Credit Suisse and SVB: Where were the regulators and who governs them?

Here we go again! Banks are starting to pop left and right, and in the US and Switzerland – countries that should have learned from the 2007-08 Global Financial Crisis (GFC) and know better.

This raises a fundamental question: who governs the regulators so that they learn and retain their lessons from previous crises, and apply them with determination to avoid a repeat scenario? It’s not simply about changing the rules but also asserting themselves where necessary.

The 2007-08 crisis already was the result of a sequence of relaxing constraints on the US banking system. It started with the relaxation by the SEC of the net capital rule, allowing investment banks to greatly increase their level of debt. This fueled the growth of mortgage-backed securities and subprime mortgages. Shadow banking developed, allowing financial firms to take on much greater leverage than banks could. LTCM, with Nobel Prize winners Merton and Scholes as principals, together with Salomon bond trader king Merriweather, and Federal Reserve chairman Alan Greenspan, practiced and preached the gospel of “the virtues of the market”, self-regulation, and expertise. It kept derivative markets out of regulatory oversight. Financial groups could post substantial off-balance-sheet (OBS) assets and liabilities through structured investment vehicles. President Clinton signed the Gramm-Leach-Bliley Act into law, repealing the Glass-Steagall Act, the major legislation emanating from the 1929 crisis which prohibited banking groups to own other financial companies.

It sure looked like Wall Street had its own Woodstock; spirits and alcohol flowing in greater amounts than in the Catskills, but with one important difference: the gents of downtown New York had bigger wallets and greater individual ambitions. When Wall Street awakened, it was worse than in 1969. The whole world – and not just a piece of upper New York state – was in turmoil.

A reasonable assumption would be that the 2007-08 repeat of the 1929 crash would have led the global financial system to learn that governance is important and that bad governance can be very costly. Not to mention that many so-called “business problems” were consequences – with poor governance as the root cause.

Another Nobel Prize winner, Joseph Stiglitz, wrote a comprehensive account in Vanity Fair. The piece can be considered a counter to Milton Friedman’s seminal New York Times Magazine article about the social responsibility of enterprise. Most people think of the latter as a biblical retelling of the virtue of free markets. Friedman was talking about governance, urging the world to oversee CEOs more seriously. He argued convincingly that such oversight requires an objective measure and suggested firm profitability as the way to evaluate value creation by CEOs. Short of effective monitoring, CEOs are likely to run the firm for their own agenda – not that of the firm, or its shareholders.

Remarkably, Friedman’s paper does not mention directors or the board of directors, only shareholders. But then, this is America, the powerful CEO being – certainly in those times – most likely to also be the board chair. Under those conditions, a board may not make much difference. Many US economists and financiers, as well as entrepreneurs, believe boards to be bureaucratic governance instruments and favor outsourcing the governance to the market. Faster, cheaper, and more effective in their eyes. America is no doubt known for its culture of execution. It never ceases to amaze us that so many people are of the opinion that business is all about execution. The word is brutal. Modern parlance prefers the more civilized value creation. But governance is based on the realization that powerful execution of a bad plan amounts to value destruction, its opposite.