(The following post is fairly complicated but well-worth the effort in order to understand the economic crisis we are in.)
According to an article in today's NYT, the investment banking industry's risky behavior began in earnest about 4 years ago, when the government's Security and Exchange Commission (SEC) voted to allow the banks to greatly expand their debt levels (called 'leverage') in very risky investments, and then never properly monitored the allowed behavior. The author asserts that the leadership of the SEC, with their 'markets self-regulate' mentality, were never interested in the kind of oversight that might have prevented the meltdown of Bear, Stearns, Lehman, etc.
"The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush. A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies."
“'It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,' said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. 'The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.' As was the case with other agencies, the commission’s decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas."
“'We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,' said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox). 'Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,' he added."
"Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency. In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors."
Lesson: Banks and businesses will sometimes tend to push the boundaries and take risks far beyond reasonable limits in order to make money. They are not completely self-regulating. If they are big enough so that it is seriously detrimental to society for them to fail, then oversight regulation by government must be serious and effective. But for this to work, the governing regulators must believe in regulation. Appropriate government regulation is good, not bad, and it is essential to the proper functioning of market capitalism.