Financial Reform: Will it Forestall a Future Crisis of Ethic Proportions?

07/22/2010 02:50 pm ET | Updated May 25, 2011

The financial reform act that was signed into law this week -- while imperfect -- represents an important first step in attempting to preclude or mitigate future financial collapses. But increased regulation and oversight alone will be insufficient to prevent a recurrence of the recent financial crisis.

The causes of the collapse are no secret. While it is often claimed that "victory has a thousand fathers, but defeat is an orphan," the defeat suffered by investors in our devastating financial crisis seems to have, figuratively speaking, a thousand fathers. The Federal Reserve kept interest rates too low for too long after the 2000-2002 stock market crash, and failed to impose discipline on mortgage bankers. Not only did our commercial and investment banks design and sell trillions of dollars worth of incredibly complex and risky mortgage-backed bonds and tens of trillions of dollars worth of derivatives (largely credit default swamps) based upon those bonds, they were also left holding the bag, with many of these toxic derivatives held on balance sheets that were highly leveraged -- sometimes by as much as 33 to one or more. Just do the math; a mere three percent decline in asset value wipes out 100 percent of shareholder equity.

These institutions also brought us "securitization," selling off loans as the backing for untested financial instruments, and severing the traditional link between borrower and lender. With that change, the incentive to demand credit-worthiness on the part of those who borrow almost vanished as banks lent the money, only to sell the loans to the creators of these new financial instruments. In banking, we've come a long, long way from community lending built on the financial probity and the character of the borrower, the kind of thing that we saw in It's a Wonderful Life.

Our market regulators, too, have a lot to answer for: The Securities & Exchange Commission was almost apathetic in its failure to recognize what was happening in the capital markets. The Commodity Futures Trading Commission (CFTC) allowed the trading and valuation of derivatives to proceed opaquely, without demanding the sunlight of full disclosure, and without concern for the ability of the counterparties to meet their financial obligations if their bets went sour.

And let's not forget Congress, which passed responsibility for regulation of the derivatives market to the CFTC almost as an afterthought. Congress also allowed -- indeed encouraged -- risk-taking by our government-sponsored (now essentially government-owned) enterprises -- Fannie Mae and Freddie Mac -- enabling them to expand far beyond the capacity of their capital, and pushing them to lower their lending standards. Congress also gutted the Glass-Steagall Act of 1933, which had separated traditional deposit banking from the riskier business of investment banking, a separation that for more than 60 years well-served our national interest.

Our professional security analysts also have much to answer for, especially in their almost universal failure to recognize the huge credit risks assumed by a new breed of bankers, who were far more interested in earnings growth for their institutions than in the sanctity of their balance sheets. So do our credit rating agencies, for bestowing AAA ratings on securitized loans in return for enormous fees--handsomely paid in return by the very issuers who demanded those ratings, allowing what proved to be largely junk bonds to be marketed as high-quality securities. (Yes, it's called conflict of interest.)

An Ethical Crisis

But there is yet another factor underlying this crisis that is the broadest of all, pervasive throughout our society today. It was well expressed in a letter I received from a Vanguard shareholder who described the global financial crisis as "a crisis of ethic proportions." Substituting "ethic" for "epic" is a fine turn of phrase, and it accurately places a heavy responsibility for the meltdown on a broad deterioration in our society's traditional ethical standards.

Commerce, business, and finance have hardly been exempt from this trend. Relying on Adam Smith's "invisible hand," we have depended on the marketplace and competition to create prosperity and well-being. But self-interest got out of hand. It created a "bottom-line" society in which success is measured in monetary terms. Dollars became the coin of the new realm. Unchecked market forces overwhelmed traditional standards of professional conduct, developed over centuries.

The result has been a shift from moral absolutism to moral relativism. We've moved from a society in which "there are some things that one simply does not do" to one in which "if everyone else is doing it, I can too." Business ethics and professional standards have been lost in the shuffle. The driving force of any profession includes not only the special knowledge, skills and standards that it demands, but the duty to serve responsibly, selflessly and wisely, and to establish an inherently ethical relationship between professionals and society. The old notion of trusting and being trusted -- which once was not only the accepted standard of business conduct, but the key to success -- came to be seen as a quaint relic of an era long gone. Somehow, our society must be spurred into action to return to that standard.

Until it is, I fear that a repeat of our recent meltdown is not just possible, but probable, for there's no end to the ways that motivated individuals can get around even the most stringent regulations. True reform of our financial markets will not be found until our nation's financial professionals turn their focus away from the salesmanship that produced so much of the excess of the recent era, and embrace the stewardship that their profession demands. Such a change cannot happen soon enough.

This essay has been adapted from the Author's Note of Enough: True Measures of Money, Business, and Life.