Wall Street sends signal for Asia to be on guard

PUBLISHED : Wednesday, 24 September, 2008, 12:00am
UPDATED : Wednesday, 24 September, 2008, 12:00am

The demise of the great investment banks on Wall Street marks the end of an era of excessive leverage. No doubt some people will feel nostalgic, but the world will be the better for it. In just one week, we have seen Lehman Brothers going bankrupt, Merrill Lynch disappearing into the arms of Bank of America, and Goldman Sachs and Morgan Stanley being transformed into commercial banks that are subject to tighter reserve and leverage controls. What we are witnessing is a repudiation of the ethos of over-the-top gearing of which investment banks were most representative.

The process of de-leveraging has now begun. Taking place as it does after the bursting of a big credit bubble, this will be a long and painful process. Doubts have already been raised about whether a US$700 billion proposal by the US government to bail out financial firms being negotiated in Washington will be enough to avert a collapse of the American economy. Critics wonder if it might lead to a blowout of the US federal budget and a massive devaluation of the dollar, as the rescue would have to be financed by issuing more government debt. That is unless the US puts xenophobia aside by allowing foreign money to come in to recapitalise its economy by buying up distressed assets.

Regardless of the outcome of the negotiations in Washington, there is no doubt that the world economy is in for a rough ride because of American mismanagement of its financial institutions. The financial turmoil that originates in Wall Street has delivered a wake-up call, prompting everyone to redefine the way they understand risk and profit. Out of the debacle, it is to be hoped there will emerge a healthier and fairer understanding of how work and reward ought to be proportional; and how business, economy, and capitalism in general ought to be organised and regulated.

For years, investment banks have been allowed to take on excessive risks and earn outsized profits, primarily because of two factors: deregulation and innovations in financial technology. Since the start of this decade, they have enabled single-purpose financial institutions to become multi-functioned behemoths. In the process, Citigroup and JPMorgan Chase have been transformed into so-called universal banks, operating simultaneously both as commercial and investment banks, while AIG, taken over by the US government last week, became a hedge fund wrapped around by an insurance company.

Deregulation and financial innovation have been championed under the ideology of free enterprise, which has arguably been the United States' greatest cultural export to the world in the past two decades. Many countries, especially those in Asia, are no doubt thankful they have not followed the US all the way.

Profits cannot be increased without taking on extra risks. But complex derivatives create the illusion that profits can be juiced up and risks eliminated or at least managed, when they are merely hidden away.

Just about the only way to take extreme risks while guaranteeing one's profits are the obscene bonuses that Wall Street chieftains have collected for themselves by gambling with other people's money; and the ideology of free enterprise has helped to legitimise this obscenity of our time. Clearly these people need to be reined in, and the industry they run subjected to proper supervision. Far from being a paragon to emulate, Wall Street should now serve as a cautionary tale for Asia.