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Financial Market Reform: A Return to the Partnership Model

|Includes: Citigroup Inc. (C), GS, IAI

Private enterprise is taking a beating. Whether in health care or the financial services industry, policy debates rarely feature the economics of supply and demand—much less self-correcting mechanisms. Instead policymakers have re-conceived market dynamics as a web of casual relationships.

Take, for example, these common lines of argument that advocate government intervention in the capital markets. Big Wall Street bonuses lead to excessive risk taking, which forces "bad behavior" in the capital markets. Likewise, improperly incentivized ratings agencies inflate the quality of securities, which bloats leverage ratios. Or, inconsistent regulation fails to curb market excess, which contributes to a moral hazard.

The fix, then, should be simple, right? Legislate—or mandate—bonus limits, new business models for ratings agencies and more comprehensive regulation.

Okay. Let's say we accomplish this and call it common-sense rules. (Read the text of President Obama's Wall Street speech here.)  Will it achieve the desired effect? Well, that depends what we mean by "desired effect" or "common-sense".

And here's the rub. The capital markets work as they do exactly because countless thousands (millions) of people interact with them daily, a few directly and many more indirectly, for many different purposes: investing, funding, speculation, arbitrage, price information, short-term needs, long-term needs, and more. Like Facebook or MySpace, the markets are a social network, except much bigger, much broader and much more unifying.

If it's control lawmakers want, then whatever they establish today risks obsolescence tomorrow—or, worse, some significant unintended consequence. Just look at the fallout from the short sale ban last fall. Market volatility elevated and the price discovery process deteriorated: the exact opposite of what the SEC and market participants intended, and needed, to take place.

Rules and regulation designed for control can never keep pace with market innovation. Nor would we necessarily ever want them to keep pace. Because if they ever were to match innovation, innovation could never occur, by definition.

Rules and regulation should, instead, support market innovation. Consider this in terms of Lehman's demise. Whether the Feds were correct in allowing the bank to shutter is secondary to the fact that the business model—Wall Street's business model—failed.

And let's not confuse the markets with Wall Street. The markets themselves didn't err. They got it right, punishing those who got it wrong. And we know government and regulators were far behind, having little clue that the Wall Street business model was failing as badly as it was.

Fast forward one year, and we're at the same place we were before the crisis. Nothing has really changed in terms of a new model taking root. The bulge bracket features new name plates, and one or two old ones. But if we view the landscape as a continuum of capital flows, then money is just as—or more—concentrated among these big guys as it was in September 2008.

In the name of 'Too Big to Fail', taxpayer money is effectively buttressing a broken model, and postponing its inevitable replacement.

The question should be: What's the opportunity cost of not allowing this transition process to take place? Weak economic growth, high unemployment, a diminished dollar, market uncertainty? Likely all four and more, as Wall Street fails to expand money flows between corporations and institutions.

Here are four expectations for the next Wall Street business model, in sequence.

A return to the partnership model. It should be no surprise that Goldman emerged on top because it embraces a model closest to a partnership than any of its competitors. In contrast to a shareholder controlled firm, a partnership ties the firm's capital directly to its manager, so that risk capital is their money, not other people's money.

A breakdown of concentrated capital. Empire building may be instinctive, but emperors will always define themselves by personal gain. It would be naive to expect that market participants would ever curtail their pursuit of personal fortune. That pursuit, though, could be much more lucrative in a different business model, even if the ultimate scale of the business is much smaller than, for example, Sandy Weill's Citigroup at its peak.

A greater sense of firm identity. An important byproduct of the partnership model is less employee turnover. The compensation format ties individuals to a firm. Wall Street had become a battlefield of mercenaries: analysts and bankers, for example, benchmarking themselves against external polls, instead of their own contribution to the firm's bottom line. Firms became faceless and amorphous, as employees sold themselves to the highest bidder.

A shift to longer-term planning. Goldman demonstrates that a partnership-like model can function within a publicly traded company. Other firms, however, may opt to proceed as private businesses. Either way, this shift will allow managers to plan longer-term and respond less to "best practices", which can often standardize quality. Firms may become more cautious, but they will likely become more specialized.

So, who's to say what's right and what's wrong? Definitely not government or regulators, or really anyone but the market itself. That's not to say there is no place for oversight or rules, just not the kind that impose control.

Capital is finite. It's an economic good. If there's one lesson we should take from the health care reform debate it's that we should never depend completely on the expectation that somebody will do something for us. The sooner that policymakers can trust markets, the better off we become, and the faster our economy will recover.

After all, the last thing we can afford is the restriction by non-market forces of a natural market transition.

Disclosure: No Positions