The near implosion of the Knight Capital Group on an accidental $440 million trading loss may make many feel that Wall Street firms are on automatic self-destruct with the timer set to go off fairly soon.
The truth may instead be that the finance industry not only has fewer missteps than the rest of corporate America, but that sometimes failure is a good thing.
The wunderkinds at Knight Capital certainly did seem to blow up the joint. The market maker's trading program ran amok over the course of 45 minutes last Wednesday morning, leading to $440 million in losses. At best, this was an unintentional programming malfunction, but whatever the cause, it was a stupendous error that necessitated a rescue of the firm on Monday by a group of investors.
And the Knight Capital debacle follows a long list of Wall Street failures. In the last few years, Lehman Brothers, Bear Stearns and MF Global have destroyed themselves. Before that, Drexel Burnham Lambert filed f or bankruptcy in 1990, Barings in 1995, Long-Term Capital Management in 1998, Refco in 2005 and Amaranth Advisors in 2006. In the late 1980s and early 1990s, the savings and loan scandal resulted in a spate of bank liquidations. In the 1970s, there was the implosion of the Wall Street financial institution Goodbody & Company, and in the decade before, the failure of Ira Haupt & Company.
While you may look at horror when you see this record, Wall Street is actually better than average in the failure department these days.
Look at corporate landmarks like Eastman Kodak and American Airlines, which are now in bankruptcy. Last year, 86 publicly traded companies went bankrupt, according to bankruptcydata.com, with an average filing size of $1.2 billion. Only 4.7 percent of these companies were in finance or banking. Since 2000, 1,768 public companies have filed for bankruptcy, but only about 6 percent have been financial and banking companies.
Putting this in pe rspective, about 15 percent of the Standard & Poor's 500-stock index is made up of financial companies. Financial and banking companies appear to have a lower rate of failure than the rest of corporate America.
Even so, this doesn't mean that failure is bad. Failure is a necessary component of the creative destruction that the Austrian economist Joseph Schumpeter wrote about.
Schumpeter's theories have been extrapolated by free-market advocates into an explanation of how dynamic, capitalistic economies renew themselves through failure.
Normally, Americans take this failure as the price to pay for a successful capitalist system. The nation does not seem terribly upset about the fall of Kodak, or before it, Polaroid. These companies failed to adapt and change, and if you buy into creative destruction, they were eclipsed by swifter, faster companies like Shutterfly and Instagram.
Obviously, these events are terrible for the employees and communities invo lved, but you don't see this bring new cries for regulation to prevent Kodak from going under.
The question is whether creative destruction is different on Wall Street, and if so, can we even stop it.
Creative destruction certainly hasn't gone away. In recent years, we've seen the creation of boutique investment banks like Moelis & Company and Evercore. Hedge funds have gradually captured significant trading volume from the investment banks. Knight Capital itself was a symbol of the rise of the market makers, which compete with the exchanges for trading business.
These newer entrants counteract what has been the huge consolidation in the investment banking industry over the last 40 years. Investment banks swallowed each other only to be subsequently acquired by big commercial bank holding companies. Lehman Brothers, for example, was an agglomeration of a number of storied banks like Kuhn Loeb, E. F. Hutton and Shearson/American Express. Lehman's remnants ar e now part of Barclays and Nomura.
In other words, Wall Street is continuously evolving. In such a place, failure, as it does everywhere in corporate America, must occur. This is the way weak players are discarded so stronger players can survive and provide better and more stable services.
In this system, the dumb must also go. In the case of Knight Capital, regulators appeared to agree, declining to make any exceptions for the firm.
The difference is that finance is about risk, and when financial companies collapse, it can happen quickly, with extensive harm to others. When a bookstore chain goes bankrupt, people are inconvenienced and there are losses, but the losses are mostly containable.
In finance, however, the collapse of a single firm can jeopardize the system, and as with Knight Capital's teetering on the brink last week, it can happen very quickly. We're all understandably on edge about that because of the financial crisis.
The chairwo man of the Securities and Exchange Commission, Mary L. Schapiro, said before the rescue that a failure of Knight would be “unacceptable.†There is also public hand-wringing by commentators that we need to go after computerized trading.
It may well be that we need more regulation of computer trading, but we also have to realize that failure will happen with financial firms, and that this is part of the weeding out. It's not just acceptable, but desirable.
Firms that can't manage their risk should be replaced by firms that can. If we instead regulate these firms so they take no risk, finance will dry up. The existence of a financial system is a trade-off for the benefits that finance can provide. And yes, there are benefits, like credit and financing for a $15 trillion economy.
The trick is to strike the right balance. That is actually what the much-criticized Dodd-Frank Act does - allowing firms to take risk but tempering that risk-taking with regulatory oversight. Dodd-Frank also creates a new insolvency system for banks that pose systemic risk to manage the inevitable failure.
But Dodd-Frank's insolvency net would not have activated for Knight because it wasn't systemically important. Instead, the normal system worked to minimize the impact of Knight's losses and absorb it. In other words, the near failure of Knight was a success for Wall Street, showing that it can manage the inevitable collapse.
All told, it may be that new rules are needed in light of Knight, but it should also be recognized that we can't just regulate failure away without eliminating risk, too. And we can't have a financial system without both.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.
