We asked Harvard Business School Professor Robin Greenwood about new regulations of the financial services industry, the future of hedge funds, and what Wall Street will look like in five years.

BT: What types of new financial services regulations are most likely to be enacted in the coming months?
RG: The biggest regulatory problem facing the financial markets today is that we don’t have a good system for shutting down financial institutions without having significant spillovers on the rest of the system. There are too many firms that are “too big to fail.” The contracts between financial institutions have been so complex that we don’t know what would happen if we extinguished one of these institutions. Nor do we have a good system for dealing with such a bankruptcy. The fear of what might happen has made the government unwilling to make tough decisions, and has led us to spend significant taxpayer dollars to avoid the unknown.  Citigroup is the canonical example.

Part of the regulation is sure to focus on simple technical issues such as trade disclosure and trade clearing. These are important. Consider the following. Suppose that bank A owes bank B $100 who in turn owes bank C $100. If B were to go bankrupt, in theory we would roll over bank A’s claim directly to bank C. In practice, however, we haven’t set up any mechanisms to do this. In a worst case scenario the bankruptcy of bank B causes bank C to file for bankruptcy before it has time to recover its claim on bank A. Thus, we can expect that the government will push for more centralized exchange (and the disclosure that goes along with this) of opaque financial products, which are currently traded in over-the-counter markets.

There are likely to be other regulations dealing with leverage requirements, short sales, securitization, and possibly even executive compensation. I have mixed feelings about these.  I think we have seen plenty of evidence that the private sector cannot enforce sensible leverage on itself: bank leverage increased dramatically in the past decade, with devastating effects when banks’ investments lost money. But one worries that if the incentives to take high leverage persist then institutions from abroad with lower capital requirements will step in where constrained institutions cannot. Thus, one always worries that the effects will be to drive business abroad without actually having any effect on systemic risk.

BT: How should the hedge fund industry respond?

RG: The hedge fund industry has been one of the survivors of this mess. Running a hedge fund is likely to get more expensive in the coming years, with additional disclosure requirements. Hedge funds will spend more time explaining or justifying what they do, rather than actually doing it. There are two implications. First, I worry that they will have insufficient flexibility for performing their main function, which is to be the smart money that keeps prices efficient. Second, one or two-person hedge funds such as were common in the past decade are sure to decline relative to the mega-hedge funds, as the legal and compliance costs are likely to rise. These mega-hedge-funds will look more like traditional asset managers— with client service professionals, a compliance team, global offices, etc. But this is a trend of consolidation that would have happened anyway. To me, the biggest unresolved question is, what will happen to fees?

BT: What do you think the hedge fund managers most want to know from the administration?

RG: The Obama tax plan for 2010 calls for hedge fund managers to pay ordinary income tax on “carried interest,” which previously has been taxed at the lower capital gains tax rate. This will more than double the tax rate on these earnings. I suspect that for most hedge fund managers, future tax policy remains the biggest question mark.

BT: How will the operations of Wall Street be different in five years?

RG: Wall Street will be smaller, and it should be. Finance should return to its rightful place in the economic system: a lubricant that greases the wheels of real economic activity, rather than an end in itself. Paul Krugman has argued that the business of finance during the 1930s, ‘40s, and ‘50s was essentially a boring business, and never more than 4 percent of GDP. Our financial system became out of whack during the past decade: nearly all of my best students went to Wall Street rather than starting or running companies. Financial Services commanded nearly 8 percent of GDP in 2007, and an even greater share of corporate profits. In some ways, the crisis is an important reality check for our economy. But it is turning out to be very costly and having large negative effects on non-finance businesses that rely on the credit markets to do business.


About Robin Greenwood:

Harvard Business School Professor Robin Greenwood investigates the effects of investor demand on asset prices, as well as the implications of investor demand for corporate financing and investment. He now teaches a new course on behavioral finance and value investing.