Independent Investment Banking Firms and their Disappearing Act

The Commission and the Fed announced the execution of an MOU providing for increased information sharing between the two agencies.  As the press release described:

• Under the MOU between the two agencies, the SEC and the Board would share information and cooperate across a number of important areas of common interest including anti-money laundering, bank brokerage activities under the Gramm-Leach-Bliley Act, clearance and settlement in the banking and securities industries, and the regulation of transfer agents. The MOU specifically covers bank holding companies and so-called Consolidated Supervised Entities that own securities firms. It builds on and formalizes the long-standing cooperative arrangements between the SEC and the Board, as well as the more recent cooperation on matters including banking and investment banking capital and liquidity following the Board's emergency opening of credit facilities to primary dealers.

The step probably reduces the likelihood that Congress will intervene (although Paulson is still suggesting the need for additional legislative reform) and strip authority away from the SEC with respect to the supervision of investment banking firms.  It is inevitable, however, that jurisdiction over the large brokers will end up with the Fed, not because of a regulatory change but because independent investment banking firms will go the way of the Dodo. 

Glass Steagall was repealed back in the 1990s with great fanfare.  It was the elimination of unnecessary regulation left over from the Great Depression.  In The Great Fall:  The Consequences of Repealing Glass Steagall, I predicted that the repeal would result in the disappearance of independent investment banking firms.  Instead, their tasks would be taken over by large commercial banks that could now engage in the same activities.  It didn't take brain surgery to figure it out.  When commercial banks were allowed into investment banking in the 1920s in the US, they quickly began to push out investment banks until Glass Steagall put a stop to it.  In Great Britain, which once had a class of independent merchant banks, the commercial banks took them over once they were allowed. 

The same will happen here.  Commercial banks have inherent advantages that, over time, result in business shifting to them and away from investment banks.  Look at why the hedge funds in the CSX case moved their swap positions away from the investment banks to the commercial banks.   

At the beginning of the calendar year, there were five large independent banking firms left:  Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns.  Bear Stearns is gone, absorbed by a commercial bank.  Merrill considered the same strategy.  Now the rumors are out that Lehman is in trouble and may have to sell itself at a "bargain-basement" price.   The article contained speculation with no real hard evidence other than Lehman's share prices took a big hit and it remained exposed to the mortgage market.  Nonetheless, it is only a question of time.  Lehman may hang on through this crisis but, as the smallest of the independents, will likely be the next to be acquired by a commercial bank.

So interesting that there are plenty of loud voices that come out to ostensibly protect the capital markets when the subject is about additional regulation.  Look at the criticism of SOX, for example.  But where deregulation threatens to do significant structural damage to the capital markets, silence ensues.      

Comments

[Ales Smutny]

The UK has quite efficient capital market, but no Glass Steagall - which seems to imply that i) universal banking is not necessarily detrimental to the capital market or ii) there are other ways around. Or may be not, but what then with "legal origins" or "war impact" theories?

I heard somewhere that Israel introduced separation of commercial and investment banking few years ago and would appreciate any info on its experience.

[J. Robert Brown]

Ales:

Until the 1980s, the UK had an implicit Glass Steagall. There were merchant banks and commercial banks but each did not really intrude into the other's territory. This ended in the 1980s and 1990s. As a result, there are no "independent" merchant banks, with all of the large ones having been acquired by commercial banks (sometimes after a financial crisis like with Bear Stearns, look at Barings).

We shall see if ultimately the elimination of these firms as independent entities is harmful. But of course there is addtional competition in the UK that does not really exist in the states. I believe that without independent banking firms in the US, the markets will suffer. Would there have been a dot com boom or a biotech boom without them?