05.08.08

Some Kind Words for Glass-Steagall

Posted in Blog at 8:32 am

—April 23rd, 2008

The boom-and-bust, euphoria-followed-by-despair cycle seems a permanent feature whenever future gain is contemplated by a mass of human beings. As Warren Buffett so aptly put it, investing in the stock market is like being in partnership with a very wealthy manic-depressive. Periodically, in his manic phases, your partner will offer you too much for your share in the business, and you should sell it to him; when he is overly depressed, he will offer you his stake in the business for far less than it is worth, and you should buy it back. Unfortunately, most investors are more likely to follow this “partner’s” moods than to take advantage of his pocketbook. This is human nature, and explains why it is possible to make an excess return from otherwise efficient capital markets: irrational enthusiasm makes peaks too high, and irrational pessimism makes troughs too deep. When the national mood swings are too great, and too many market participants in too many markets get stampeded, these market phenomena can completely overwhelm the real economy. This is how the agricultural decline beginning in 1926 and the stock market collapse of 1929 morphed into the 10-year Great Depression.

Does it always have to happen this way? In remarkably similar circumstances in the early 1930’s, elected officials and their advisors decided that such manic-depressive phenomena should no longer be allowed to infect the commercial banking system, and they came up with the Glass-Steagall Act. Deposit-taking institutions were not allowed to create or sell most securities, and the underwriters of securities were not allowed to engage in commercial banking. Later, the barrier was extended to wall off the insurance sector as well. But financial innovations in the 1980s allowed the super-brokerage/ investment banks to undercut the commercial banks’ franchise, and the threat of disintermediation further impelled the big banks to lobby for repeal of the Act. Diversification was supposed to make big banks less risky, and provide the investment markets with more capital to finance the expansion of industry.

Perhaps it did make life better for issuers. But the first beneficiaries of repeal were the owners of investment banking businesses, who were able to sell their sexy firms to big, rich, dull banks at high multiples to future earnings. Traders, syndication administrators, stockbrokers, and other underlings in the once-stratified world of investment banking suddenly began to make seven and eight-figure bonuses just as the major dealmakers had. And the banks began to experience a roller-coaster in earnings such as they had seldom seen before. Issuers of securities may have benefitted by forcing underwriters to put their own capital at risk, but shareholders and other stakeholders in the big banks have had a less joyous experience. As Kenneth Lewis, CEO of the Bank of America, recently put it, “I’ve had about as much investment banking fun as I can stand.”

Under the Glass-Steagall system or its even more compartmentalized U.K. counterpart, single capacity, the troubles of a brokerage house or an underwriter were seldom of national concern. Brokers were primarily agents, and did not invest much for their own account. Underwriters, which were traditionally under-capitalized service businesses, were skilled at unloading their risks in a few hours. As unlimited partnerships, most Wall Street or City of London firms were careful to limit their own risks.

In the U.S., this changed with incorporation and admission to public quotation. Once stock exchange members were permitted to issue shares, they could play with someone else’s capital, buy deals, and put tremendous sums of cash to work in proprietary trading, in effect competing with their own customers. The customer may not have felt so happy with the service he was getting, but the investor had a new way to speculate upon business cycles: buying shares in the investment banks for the dizzying ride through an anticipated bull market, and holding the commercial banks for yield and safety, in more uncertain times.

Mergers and industry consolidation have undone this choice. The move to diversify the commercial banks’ own businesses has led to less, rather than more stability. Now banks’ results are usually dominated by their returns from capital markets activities. Given the ever-rising opacity of increasingly complex derivative structures, the bank has itself become a huge black box, and no investor can be sure of its contents—the boards of the banks themselves are not sure!

In the U.K. and elsewhere in Europe, the abolition of single capacity was imposed by the American investment banks as a precondition for investment in these markets. U.S.-based “global” investors were more comfortable with a system with which they were familiar, especially when it meant that they could seem to be driving a harder bargain by negotiating commissions. Most did not bother to find out what they might be losing by the exchange. The important thing was to be more ‘modern,’ and ‘professional,’ i.e. to be more American. The partners and shareholders of these smaller entities loved being taken out at huge premiums to their net worth, of course, and no one asked the shareholders of the acquirers if they minded paying for this bonanza. As the brokers merged with the market makers, and the combined firms merged with the merchant banks, few asked if the system was taking on more volatility.

During the stock market crash of 1987, North American underwriters stuck with huge blocks of BP in their syndicates were in serious trouble, and begged the British government to pull the issue. Their British counterparts, having sub-underwritten the issue with client investment funds and insurance companies, as was usual under traditional British practice, were unhurt. The Canadian investment banks were almost all driven to the wall, and had to be bought and recapitalized by the commercial banks. In answer to the Americans’ pleas to Westminster to pull the issue, Margaret Thatcher famously asked, “If underwriters aren’t there to underwrite risk, what are they there for?”

But the solution has been to put more capital into ever-larger monolithic intermediaries, rather than to analyze the system. The answer to all problems is inevitably ever-more burdensome controls and ever-larger compliance bureaucracies. A major bank is almost destroyed by a rogue trader, operating in an obscure department that was never supposed to be taking on risks. An even larger bank has to be recapitalized twice because of excessive involvement with one single form of trading vehicle; its shareholders have lost two-thirds of their investment in nine months. One of the historically best run of the independent investment banks has to be bought out—at seven cents on the dollar—because of a minor subsidiary whose exposure featured in almost no one’s model of the bank. Are these huge bureaucratic organizations, which have such difficulties monitoring the hundreds of different activities in which they are involved, necessary in order to have flourishing capital markets? Are the funding requirements of business only met by mega-banks capable of treating every type of financing as if it were a commercial loan, which they can carry themselves? Should pension management and broking be under the same roof as corporate finance and trading for the house account? Most important of all, are any regulators asking themselves these questions?

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