The danger in financial markets' unchecked 'doomsday machines'
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May has been a month of deregulatory debacle, of machines running out of control in the Wall Street meltdown and the Gulf oil spill, both of which could have been averted by some prudent rule-making. Such massive mishaps were prefigured, in a sense, by the Doomsday Machine -- the Soviet device, in the concluding scene of "Dr. Strangelove," that reduces the world to a cinder. Designed to automatically detonate so many atomic bombs if just one nuclear weapon is fired at the U.S.S.R. that it would deter any foe from dropping the big one, it works perfectly, with one small hitch: A U.S. B-52 drops the bomb on Russia before Americans learn of its existence, and mere humans are powerless to intervene as it blows up the planet.
Last week Wall Street stumbled upon its very own Doomsday Machine: computers programmed to go into automatic selling mode when a share price plunges unexpectedly. When the prices of several stocks declined Thursday, the New York Stock Exchange suspended trading in those stocks. But they continued to plunge on multiple other exchanges. Within seconds, stocks everywhere were tanking; within 15 minutes, the Dow Jones industrial average had dropped a thousand points.
Although our image of stock markets consists chiefly of traders yelling on exchange floors, stock sales are largely handled by computers. The number of exchanges has grown in recent years, and while some exchanges have rules for when to suspend trading, others don't. The day after Thursday's swoon, the free-marketeers who buy and sell stocks were fairly begging the government to regulate their trading floors and software programs.
"There's no mechanism in the current system to stop an error from crushing a stock," Dan Mathisson, head of electronic trading at Credit Suisse, told the Wall Street Journal. "The regulators will need to explore restricting the use of market orders, or adding some types of circuit-breakers" that stop the automatic-sell programs. On Monday, the Securities and Exchange Commission did just that, demanding that major U.S. exchanges agree to common rules for slowing or suspending their trading.
In the Gulf of Mexico, BP has not yet found a way to cap its spewing well, but each day we learn more about its successes over the past decade at blocking government efforts to tighten safety standards. Unfortunately, the same federal agency that oversees oil production, the Minerals Management Service, was also charged with ensuring the safety of those operations. Interior Secretary Ken Salazar acknowledged the incompatibility of these two missions on Tuesday by announcing that he would split the agency, creating a separate bureau charged with mandating and enforcing safety standards.
These lessons in appropriate regulation come in a week when the Senate will consider amendments to strengthen regulations on banks. One, by Jack Reed (D-R.I.), would recognize that creating an entity with conflicting missions of both regulating and bolstering the banks is a formula for failure. Reed's amendment would take the proposed Consumer Financial Protection Agency out of the Federal Reserve, where it is placed by Connecticut Democrat Chris Dodd's omnibus financial reform bill, and make it a free-standing agency. Dodd's language gives the agency considerable independence, but Reed's amendment would ensure that independence is preserved.
Probably the most important pending amendment comes from Sens. Carl Levin (D-Mich.) and Jeff Merkley (D-Ore.). It would replace the vague language of the Dodd bill, which gives discretion to regulators as to how much proprietary trading they would allow, with a clear provision banning federally insured banks from such trading (the "Volcker rule"). If banks want to turn themselves into casinos, they can -- but if Merkley-Levin passes, they would do so without taxpayer support when their bets go sour.
Last Thursday the Senate voted down an amendment from Ohio Democrat Sherrod Brown and Delaware Democrat Ted Kaufman that would have limited the size of the biggest banks. That bill included language setting strict leverage ratios for banks, rather than leaving it to regulators, as Dodd's bill does. Proponents are considering reintroducing the leverage restrictions as a separate amendment.
The problem with leaving so much to regulators is that regulators may work so closely with bankers that they lose sight of the public good. Last week's vote on the Brown-Kaufman amendment illustrates how that phenomenon works in the legislative branch. While Senate Democrats backed the amendment 30 to 27, the 13 Democrats on the Banking Committee, who tend to receive the biggest contributions from banks, voted it down 11 to 2.
Leaving regulation to the discretion of imperfect public servants means that real-world doomsday machines roll on unchecked until they explode. Senators, it's time to write some real rules.
