Financial Reform: Welcome To The Dark Side

As I might have mentioned a time or two before, there are two fundamental ways to think about Strategic Management. The more common, because it makes us feel and look better, is that, unlike economics, we realize that in the real world there is no equilibrium solution, so we train managers to focus on innovating in the gathering, designing and using of corporate resources. In that way, they can gain a temporary competitive advantage that, we hope, allows them to continue innovating further temporary advantages. Everyone from the manager, to his employer, to society at large gains from efficient new ways to do exciting new things.

There is another way to think about strategy. It can also be seen as the dark side of economics. For example, where economics warns that cartels are bad for society at large, dark side strategy encourages industry to join with regulators to form cartels. If done properly, the cartel can last as long as the regulators last; and we have yet to witness a regulator dying a natural death (except for the Civil Aeronautics Administration, the exception that proves the rule).

With that context in place, let's think about the recent financial reform legislation. I borrow the following two paragraphs from Michael Hirsch at Newsweek:

[B]y midsummer of 2010 the Volcker rule that Obama finally backed was so full of exemptions—allowing banks to invest substantially in hedge and equity funds—that even Volcker expressed dismay. The fundamental structure of Wall Street had hardly changed. On the contrary, the new law effectively anointed the existing banking elite, possibly making them even more powerful. The major firms got to keep the biggest part of their derivatives business in interest-rate and foreign-exchange swaps. (JPMorgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley control more than 95 percent, or about $200 trillion worth, of that market.)

The same banks may end up controlling or at least dominating the clearinghouses they are being pressed to trade on as well. New capital charges, meanwhile, have created barriers to entry for new firms. This consolidation of the elites has in turn kept alive the “too big to fail” problem. “It makes it way tougher now to kiss somebody off when they get in trouble,” says the former Fed official. Eugene Ludwig, a former comptroller of the currency, believes the new law’s impact will be “profound” in changing the way banks do business. But he worries about a “skewing of the playing field” in favor of the big banks, putting community banks at a disadvantage.

The major financial firms have had to accept new regulation, but that regulation doesn't seem to change what the largest firms can or can't do. More to the point, the new legislation makes it unlikely that a new financial giant can arise, while the government is probably still tacitly on the hook if any of the existing giants look like collapsing. Now, this might be the best political deal that could be struck ("too big to fail" is a legitimate policy problem, not simply a gift to politically connected bankers), but it looks a lot like strategy from the dark side.