As is well known, starting on October 24, 1929 and continuing through October 29, the U.S. stock market plunged off a cliff constructed of jerry-rigged speculation and “irrational exuberance,” triggering what became known as the Great Depression. Less well known is the fact that the eventual reaction to the Crash brought about a new framework of regulation and, in time, a new set of professional norms that went along with it. Decisions taken in the first year of the Roosevelt Administration in banking and securities regulation, as well as labor market and social security reforms, produced not only important pillars of U.S. economic policy that stand to this day, but also many reforms that became the recognized international “gold standard” of efficient and effective modern regulatory systems. As a result, these early New Deal-era U.S. institutional reforms served as a model for many other countries in the following decades.
The question now is whether these reforms can inspire emulation in post-communist countries still suffering institutional deficits as they attempt to build mature, prosperous, and stable market-based economies.
At first blush, the prospect may seem promising. The market crash of 1929-32 destroyed a huge portion of American private savings and investment. As with many other bubbles in the history of stock and commodity market collapses, the Crash was preceded by a period of fast-growing equities prices inflated by the unscrupulous (but not yet necessarily illegal) behavior of many banks and investment companies. A set of scoundrel cascades had developed in what was essentially a positional competition: When one or two niche actors adopted shady or risky behaviors, competitors felt pressure to follow suit lest they suffer competitive disadvantage. In a “wild west” context that proffered few constraints, the situation grew accident-prone, partly because the throngs of new participants in the stock market were unaware of the shady and risky behaviors going on behind ornate closed doors.
The “securities and exchange” status quo in Russia today, as well as in several other formerly European communist countries, in several respects resembles the 1920s-era American “wild west.” The collapse of the Soviet Union and soon the Russian economy was in some ways analogous to the Crash. Certainly, lots of Russians lost their life savings; indeed, the post-Soviet Russian economic depression was much deeper than the American one 60 years earlier. Thereafter, what became known as the Russian “oligarchy” engaged in fierce positional competitions, and it is not unreasonable to describe much of the related ensuing behavior as a set of scoundrel cascades. At the same time, just as was the case in the United States in the 1920s, the Russian regulatory framework has been insufficiently robust to rein in such cascades. That framework may therefore be ripe for institutional reform as the second generation of post-Soviet economic and political elites seeks a more stable economic environment.
All that said, the differences between America then and Russia now are at least as striking as any similarities. The differences break down into remote cultural differences and more recent path-dependency choices. As to the former, the underlying political cultures of the two nations are very different, with the United States shaped by an early-modern “contract”-based paradigm and Russia by an older and more hierarchical, autocratic-dynastic model. Citizenship does not mean the same thing to typical Americans and Russians, and attitudes toward political authority differ as well.
As to path-dependency disparities, the United States was a market-based economy both before and after the Great Depression; what changed was the relative weight and design of governmental regulation. Russia, on the other hand, had been frozen in a statist command-economy for more than 70 years before 1992, and before 1917 Russian economic modernization has progressed but modestly away from what can reasonably be described as a particular form of feudalism.
Additionally, liberal market-friendly policymakers in Russia were discredited almost entirely by the wretched conditions of the 1990s, so that institutional consolidation as time has passed has not rested in the hands of those inclined toward institutionalized market systems. American advice has been discredited as well, since the economic debacle of the 1990s is associated in many Russian minds not only with failed policies but also with American consultants who, for better and for worse, chaotically helped design such policies under tight constraints and with limited financial assistance.
In light of this mixed picture, is there anything useful in the post-Crash American experience that Russia could learn from in the months and years ahead? Possibly, yes; but to properly understand the sharp limits of that utility, a little history comes in handy.
The Pecora Commission
The shady practices uncovered during government-directed and mandated investigations that began during the waning months of the Hoover Administration on March 2, 1932 had an electrifying effect on American politics. On that late winter day, the U.S. Senate passed a resolution authorizing the Committee on Banking and Currency to investigate “practices with respect to the buying and selling and the borrowing and lending” of stocks and securities. During its first 11 months the investigation made little progress. But in early 1933, just weeks after the inauguration of Franklin Delano Roosevelt as President, the Committee’s Chairman, Peter Norbeck (R-SD), hired a new, now fourth chief counsel: former New York City deputy district attorney Ferdinand Pecora.
Pecora, who was born in Sicily in 1882, had spent a dozen years accumulating a reputation as an honest and effective prosecutor. During that time, too, he had shut down over a hundred “bucket shops”—unregulated private gambling parlors that took bets on everything from stock prices to a range of commodity prices. The bucket shops of the early 20th century bore more than a trivial resemblance to the derivatives markets of more recent times, except that the size of the latter dwarfs the size and influence of the former. What they have in common is their casino-like nature, which inheres in the fact that there is no need to actually own a stock of futures contract in commodities in order to profit from changes in prices.
Pecora was in line to become District Attorney when, in early 1929, Joab Blanton chose him to become his heir apparent. But the Democrats at Tammany Hall refused to nominate him; he was just too honest and effective for their tastes. So Pecora resigned and went into private practice until 1933, when Senator Norbeck brought him to Washington. There Pecora found what we call nowadays a “target-rich environment.”
Once Pecora sized up in some detail what had gone on before the Crash, based in part from his familiarity with Wall Street habits and “ethics,” he decided to apply shock tactics to the case. He subpoenaed high-profile bankers to testify, and used his subpoena power as well to obtain the records of the nation’s largest financial institutions. The key episodes of the public hearings Pecora managed were the testimony of New York Stock Exchange president Richard Whitney and the chairman of National City Bank (now Citibank), Charles Mitchell. During the interrogation Mitchell recounted not only the dubious financial transactions that allowed him to avoid taxes, but also many of his banking group’s questionable banking and investment practices that led to the loss of a huge portion of private savings deposited in the National City Bank.
It was not just depositors who had suffered after the Crash, but also investors in bank stock. The National City Bank—and of course many others—had hidden bad loans accumulated on its balance sheet by packaging them into composite securities and pawning them off to (as we call them today) non-qualified investors—sub-prime shenanigans, in other words. Though ordinary shareholders suffered enormous losses on bank stocks, Mitchell and his top officers had set aside millions of dollars from the bank in interest-free loans to themselves. This was perhaps not quite as bad as Goldman Sachs making billions by betting against its own clients before 2008, but it was close. The interrogation of J.P. Morgan, Jr. uncovered evidence that the financier maintained a “preferred list” of friends of the bank who were offered stock at highly discounted rates. Those friends included a former U.S. President and a sitting Justice of the Supreme Court.
The committee hearings continued for nearly a year, and as time passed Pecora learned how to use the media to amplify the revelations that his interrogations uncovered. That helped Pecora to highlight the most shocking episodes, and to parley that shock into broad congressional support for stricter regulatory oversight of U.S. financial markets. The result was the Securities Act of 1933, under which Congress established the Securities and Exchange Commission (SEC) to regulate the stock market and to protect the public from fraud. (After the Pecora hearings ended in July 1934, President Roosevelt appointed Pecora to be one of five SEC commissioners).
The Pecora Commission’s report was also used as background analysis for the separation of investment and commercial banking that was incorporated into the Glass-Steagall Act passed later in 1933. Also on the basis of the Pecora investigations the Federal Bank Deposit Insurance Corporation (FDIC) was established to guarantee individual bank deposits. That brought a huge amount of capital out from under the nation’s mattresses and into the banking system, a more efficient mechanism than bedding for getting it into the hands of those who could make best use of it.
And finally, the Pecora hearings set a new standard for Senate committee investigations themselves. As the official record of Pecora Commission stated, “the Committee on Banking and Currency’s investigation of Wall Street established several historic precedents. It regularized the practice of Senate committees subpoenaing materials from individuals as well as institutions. . . . Under Ferdinand Pecora’s direction, the committee staff had set a high standard for thoroughness and offered a model of excellence for future Senate investigators.”1 The bottom line was that a skilled and relentless man managed to create a bright and shining example of how extrajudicial public investigations could identify not only violations of law, but also lead the way to reforming the legal framework itself.
The Path-Dependency Problem
If there are lessons Russian reformers can learn from Ferdinand Pecora, they do not derive from direct application of the Pecora experience. The context is simply too different.
Before the collapse of the Soviet Union, its Constitution did not recognize private property except for what was used by citizens in everyday life. There were no private banks or corporations and no legal framework regulating their activities—so there was nothing to reform. Post-Soviet Russia needed to design its own banking and securities regulation from scratch. Russian lawmakers and experts set about doing just that in 1992, and as they did they analyzed the U.S. regulatory framework and adopted many of its characteristics in drafting Russian laws.
But that, ironically, has become part of the problem. Whatever from-scratch frameworks developed, they did not develop fast or strong enough to prevent lots of bad behavior that produced enormously bad results for most Russians. Indeed, several episodes over the past 25 years have demonstrated that financial crises resulting in massive losses of private savings can occur regardless of regulations that look good on paper. A little history, Russian history this time, helps to explain the gap between regulatory frameworks on paper and how the real Russian world works.
In March 1990, the tottering USSR adopted the law “On Property,” which allowed the creation of joint-stock companies and gave citizens the right to own shares. Immediately thereafter new companies and banks started to appear in the form of joint-stock companies or limited liability corporations, and these began to attract funds from citizens and companies to form their capital. Due to a lack of regulation allowing new companies to implement large investment projects, the size of these new joint-stock companies was, as a rule, fairly small. In addition, the development of new companies was hampered by the continued system of centralized distribution of the vast majority of manufactured goods in the country, as well as a continuing state monopoly on exports and the extremely limited access of private companies to purchase foreign currency.
Russia inherited from the Soviet Union tens of thousands of industrial, agricultural, transport, and communications enterprises. The planned economy did not envisage competition between producers, so the average size of Soviet enterprises was much larger than in Western countries. Already in mid-1991, six months before the collapse of the USSR, privatization began in Russia, when state-owned companies and banks began to be transformed into joint-stock companies, and their shares were transferred to private ownership. Privatization significantly accelerated in 1992 after the adoption of legislation on voucher privatization, which brought the first truly massive securities to the Russian market.
Changes in the Russian economy were moving rapidly forward, so fast that lawmakers could rarely keep up. Remember that Russia had to adopt the most fundamental of laws because Soviet legislation, laws of a state with a planned economy, had suddenly become obsolete in the new environment. Additionally, the political conflict between the President and the parliament, which in October 1993 turned into an armed insurrection and led to the dissolution of the parliament, obviously slowed the capacity of the legislature to act.
Hence, the first Russian law “On the securities market” did not come about until April 1996; before that, this area was regulated by the decisions of the Federal Commission on Securities (FCSM), which was part of the government executive. The activity of the FCSM before 1996 was actively supported by U.S. consultants, so it is not surprising that many norms from U.S. legislation were copied into the regulatory protocols of the Commission. At the same time, legislators could not ignore the Russian specifics so, for example, they did not introduce the separation of banking and investment activities into Russian practice because by that time Russian banks had already become key players in the securities market. In addition, the FCSM lacked the powers of law enforcement agencies and had no authority to conduct independent investigations having legal force.
Meanwhile too, unlike the United States, Russia has opted for the path of consolidating banking and financial regulation and supervision within one body, the Central Bank. Since 1991, the Bank of Russia has regulated the banking system and carried out banking supervision. In 2013, the Securities Commission was attached to the Central Bank. After that, the Bank of Russia began to regulate and control not only everything related to capital markets, but also pension and insurance companies. Since 2017, the Bank of Russia has controlled a majority of votes in the Board of Directors of the Deposit Insurance Agency (ASV), which has under its control the deposit insurance system. This year the Bank of Russia established the Banking Sector Consolidation Fund, which retains the right to inject its funds into the capital of banks that have lost financial stability and manages their rehabilitation.
Critics in the United States often grouse over the alphabet soup of Federal agencies and congressional oversight committees with a role in financial and banking regulation—and that is not even to mention the role that the states play in this sector. The structure as a whole can look incoherent, and is often accused of serving as an invitation for powerful private actors to arbitrage their own regulatory watchdogs. There is something to the criticism, no doubt, but Russia has the opposite problem: over-centralization, and hence little to no accountability in Central Bank decisions regarding any of its many functions.
These many and important differences explain why copying American legislation after the law on securities markets was enacted did not solve the problems that Russia faced in the early years of a market economy. Since the privatization of state assets was the primary form of the initial private property, the securities market did not become an important instrument for raising capital. The volume of the initial public offering was extremely small, these transactions were not significant for the market, and equities or investment products based on them did not become the basis of private savings. At the same time, during the initial distribution of former state property a struggle ensued for absolute control over assets, which implied the emergence of a controlling shareholder in whose hands more than half of a company’s shares were held. Hence the mathematics witticism of the time: 51=100, and 49=0.
As a result, the main form of dishonest behavior that the state should have been fighting against was the deliberate exclusion of minority shareholders. Usually, this exclusion came in the form of a decision to issue new shares taken at a shareholder meeting held in a remote location, where minority shareholders could not go because of high costs. The number of shareholders participating in the meeting decreased sharply, which allowed the largest shareholder to obtain the majority of votes necessary for making decisions. In cases when several shareholders competed for absolute control, a traditional instrument of unfair struggle was corrupted court decisions prohibiting certain shareholders from voting at the meeting. The reason for such court decisions could be appeals of unknown individuals, not infrequently offering bribes, who filed suits against shareholders demanding interim arrest or the freezing of shares.
Another phenomenon of the Russian reality of the first half of the 1990s was the proliferation of financial companies using Ponzi schemes (MMM, Khoper-Invest, Vlastelina, and others). These companies masked their activity under investment funds conducting active advertising campaigns on national television and collecting a huge number of participants who were promised super-high returns. Although in time all these companies collapsed, new ones appeared in their place, often with the same founders continuing similar fraudulent activities under new names. The FCSM stated that the activities of these companies did not fall within the scope of its regulation; and no other government agency, including law enforcement, had decided to take any responsibility for limiting such activities.
The fast growth of the Russian economy in the early 2000s led to a rapid increase in household incomes. Sky-rocketing oil prices and the active foreign borrowings by the Russian banks and companies led to a sharp expansion of bank lending, including for mortgages. To own a house became the dream of Soviet citizens who used to have to wait for years and even decades for the state to allocate an apartment for them. Therefore, as soon as private incomes began to grow, the demand for new housing grew even faster.
Numerous homebuilders appeared on the market. But since their financial resources were extremely limited and they could not raise bank financing, the practice of shared financing became widespread. Homebuyers paid a significant portion of the price at the time of signing the contract, often when construction had not yet begun. Soon it became clear that for various reasons—fraud or an inability to plan financial activities properly—tens of thousands of citizens across the country never became homeowners because construction companies did not complete construction, or in some cases did not even begin it. The attempt of Russian authorities to introduce legal restrictions by adopting the special law in 2005 was in vain, since no government agency received adequate regulation, supervision, or enforcement functions, and the law retained numerous evasion opportunities.
The situation worsened further in 2009, when the demand for housing fell sharply as a result of the economic crisis, and many homebuilders could not pay off their bank loans. This led to their bankruptcy and freezing of construction. In 2014, the law was amended to close many of the gaps and that in turn drove most small companies the market. The crisis in 2014-16 then led to a new wave of builders’ bankruptcy, resulting in the collapse of several very large companies, including in Moscow, leaving tens of thousands of contracts unexecuted. Finally, in mid-2018, a new law passed that prohibiting homebuilders from using the shared financing method in any form during the construction period. According to experts, this is likely to reduce new construction and increase the cost of housing.
There was no banking supervision in the Soviet Union. There was just no need for it. Until 1987, there were only four state-owned banks in the country: Gosbank provided settlements and current lending to state enterprises; Stroybank dealt with the financing of investment projects; Vnesheconombank carried out all foreign-related operations, and Savings Bank consolidated private deposits with no active operations. In 1987, Gosbank became exclusively an emission center, and its settlement and lending operations were transferred to three new banks specializing on a sectoral principle, combining current and investment financing. However, the activities and volumes of lending operations have always been regulated by the Gosplan (State Planning Committee) and the Ministry of Finance.
Private banks began to appear only in 1988, when the law “On Cooperation” allowed the creation of cooperative banks. In the middle of 1990 the Soviet government permitted the creation of joint-stock companies, and the Russian parliament passed a law on the transformation of regional branches of state banks into independent joint-stock banks. By early 1992, there were already 869 banks in Russia; by the end of the year their number had grown to 2,000. But the banking supervision department at the Central Bank was established only in the autumn of 1994.
Like many other spheres of state regulation, banking supervision cannot arise overnight; its formation requires time to train employees and develop methodologies and technologies for supervision. For several years banking supervision existed in Russia only formally and was unable to adequately assess the risks and sustainability of banks. Therefore, it was not surprising that in the 1998 crisis, the largest private banks went bankrupt for various reasons.
The rapid growth of the Russian economy in 1999-2008 favorably affected the banking system, which became one of the fastest growing sectors. However, when the global economic crisis began, many large banks faced serious problems. The government and the Central Bank allocated huge funds to save the largest banks (more than 4 percent of GDP), but many large banks went bankrupt nevertheless. The Central Bank explained these problems by blaming a global crisis, but even a helicopter-view analysis showed that many of the problems were related to the excessive risks that the banks took on themselves that banking supervision was supposed to see and prevent—but did not.
Refusing to acknowledge the failure of supervision, the Central Bank did not take adequate actions, and when the economic situation began to deteriorate again in 2013, a process called “bankfall” began in Russia. Dozens of large and medium-sized banks began to crumble, and often it turned out that the capital of such banks was negative by the time the license was revoked. Banks lost clients’ funds in huge amounts. Thanks to the deposit insurance system, most private depositors did not suffer losses, but then the insurance system itself actually went bankrupt; as early as 2015, the ASV had used all of its available financial resources and could later pay depositors only at the expense of loans provided by the Central Bank. By mid-2018, the total amount of such loans exceeded 3 percent of the amount of private deposits.
The losses of the corporate sector from the “bankfall” were so formidable that the government and the Central Bank established a special program for the rehabilitation of collapsed banks, which in effect provided for the payment to customers of collapsed banks at the expense of Bank of Russia loans. By mid-2018, the total amount of such loans exceeded 4 percent of the average annual GDP for 2015-17. The collateral damage of this process was the nationalization of the banking system; by mid-2018 the share of state-controlled banks exceeded 75 percent of the Russian banking system (measured by assets).2
The Need For Reform
Obviously, the Russian financial sector is in dire need of reform. But it is hard to see how it can come about when the regime insists on over-centralization for the sake of political control, even though over-centralization is dysfunctional. All else equal, it has made and still makes sense to empanel a Pecora-style parliamentary commission empowered to analyze reasons and identify problems. So why has nothing like this happened?
Parliamentarian investigations (commissions) were actively used in the last years of the Soviet Union after the first (and the last) semi-free election that took place in 1989. Those commissions investigated political events: the Ribbentrop-Molotov pact, the invasion in Afghanistan, and so forth. In the 1990s special commissions in both chambers of the Russian parliament were empaneled on the Chechen war, on the murder of General Rokhlin, and on the financial crisis of August 1998. In 2004 a special commission was established by the Federation Council targeting the hostage takeover in Beslan when 333 people died during the assault of special forces. Though the general conclusion of that commission was favorable to the government, several of its members disclosed personal opinions contradicting the official viewpoint and imposing responsibility on the FSB (secret police), which was in charge of the assault, for the death of hostages. This bothered the authorities, it seems, and so in 2005 a special law on parliamentary investigation was adopted in Russia. The result: No investigations have been launched since.
The absence of an independent and qualified judiciary makes it almost impossible for the Russian financial regulator to prevent price manipulation in the securities market; very few cases have been discovered and proved. On the other hand, the Central Bank is responsible for banking supervision in Russia while at the same time being the regulator of the banking sector and the owner of several major banks, including the biggest Russian bank, Sberbank. Obviously, there is a conflict-of-interests problem baked in to this arrangement, resulting in irrational decisions. Additionally, the absence of an independent legislature in Russia prevents a special parliamentary commission dedicated to analyze failures of the banking supervision, and so bankfall continues.
One of the most important elements of the 1933 Securities Act defending ordinary citizens’ savings was the distinction between a qualified and non-qualified investor. Though many of the norms from the U.S. legislation have migrated to the Russian law, key definitions were not incorporated into the Russian legislation until spring 2008. There was never a clear explanation given for this, but the biggest losses related to the lack of this definition involved the state-controlled companies VTB Bank and Rosneft, which issued their shares in 2006-2007 and attracted 115,000 and 150,000 small private investors, respectively.
One could go on, but the point is already as clear as it need be for the purpose: Something like a Pecora Commission cannot emerge in a non-democratic country lacking strong checks and balances, where executive power dominates and controls the legislature and the judiciary. It cannot emerge in a country with no political competition, where parliament members are not elected but are de facto nominated by the Kremlin—and where any uncoordinated or rogue behavior results in the loss of the seat. It cannot emerge in a country where all national news TV channels are owned by the government or by the friends of the President. So clearly, unlike in the United States and other Western democracies, the practice of parliamentary investigative commissions in Russia is very limited, and it is important to understand what prevents Russian legislators from using such an instrument.
Some 85 years later, we can distill out what enabled Pecora to be so successful. First, he worked within a democratic legal framework in which the Legislative Branch could drive public policy reform, in this case with requisite sympathy from the political party that had just assumed control of the Executive. Second, he acted in the heat of crisis, when the pain of the Crash and its consequences were still fresh and raw. Third, he learned quickly how to use media exposure as pressure on the legislature, back in the day when only newspapers and radio were available to him for the purpose. What limited lessons reside here for would-be reformers of post-communist Russia, and other post-communist countries whose institutional frameworks for regulating financial markets still need work?
At the present time, Russia’s legislature cannot drive major policy innovations on its own, partly because, unlike in the United States, the Duma lacks the power of the purse. And it may be doubted whether the Russian Executive would look kindly on such reforms, since they might weaken the political and economic utility of the oligarchs who operate at the regime’s pleasure. Second, there is no longer much heat from the meltdown crisis of the 1990s, and the series of crises that hit typical Russians thereafter. A new crisis is quite possible, but it is not here yet. And third, there is virtually no independent media left in Russia to help a Russian Pecora leverage shock to influence public opinion and hence policy.
But things change. After the Putin era, the Duma may become a more independent body, and the judiciary may wriggle into the light of independence as well. Free media, never completely extinguished, may make a comeback as well. When the planets line up, the history of the Pecora Commission will furnish a tactical guidebook for how to translate opportunity into regulatory reform. Use hearings to lustrate corrupt behavior; deploy the media to spread the word; pressure parliament to do something; and make sure the vanguard of the investigations have sufficient experience to guide the framing of new regulations. One day, maybe, this can happen even in Russia. Maybe.
1 “Subcommittee on Senate Resolutions 84 and 234 (The Pecora Committee),”https://www.senate.gov/artandhistory/history/common/investigations/Pecora.htm.
2 “State-controlled banks” are here defined as those where the federal or regional governments, the Central Bank or its subsidiaries, or state-owned companies are the shareholders controlling more than 50 percent of the capital.