Entrepreneurship, Unruliness and Regulation

In an attempt to find out why things recurrently spin out of control in American business, I’ve recently read through two critical books about Wall Street. The first, License to Steal: The Secret World of Wall Street and the Systematic Plundering of the American Investor by "Anonymous" and Timothy Harper, claims to be an exposé of New York brokers’ crookedness. In that goal, it misses its mark, because it’s really an exposé of the shadier part of the brokerage industry: “broker-dealers.” The anonymous fellow who supplied the meat of it has clearly internalized the broker-dealer worldview, and thus misses the fact that broker-dealers are routinely put below the salt by full-service brokerage houses. As an example of this internalization, he insists that the spread between the highest buyers' price for a stock (the “bid”) and the lowest sellers' price for that same stock (the “ask”) is always a profit centre for the firm handling the sale. He takes it for granted that a brokerage firm can always buy at the bid and sell at the ask, and that all brokerage firms routinely do so when they need extra money. This is impossible, except for a brokerage firm that also makes a market in that stock – a broker-dealer, in other words. "Anonymous"' repeated insistence that even the most prestigious brokerage firms pull the same tricks that broker-dealers do, is the standard justification used by employees and principals of the latter for their own conduct.

Nevertheless, it was interesting to read a portrayal of the above-the-salt part of the brokerage industry from a below-the-salt fellow. “Anonymous” did get his start in a prestigious full-service firm, as a cold caller. From his description of the job, it’s clear where relatively recent brokers’ callousness, the kind portrayed in the early part of the movie Wall Street, comes from. Cold callers can’t see the person on the other end of the line as a human being; if they do, then they’ll be lousy at the job. This necessity can’t help but introduce a habitual insincerity, and an attitude that the client is merely a revenue source. Any broker who’s been through the cold-call grinder is habituated to precisely that attitude, and its implication: every sales practice is okay as long as neither the client nor the compliance officer object. “Good business” means an account that stays; “observance of fiduciary duty” means following the rules that securities regulators, securities dealers’ associations, and firm’s management have imposed.

There’s been a lot written about the professionalization of Wall Street. A largely unwritten part of the story is that security analysis, stock brokering and even investment dealer management were not professions in the days of yore; they were callings. Like any other calling, the member’s own ethical sense was also used to evaluate his (back then, it was “his”) own performance. The old descriptions of the field, as it was ‘way back then, tend to zero in on the class aspect of it: the field was all-but-impossible to make a mark in unless you went to the right private school (which, more frequently than you might think, was a Roman Catholic private school.) Also highlighted was the class attitude there, too. Less frequently illustrated was the fact that this class attitude, a different kind of “class callousness,” was the byproduct of a certain code of honour, whose fount was “take responsibility for your losses and make restoration for your mistakes like a man.” As is usual with mottoes of this sort, the word “man” excluded a lot of men from its range.

Needless to say, this kind of ethos cannot be called forth by regulating. Rules, regulations and even statutes only modify behavior. Except for family-firm holdovers and the occasional “Junior” in a regular firm, the old code is gone from Wall Street, and from Canada’s Bay Street as well.

What has replaced it is an ethos similar to the one a doctor has internalized – to get his or her way through pre-med. Quick and accurate memorizing is the cynosure of investment professionalism nowadays, and so is a kind of obedience. Reliance upon computational and analytic procedures, instead of being a badge of callowness, is now the foundation upon which the securities industry professional builds his or her career. Believe it or not, it was normal ‘way back when to laugh at “theoretical” colleagues who trusted formal techniques of investment analysis. Such colleagues were, back in the days of old, judged to be “out of it,” or “not ready for the real world.” Nowadays, expressing such an attitude in a major investment dealer, except circumspectly, marks the holder of it as a dinosaur or Neanderthal. What made the rise of the bookworms possible was, in fact, the thorough regulation of the field. Bookworms don’t resent regulation; they see it as yet another learning opportunity.

There's a certain irony in a highly regulated industry churning out far more profits than its largely unregulated forebear did. What made this ratchet-up possible was the salesperson’s attitude described above, as juxtaposed with the old-style uppers’ attitude. All codes of honour are at heart codes of self-restraint; with regard to upper-class people in trade, the self-restraint is typically expressed in turning away profitable opportunities – in some case, highly profitable opportunities – on the basis that “there are some things that one does not do.” (When the upper class is predominant in an organization, this rule is informally but very definitely - "arbitrarily" - enforced.) It’s not often noted that the upper class in business societies tend to look down on many kinds of trade as ‘opportunistic’, ‘greedy’, and/or ‘mean-minded’.

As a result, any industry that is dominated by the upper classes is managed in an unentrepreneurial way. Once this is realized, only a class barrier stands between that industry and major profit expansion in it. This has been very obvious in the investment industry.

Another, though less obvious, side effect of the replacement of honor-driven management with market-oriented management is the growth of regulations once the uppers are either edged out or have become managers-emeritus. The ultimate source of it is the accumulation of potential conflicts of interest in a firm dominated by the upper class. These potentialities are usually harmless, or benign, because taking advantage of them is something that a gentleman simply does not do. So, any conflict-of-interest scenario is dismissed out of hand as not a problem, because it usually isn’t from an atheoretical point of view.

Once the entrepreneurial middle class takes over, though, a change in perspective ensues. The activities that “one does not do” become potential profit centres. “Greed” becomes a matter of charging what the market will bear. Both of these shifts spur the industry’s growth beyond the imagination of the old gentry.

But they also actualize those potential ethical lapses. Since the uppers have a habit of confounding legitimate entrepreneurship with crookedness, the middles eventually shrug off any warnings about “gouging” as mere upper-class effeteness, once the transition is complete. Some of those previously-frowned-on activities, though, are genuinely unethical.

As a result, the regulators are called in by angry customers, suppliers, and/or investors.

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As footnote #1, I mention Martin Mayer’s Nightmare on Wall Street as a good recounting of Salomon Brothers as a firm that went down this genteel-to-entrepreneurial-to-opportunistic-to-outlaw slope. An earlier entry in this blog flushed out his worldview, which you can adjust for if you don’t share it and want to read the book anyhow.

As footnote #2: if you’re up on current management jargon and want to put a theoretical backbone to the above, here are the relevant concepts: agency problems, or principal-agent problems; tragedies of the commons; and, taboos as a means of avoiding both of the above. Also, the Coase Theorem would be informative about the transition phase, including the dark side of it. (Hint: a stake in a hot IPO can be used as a compensatory payoff for an aggrieved clent.)

And, as footnote #3, the kind of upper-class fellow who's likely, in the above transition model, to be both the profit-exploder and the accident waiting to happen is what sociologists call the "status-lender." Conrad Black is definitely one; so is John Gutfreund. A status lender is agreeable with, tolerant of, but condescending to his or her "inferiors."