The Hard Reform
In a post last April put forward a case for considering more responsible ways of using information in markets. I would like now to address a problem that stems from Gramm-Leach-Bliley which may have played a larger role in the current market collapse than problems of information, the lack of necessary interdependence between different financial institutions that arose out of cross sector integration.
When Gramm-Leach-Bliley repealed the restrictions from Glass-Steagall which prevented several different types of financial institutions from merging, each class of which performed different market functions, it removed and important barrier which served to assist in preventing bad transactions and toxic securities. That barrier was the need to do business with other institutions to accomplish certain kinds of transactions. The merging of differing types of financial players into single businesses allowed internal transactions to take place which created securities that would not have been created had these securities had to have been created through the cooperation of several different businesses.
The collateralized debt obligations and mortgage backed securities which precipitated the crisis would have been much more difficult to craft had the transactions necessary to create then been made to go through outside firms rather than being crafted in house before being released for purchased by other firms. The necessity of dealing with an outsider to have individual mortgages and other debts repackaged makes it harder to include bad debts in the final securitized amalgamation of debt, because the other firm isn’t going to want to buy something that it can’t make money on.
Both parties to a transaction enter that transaction because they are under the impression that they are getting a good deal. The adversarial element that comes from the possibility of a transaction offering a lopsided benefit makes caution a virtue in deciding which transaction to enter. The diminished amount of trust involved in doing a transaction with an outside entity offers a check that isn’t present when a firm can produce a finished product internally.
The problem is one of balance. Trust is what allows transactions to happen in a market economy, but caution is what allows for any level of market stability. The relations between different players on the market or lack thereof are the problem the meaningful stability related reforms are going to have to address as cleanup continues of the current financial mess and the economy migrates towards a more pleasant equilibrium.
