Corporate Governance

Bear Stearns, Corporate Governance, and the Capital Markets: Bring Back Glass Steagall (Part 5)

By J. Robert Brown

We are discussing the collapse of Bear Stearns and the significance for the financial markets.  One of the consequences not yet discussed concerns the elimination of a separate class of broker dealers, with investment banking functions becoming a subsidiary operation of commercial banks.  This will result in long term harm to the vibrancy of the capital markets. 

There have been growing calls for increased regulation.  They arise from the growing realization that the big four investment banks (not counting Bear Stearns) are capable of taking steps that can destabilize the economy (as happened with Bear Stearns).  They can do so primarily through the absorption of excessive amounts of risk, ultimately exposing the entire firm to financial failure (and collateral damage to the economy).

Unlike banks, the investment banking firms are at their core securities brokers and subject primarily to the regulation of the Securities and Exchange Commission.  It is the Commission that enforces disclosure requirements, inspects the firms, and enforces minimum capitalization requirements.  What the Commission cannot do is provide liquidity.  As a result, some have suggested that regulatory oversight for these firms be transferred from the SEC to the Federal Reserve Board.  As David Wessel observed in the WSJ:  "So comes the inevitable conclusion:  Securities firms should be regulated more like banks."  Henry Paulson at Treasury apparently feels the same way.  With Fed or bank regulator oversight, the investment banks would essentially be subjected to a tighter regulatory regime, one more typical of traditional banks. 

We appreciate the sentiments for this approach.  Certainly, the investment banking firms have the capacity to destabilize the entire economy.  Moreover, the Bear Stearns example demonstrates that they are quite capable of mismanaging the degree of risk that ought to be absorbed by a single institution. 

Having said that, we note that regulatory proposals are going in the wrong direction.  The effort to treat investment banking firms like banks is a mistake.  The approach to regulation will only hasten a time when there are no independent investment banking firms, all of them either out of business or subsidiaries of commercial banks.  This is all a product of a mistaken decision back in the 1990s to allow banks to engage in securities activities. 

There was a time when the two industries were legally separated.  Known as Glass Steagall, the restriction was repealed in the 1990s in a rush of deregulation.  The result was that banks can engage in securities activities and securities firms can engage in banking activities.  Additional competition and additional diversification seemed like a good thing to most.  The repeal passed with hardly a complaint.

But as I warned, (seeThe Great Fall:  The Consequences of Repealing Glass Steagall) the repeal of Glass Steagall would lead to the disappearance of independent broker dealers, replaced by banks. 

• The best argument against repeal is really an old argument: once allowed into underwriting, banks will dominate the market at the expense of other financial intermediaries. This will result in reduced competition in the securities industries, damage to the securities markets in general, and a reduction in the sources of funding for some companies.

The evidence?  All other capital markets are bank dominated.  Astudy of the four largest markets -- Britain, the US, Japan and Germany -- shows that this is the case.  At one time, Britain was not, with a class of strong merchant banks.  But with the end of their own variation of Glass Steagall, the merchant banks have, one by one, been acquired by banks.  Moreover, back before Glass Steagall, securities firms initially dominated underwriting.  After regulatory uncertainties were addressed, banks entered the area and entirely dominated the activity.

• Commercial banks went from holding a negligible percentage of corporate underwriting to control, almost overnight. By the early 1930s, commercial banks had pushed aside their competitors and gained control of more than half of the underwriting business. This was particularly true with respect to corporate bonds, where commercial banks had sixty percent of the market immediately before the adoption of the Act.  

It is no accident that this occurs.  Banks have natural advantages including strong access to issuers, cheaper funding sources (deposits) and a strong interest in the capital raising process.  They also have a strong conflict of interest:  to push companies towards a system of capitalization that benefits them rather than the company.  Thus, there has at least historically been an emphasis on lending rather than raising capital in the public markets. 

As a result, bank dominated systems have less vibrant capital markets.  In other words, capital markets benefit from a well capitalized class of brokers unaffiliated with banks that can concentrate not on lending but on selling stocks and bonds. 

With the repeal of Glass Steagall, however, the natural advantage of banks has reasserted itself.  Independent brokers, with a weaker capital base and more prone to take risks, will eventually confront financial difficulties.  Merrill Lynch has suffered mightily in the subprime scandal and the other large investment banking firms are under scrutiny.  They will either go out of business or, more likely, be acquired by commercial banks.  This is exactly what occurred in connection with Bear Stearns, now to become a subsidiary of JPMorgan Chase, with about half the employees and no doubt a more conservative approach towards securities activities. 

Where does that leave us?  As I wrote back in the 1990s:

• The problem [with repeal of Glass Steagall] lies in the long-term consequences. To the extent that banks do dominate the market, as historical and international evidence suggests, competition will likely decline. Moreover, the shape of the securities markets will also likely change. Bank domination will probably mean less access to capital markets for smaller companies.

A return of Glass Steagall will also reduce some of the moral hazard for banks, reducing at least some of the risk that comes with securities activities.  But mostly it will help retain a strong class of brokers who help keep the securities markets vibrant and liquid.

Full post as published by The Race to the Bottom on March 28, 2008 (boomark / email).