HUMAN CAPITAL & THE FINANCIAL CRISIS

Almost every day there is another article that dwells on what really caused this financial crisis. The credit rating agencies have been charged with accepting fees from companies that they rate, and therefore permitting obviously questionable securities to pass muster because they feared losing fees. Conflict of interest? Yes. Will it change? How best to solve this problem is one of many policies the government is considering. I am certain all of the ratings companies want the financial community to perceive them as maintaining the highest standards of professional conduct. But there is obviously a public relations issue here that needs to be addressed.

Obama addressed the lax regulation of the financial system at the Federal Reserve on Wall Street recently. He talked about a shadow unregulated financial market that existed with a variety of complex instruments (including mortgages, derivatives and credit swaps) and enabled certain folks to reap unwarranted large profits. While the Federal Reserve has been proposed to be the watchdog over a rehabilitated financial system, it has presided over many cycles since it was created in 1913, and a number of experts question whether it is indeed the right body to be responsible for oversight. According to an op-ed by Peter Boone and Simon Johnson in The New York Times on Sept. 20, “The Recession Is Over — for Now,” from 1935 to 1980 the Fed (along with other agencies) was successful at ensuring “that banks’ activities did not put the public purse at risk.” The authors cite derivatives as the reason for the growing interconnectivity of banks, and hence the increased systematic risks, as an example of what went wrong this time. But they also say that there have been problems since 1980.

The article contends that, as with the credit agencies, there is a basic conflict of interest here. The same folks who are running American banks are also regulating them, moving people (e.g., Robert Rubin and Henry Paulson) from high level positions in finance to high level officialdom and back again. The authors point out that “these cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast with far too little capital for the risks it takes.”

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