In October 1907, New York's Knickerbocker Trust Co. failed, setting off a banking panic nationwide. Earlier that year stock prices had suffered two severe declines.
At the height of the panic, J.P. Morgan, the leader of American banking, was called from a church conference in Virginia to return to New York to stop the carnage. Morgan summoned other bankers to an all-night meeting in his library, virtually commanding them to pool their money to save tottering financial institutions and prevent a meltdown. It worked. The crisis soon ended and the stock market rallied, although the economy slowed to a crawl.In the aftermath, Congress established a commission to find out what had gone wrong and to recommend an overhaul of the American financial system. The result in 1913 was the establishment of the Federal Reserve - in effect a replacement for J.P. Morgan, who died the same year.
Thus it came to pass 85 years later that Fed officials summoned Wall Street financial leaders to a boardroom of the New York Federal Reserve and called for a pooling of private money to prop up Long-Term Capital and stave off financial meltdown. And last week, the House Banking Committee grilled the Fed chairman, Alan Greenspan, about the central bank's role.
Some experts say the Fed was wrong to arrange the bailout. Reducing the risk of meltdown in the short run, they argue, only increases it in the long run, as other investors learn that they are too big to fail and take on greater risks. Other experts, while praising the Fed for staving off potential panic, say that the only way to prevent future crises is to rein in the hedge funds, heretofore unregulated. Both of these positions miss the mark.
Conventional wisdom also holds that hedge funds are small fish in the big pond of the markets and there-fore have liquidity, the ability to sell an asset for close to what it cost.
When an outfit like Long-Term Capital can use $4 billion to borrow and bet upward of $100 billion, it is no longer a small fish - it's an important player in the financial system. Yet we can't set rules that forbid a fund to borrow money; betting with borrowed money is the nature of the industry.
Regulating the hedge funds won't solve all financial problems, any more than regulating trust companies would have solved anything after 1907. Something more substantial is needed, something to serve as an international regulator and lender of last resort for financial institutions.
Without such a global institution, financial turmoil will continue into the next century and may become sharper and more frequent.
Will world financial leaders step forward and address these fundamental issues, as they did in the United States after the crisis of 1907? If not, it will be a long road to re-establishing financial stability.