Civility, decency, and high ethical standards are essential not only for social and political life but for economic and financial progress as well.
For a generation or so after World War II, financial behavior was sensible and moderate. The excesses of the late 1920s, which many believed led directly to the long collapse that followed, were still fresh in the national consciousness. More than that, the New Deal regulatory regime had put into place a host of restraints governing the financial sector (and several others). Wall Street managers and traders generally acted conservatively in lending and investing.
But that prevailing culture began to change as memories of the Great Depression faded and regulatory restraints were gradually relaxed. From the mid 1960s through the latest financial debacle, there have been 15 U.S. financial crises of varying sizes, and many more around the world. The recent financial crisis is by far the worst in the postwar period. If not for intervention by the federal government and the Federal Reserve — however belated — many major financial institutions here and abroad surely would have failed.
How did this irresponsible financial behavior become so widespread? One reason was that markets have become increasingly depersonalized throughout the postwar period. One by one, leading investment banks shifted from partnerships to publicly held corporations, while at the same time their relations with clients became more strictly based on quantitative analysis.
I know from my own experience as a senior partner of Salomon Brothers that the shift from partnership to corporation had profound impact over time on the level of our risk taking and in our relationship with clients. Let me give you just a few examples.
During one of our executive committee meetings in the 1970s, a young trader interrupted the meeting by giving Bill Salomon, the then managing partner of the firm, a slip of paper informing him of a very large bond trade we had just completed with one of our institutional clients. Bill asked, “How much did we take out of the trade?” The young trader replied, “A point.” Bill then called in the partner in charge of the transaction, who reaffirmed that the firm made a 1-point profit. Bill Salomon's admonition was pointed and brief. He said that Salomon Brothers does not take such a profit — the bonds purchased were all highly marketable and the selling institution was a valued client. He ordered the trading partner to return part of the profit to the institution. In addition, he told the trading partner that his participation in the profit of the firm for the current year would be reduced.
What prompted Bill Salomon to take this action? It was, among other things, to protect a relationship with an important institutional client. But it was also to ensure that this would not happen in other transactions of this kind carried out by the firm. In that era, the strong competitive zeal within Salomon Brothers was tempered by a strong culture of integrity. When the firm became part of a publicly traded corporation named Phibro, the level of risk taking in trading and in positioning securities gradually increased.
The shift from partnerships to corporatized Wall Street encouraged the growth of leverage. In the earlier period, the owners of the business — the partners — were on site and many were actively involved in day-to-day affairs. And they had, to use the modern parlance, considerable “skin in the game” — which is to say, their liability was unlimited. I will always remember when Sidney Homer, one of my mentors, told me that I would become a partner. “I am sure that you will rush to tell your wife,” he said, but then added, “Be sure to tell her that once you sign the partnership papers you will be personally liable for $2 billion.” That was the firm's total
liabilities at the time, and therefore the amount of each partner's personal
exposure.
As we struggle to emerge in the aftermath of the recent upheavals, we continue to face major headwinds. Far too many financial assets are still not shown on the books at realistic prices. Oversight in both the U.S. and Europe remains under par and still has to be agreed upon. Occasionally, near-term speculative impulses in financial markets continue to flare but they will be constrained for a while by the massive debt overhang in the credit system.
We need fundamentally new ways of thinking about market behavior from our economic thinkers and political leaders. It is so difficult for those who have dominated economic thought and political life in recent decades (and still do) to think in fundamentally new ways. The new paradigms almost certainly will emerge — not from the minds of incumbents, but rather from the ranks of tomorrow's leaders. â–
This column is an adaptation of a speech the author delivered to the Carnegie Council in New York City in June 2011.