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From Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

Since the dawn of modern finance, governments have been beset by the question of how much banking should be regulated. On the one hand, twentieth-century American and European governments have generally accepted that the business of finance should be exactly that, a business run privately in a profit-seeking manner. But finance is also not quite like other areas of commerce. Money is the lifeblood of the economy, and unless it circulates readily, the essential economic activities go into the equivalent of cardiac arrest. Finance serves a public utility function, and the question government regulators must wrestle with is to what degree private financiers should be allowed to seek a profit and to what degree they must be required to ensure that money flows safely.

In practice, during the twentieth century both American and European governments resolved the dilemma by keeping banking private but swaddling it in rules to ward against excesses. During the course of the century, those rules had expanded into what felt to bankers like a straitjacket of regulation. Some of the laws were national in nature, such as the Glass-Steagall Act in the United States, which separated commercial banking from investment banking. The Federal Reserve also imposed rules specifically on American commercial banks — with investment banks left outside its purview — including the stipulation that the total size of their liabilities could not exceed twenty times the size of their equity. If banks over expanded their assets and failed to keep adequate reserve capital to cover potential losses, they were at risk of collapse, as had happened so spectacularly after the Crash of 1929. The regulations in London also imposed minimum reserve requirements.

On top of the national regulations, a set of international stipulations, known as the Basel Accord, had been agreed to by the Group of Ten nations, plus Luxembourg and Spain. A first set of agreements were drawn up in 1988 in the picturesque Swiss mountain town of that name, under the management of the Basel Committee on Banking Supervision (BCBS), whose governing body is based at the Bank for International Settlements (BIS). The first set of rules, known as Basel I, imposed globally consistent standards for prudent banking, most notably by demanding that all banks maintain reserves equivalent to 8 percent of the value of their assets, adjusted for risk. These rules were expanded and modified for some years, with a revised version referred to as Basel II issued in 2004 but not yet agreed to by all parties.

By the early 1990s, regulators were dogged by the fact that many of these rules had been drafted before the explosion of derivatives innovation. They could be extended into the derivatives world to some extent; aspects of the Basel Accord set out, for example, levels of reserves that banks must hold if they were engaging in derivatives activity. But the urgent issue now was that the business had expanded so much, and in such complex ways, that regulators couldn’t get good estimates of the risks involved. The issue didn’t worry regulators too deeply at first. In the early 1980s, swaps deals accounted for so little of overall banking activity and were being done by such a relatively small and elite group of players that regulators regarded the sector as a sideshow. What traders did with their newfangled derivatives contracts seemed as peripheral to the “real” economy as the gambling in Las Vegas is. But, as the 1980s wore on and the business began to take off, some regulators became uneasy. They began to tweak the banking rules in a manner that forced banks to lay aside more capital against their derivatives business. That left bankers nervous. They feared that profits could drop if regulators became even more involved. In response to this, in 1985, a group of bankers working for Salomon Brothers, BNP Paribas, Goldman Sachs, J.P. Morgan, and others held a meeting in a smart Palm Beach hotel with a view to agreeing on standards for swaps deals. The idea was to hash out common legal guidelines for the deals. Out of that, they decided to create an industry body to represent the swaps world, subsequently known as the International Swaps and Derivatives Association, and one of the first things the ISDA did was to conduct a survey of the market. The published results were startling. In 1987, ISDA reckoned the total volume of derivatives contracts was approximately $865 billion.

Shocked by that number, some Western government officials started to flex their muscles. In 1987, the Commodities Futures Trading Commission proposed to start regulating interest-rate and currency swaps in the same way it monitored the commodities derivatives world. That idea provoked horror from the banking world. The derivatives traders feared the CFTC would do a clumsy, heavy-handed job — not to mention that any existing derivatives contracts would be thrown into a legal limbo because the legislation the CFTC proposed stipulated that all deals not done on its exchange would be illegal.

ISDA leapt into action, sponsoring a lobbying campaign on Capitol Hill. Somewhat to their surprise they prevailed two years later when the CFTC backed down. That victory was just temporary, though. By the early 1990s, government scrutiny of derivatives was intensifying again, as the business continued to boom and a range of exotic new offerings were introduced. In truth, most regulators and central bankers still didn’t know in any detail how the swaps world worked. Its esoteric nature raised the troubling issue at the center of the regulatory dilemma: how could they allow this booming business to keep flourishing and still ensure that it didn’t end up jeopardizing the free flow of money around the “real” economy? Regulators didn’t want to stifle positive innovation, but they were growing leery. That was the impetus of Jerry Corrigan’s [resident, Federal Reserve Bank of New York] investigation of the business in the fall of 1991.

A few weeks after he had summoned Dennis Weatherstone [JP Morgan] and Peter Hancock [JP Morgan] to meet with him, in January 1992, Corrigan delivered a stern speech to the New York State Bankers Association. “Given the sheer size of the [derivatives] market,” he said, “I have to ask myself how it is possible that so many holders of fixed-or variable-rate obligations want to shift those obligations from one form to the other.” Translated from central bank jargon, this suggested that Corrigan was dubious about the banks’ motives for making these deals. “Off-balance-sheet activities have a role,” he continued, “but they must be managed and controlled carefully, and they must be understood by top management, as well as by traders and rocket scientists,” he added. “I hope this sounds like a warning, because it is!”

ABOUT THE AUTHOR
Gillian Tett, author of Fool’s Gold (Copyright © 2009 by Gillian Tett), oversees global coverage of the financial markets for the Financial Times, the world’s leading newspaper covering finance and business. In 2007, she was awarded the Wincott Prize, the premier British award for financial journalism, for her capital-markets coverage. In 2008, she was named British Business Journalist of the Year. She previously served as the newspaper’s deputy head of the Lex column (an agenda-setting column on business and financial topics), Tokyo bureau chief, economic correspondent, and foreign correspondent. She speaks regularly at conferences around the world on finance and global markets. She has a PhD in social anthropology from Cambridge University. In 2003, she published a book on Japan’s banking crisis, Saving the Sun: How Wall Street Mavericks Shook Up Japan’s Financial World and Made Billions.