America’s financial sector has shown renewed strength in recent months—political strength, that is, undermining most of the sensible proposals for banking reform that remain on the table. If we are still making any progress at all, it is because of the noble efforts of a small number of US senators. Most notable has been Senator Ted Kaufman, a Democrat from Delaware (yes, a pro-business state), who has pressed tirelessly to fix the most egregious problems in America’s financial sector. He understands that successful reform requires three ingredients: arguments that persuade, the ability to bring colleagues along, and a lot of luck in the form of events that highlight problems at just the right time. On two fronts, Kaufman has—against long odds—managed to make substantial steps. Long before it became fashionable, he insisted that the US real estate boom was fuelled in part by fraud within the mortgage-securitisation-derivatives complex, in effect at the heart of Wall Street. This thesis is gaining broader traction—newspapers now report a broadening criminal probe by the federal government, and by New York’s state attorney general, into the financial sector’s residential lending and related securities practices. With Senators Patrick Leahy and Chuck Grassley, Kaufman worked last year to pass a bill providing resources to federal law enforcement agencies working on financial fraud. More recently, Kaufman was devastating in his cross-examination of Goldman Sachs executives. Senator Carl Levin, chairman of the subcommittee that heard their testimony, was just as tough after a year-long investigation of Washington Mutual, Goldman, and the abject failures of bank regulators and credit rating agencies. Kaufman scored an even bigger coup with his warnings about the dangers of the explosive growth of high-frequency trading, which is little understood by America’s main financial watchdog, the Securities and Exchange Commission (SEC), and poses systemic market risk. His concerns appear to have been vindicated by the 20-minute shutdown of trading in New York on 6th May, when the stock market completely failed in its most basic function: price discovery between buyers and sellers. We do not yet know what combination of black-box computer programs and electronic trading algorithms, interacting across more than 50 market centres, caused this catastrophe. But our lack of knowledge itself confirms how far our regulatory and surveillance capabilities have fallen behind “financial innovation.” The SEC was once a great and powerful independent agency. It fell on hard times in recent decades and is only beginning to get its act together under new leadership. Yet it still does not routinely collect the data that it needs—trades by time and customer—to understand the actions and impact of large traders. Kaufman has consistently pressed them to do more and much faster; to be sure, they and many others are now listening. On a third issue, the results are mixed. Kaufman championed the case for making America’s biggest banks smaller, as part of financial-reform efforts. His advocacy helped build support and forced a senate floor vote on an amendment, co-sponsored with Senator Sherrod Brown, which would have imposed a cap on banks’ size and leverage (debt relative to assets). The amendment was moderate and entirely reasonable, yet it was defeated, 33-61, also on 6th May. Still, it has strengthened backing for another amendment, sponsored by Senators Jeff Merkley and Levin, which would restrict proprietary trading by megabanks for their own account—coincidentally a practice that is presumed to be a large and “dark” part of high-speed trading. The deeper and overriding point of Kaufman’s critique of the US system is the need for tough laws. We cannot merely rely on regulators to do the right thing. In particular, regulators have no chance to look over the horizon and act preventively when markets are opaque, and when powerful Wall Street interests (and their Capitol Hill allies) can circle the wagons and claim that there is no problem. Unfortunately, despite his new-found prominence, Kaufman will be out of office at the end of this year—he was appointed to fill vice president Joe Biden’s seat at the end of 2008 and committed at that time not to run for re-election. His lasting legacy will be a simple and powerful idea that reasonable people increasingly find to be self-evident: relying on deregulation and self-interest in today’s complex, opaque markets will manifestly fail to produce a reasonable allocation of capital or support entrepreneurship and growth. We must instead write and enforce laws that restore credibility to our financial markets.
