America's most important set of financial reforms in decades is coming to fruition. To be sure, lawmakers are still working out the details. But the broad outlines of the new US regulatory regime are coming into sharper focus every day. These new laws will affect financial markets and institutions in several important ways. But, as yet, neither investors nor managers seem fully to appreciate the change that is bearing down on them.
For a start, financial reform will help slow the growth of credit, which expanded at a spectacular pace in the decades leading up to the current financial crisis. As credit growth slows, so the profits of financial institutions as a percentage of total corporate profits will fall. The transition will be difficult; indeed, it began the hard way. But as new regulation and an overall slowdown of credit growth help shrink speculative debt, economic growth will become more sustainable. That, in turn, will go a long way towards maintaining the position of the dollar as the world's key reserve currency. It will also give the US more time to address its own fiscal problems.
Meanwhile, top managers at many financial institutions will find themselves in unfamiliar territory. Their mode of operating, their business culture, has been to pursue aggressive growth targets for profits and market share by diversifying operations into new financial domains and by swallowing up competitors. Wielding generous compensation incentives, managers of leading banks encouraged employees to take big risks. As institutions grew and diversified, their activities became too wide-ranging and complex for senior managers to oversee effectively. At the same time, risk-taking came to rely more and more on quantitative risk-modelling, which tended to marginalise qualitative investment judgment. As we now know, econometric risk-modelling failed when it was most needed.