wasn't merely socially useless, it had negative social utility.

Mario Draghi, Bank of Italy's Governor and Chairman of the Financial Stability Board, seemed to think that hedge funds are independent. This is simply incorrect. If the example above didn't persuade him, he might consider the assets that came back onto bank balance sheets and contributed to market instability. For example, in March of 2008 as Bear Stearns bit the dust, the Carlyle Group's CCC fund assets and the assets of Peloton's funds boomeranged back on bank balance sheets at the most inopportune time.

Bob Diamond defended structured credit products saying there is a real purpose for structuring credit for pension funds. He was probably unaware that state pension funds in the United States were damaged by the unintended consequences of a "AAA" rated structured credit product. The pension funds were wise enough to avoid investing in the product, yet as I explained in my February 2007 letter to the Securities and Exchange Commission, large fixed income pension funds were unintenionally harmed by the market distortions caused by this financial innovation.

My letter to the SEC cited this financial innovation as an example of why the special NRSRO designation of the rating agencies should be revoked. The product did not deserve its "AAA" rating. It had substantial principal risk and deserved a non-investment grade, or junk rating. Within a year all of these new "AAA" innovations blew up. Moody's estimated that investors in one of them would get back only around ten cents on the dollar.

Not all financial innovation is harmful, but it is undeniable that in recent years it was a runaway train that nearly derailed the global financial system. You wouldn't have realized that, if you listened to most of the participants. They chiefly represented the interests of large financial institutions, and the financial system is still attached to the privileged placenta of central banks doling out taxpayer subsidies. Most of the conference reflected the insulated thinking of this protective womb.