Corporate Governance

Reinstating Glass-Steagall: The Problem with Bank Dominated Securities Markets (Part 2)

By J. Robert Brown

Bank dominated securities markets are those where banks control the primary distribution process.  This is the situation for example in Germany.  It was the situation in the United States before the adoption of Glass Steagall (we will explore the history in another post). 

Bank dominated systems involve an inherent conflict of interest: The same entities providing companies with short-term credit also give advice on long-term capital needs.  Consequently, the risk exists that the advice provided by banks will be motivated by their own self-interest rather than the best interests of the company. Moreover, banks have a reputation for conservative decision-making and risk aversion, attitudes which conflict at times with corporate interests.

The risk is that bank-dominated systems will provide access to fewer sources of capital.  Given the conflict of interest and the attitude towards risk, one can predict that bank dominated systems will engage in fewer IPOs. 

Any significant reduction in the availability of equity markets will have a disproportionate affect on companies that lack the traditional attributes sought by lenders.  Bank lending depends primarily upon indicia of the ability to repay, particularly collateral and cash flow. Many companies, however, lack these attributes, and even those that can obtain some bank funding will often not be able to borrow additional amounts to expand.  Biotechnology companies in the 1980s, Internet companies in the 1990s, and software companies in the New Millenium likely fall into this category.  

In systems with active and accessible securities markets, start up companies can sidestep banks and seek funds directly from the capital markets. In so doing, they need not meet the same standards applicable to bank loans. Instead of focusing almost entirely on indicia of repayment, securities firms must look at investor demand for shares.  The different standards allow companies with minimal track records to gain access to the capital markets, so long as they can convince an investment bank that investors will buy the shares. 

Investment banks, unlike commercial banks, profit almost entirely from the securities markets.  They lack the same conflict of interest possessed by commercial banks.  Investment banks also have an incentive to encourage companies to engage in public offierings.

For more on this topic, see Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets.

Full post as published by The Race to the Bottom on December 22, 2009 (boomark / email).