FYI | Feb 03 2010
By Greg Peel
Prior to the collapse of Lehman Bros in 2008, two forms of bank existed in America – commercial banks and investment banks. In loose terms, a commercial bank offers traditional banking services, taking deposits and making loans such as business loans and mortgages. A commercial bank profits from the difference between the rate at which it can borrow money (primarily the interest rate it pays on deposits) and the rate at which it lends money (which differs for different types of loans and risks).
An investment bank is loosely everything a commercial bank is not. Investment banking activities include fee-based services such as broking (stocks, bonds, futures, commodities etc), merger and acquisition advice, and wealth management services. On the other side of the risk ledger it includes proprietary trading operations – financial market punting – which may take the form of specific hedge funds or simply a “trading desk” in foreign exchange or stock market derivatives, for example. In between there are activities combining both fees and risks, such as IPO underwriting, corporate finance structuring, and market-making in all manner of financial instruments, particularly derivative instruments.
But the distinction I have just made is far from being a clear one. One might consider, for example, that if a bank takes a management fee to invest an individual’s superannuation, that leans more towards the sort of services a commercial bank might offer, but if the bank also takes a performance fee on that investment then wealth management is clearly more of an investment bank activity. Or if a bank offers a service whereby a business customer can exchange currencies via bank facilitation then it is a commercial bank activity, but if the bank assumes the risk of that currency transaction, merely than passing it straight through to the market (in order to offer greater liquidity), then it is an investment bank activity.
Nevertheless, before 2008 the top five “investment” banks in the US were considered to be Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Bros and Bear Stearns. The big “commercial” banks included Bank of America, Citigroup, and JP Morgan Chase. However, the big commercial banks were also very much engaged in various investment banking activities, to greater and lesser extents. And “banking” activities were not confined specifically just to “banks”. We had the world’s largest insurance company – AIG – up to its neck in credit derivatives and America’s bellwether diversified industrial company – General Electric – operating a huge world-wide consumer finance business, for example. Previously, America’s biggest car manufacturer – General Motors – had operated a huge finance firm as well in GMAC, but it had already been individually split off prior to the GFC.
Suffice to say, the distinction between what was a bank and what wasn’t, and what was a commercial or investment bank, was well blurred. The only certainty was that in order to take deposits and offer commercial bank services, a bank had to satisfy certain regulatory criteria which would in turn provide that bank with deposit insurance from the government and direct access to Federal Reserve funds, including the central bank’s “lender of the last resort” facility.
The Federal Reserve was created early in the twentieth century by JP Morgan in response to the US bank crash of 1907. “Lender of the last resort” (LLR) implies that no conforming bank would be allowed to fail and thus wipe out deposits, bring down business customers and render mortgage-holders homeless. The Fed would provide rescue funds instead. The Fed model became the benchmark model for world central banks thereafter.
At that time there was no distinction between commercial and investment banks, and the banks of the day were free to pursue investment banking activities. While obviously more rudimentary, the investment banking activities of the day were no less risky in relative terms. Then along came the Crash of ’29 and the Great Depression.
In response to the subsequent Fed bail-outs required as the US banking industry collapsed, the Glass-Steagall Act was created in 1933 which from then on prevented commercial banks from participating in investment banking activities. The intention behind the Act was simple. Banks had been exploiting the safety of deposit insurance and LLR protection to engage in risky, non-commercial bank activities which had generated super-profits prior to the crash, but which had subsequently brought entire banks to their knees thereafter. Mr Joe Average with his deposit account and his mortgage would have been rendered penniless because his bank had made huge punts in the bond market, for example, and lost. The government and the Fed had to step in to save Joe, but then Joe faced the prospect of indirectly paying for his bank’s bail-out for years to come via his taxes.
Fortunately the obligation became less daunting after they sent Joe off to war.
Attitudes mellowed over time, the past was forgotten in successive generations, and by the 1990s US commercial banks were crying out to be allowed to engage in investment banking services once more, to thus be able to provide the best possible returns for shareholders. Glass-Steagall was seen as an archaic law from a past era. Thus in 1999, the Act was rescinded by the Clinton Administration, and America’s big banks set about adding investment banking divisions.
Investment banks were nevertheless also subject to regulatory controls, particularly when they chose to become listed entities, which in 1999 included a leverage limit of 12 times tier one (ostensibly equity) capital. But despite the recession of 2002-03, investment banks were quick to argue that a 12x limit was too restrictive within the sophistication of modern derivative markets. Thus in 2004, US investment banks, led by then Goldman Sachs CEO Hank Paulson, successfully lobbied to have their leverage limit extended to 40x.
Four years later, the US financial system fell apart. The GFC can be simply blamed on a combination of mortgage securitisation, unregulated collateral debt obligation instruments, loose lending, and unregulated credit default swaps, but more importantly the leveraged activities of investment banks, commercial banks, insurance and finance companies and others had become so interwoven – in the US and across the world – and systemic risk so great that the failure of one large organisation would have set in train a domino effect that would result in complete the collapse of world financial markets and subsequently Great Depression II. We were back in 1932.
Unlike the Crash of ’29, the GFC was a more gradual slippery slope. It began rather unthreateningly in mid-2007 but by early 2008, the Fed and the US Treasury (under Secretary Hank Paulson) decided that fifth largest investment bank Bear Stearns was “too big to fail” and thus a rescue was organised. By late 2008, the “government sponsored” mortgage lenders Fannie Mae and Freddie Mac were also deemed too big to fail and were thus bailed out with public funding injections. Then the same was required for AIG. By the time fourth largest investment bank – Lehman Bros – was going down, Paulson and Fed chairman Ben Bernanke decided it was simply not possible to save every “too big to fail” institution. There were just too many of them. Thus Lehman was allowed to go under and the GFC was subsequently ignited in earnest.
History books will long debate whether or not allowing Lehman to fail was a foolish mistake, but either way the government and the Fed were forced to organise for every remaining “too big to fail” organisation to be bailed out with taxpayer funds, in the form of TARP injections and other facilities. It took several months of sleepless nights but by mid-2009 it was clear the TARP rescue package had worked, Great Depression II had been averted (for now), and banks were returning to a level of profits which allowed them to pay back their TARP funds and return to paying huge executive bonuses. In essence, we were back where we started.
But the pledge was made at the time of the GFC bail-outs by the then Bush Administration that after the bail-outs, which required immediacy, would come the retribution, in the form of greater financial market regulation. The new Obama Administration picked up the same baton and the rest of the world made similar pledges.
And here we are. There have been various more specific regulatory reform ideas put forward to date, such as the exchange-listing of complex derivatives including credit default swaps, and these have not generated too much opposition. But such regulation needs to lie under the umbrella of a much more far-reaching regulation that ensures there can never again be such a build-up of systemic risk in the global financial system. And the crux of this is that no institution should ever again be deemed “too big to fail”.
Somewhere there is a Mr Glass and a Mr Steagall looking on in disbelief. Haven’t we been here already?
To lead the debate over banking industry regulatory reform, President Obama chose former Fed Chairman Paul Volcker as chairman of the President’s Economic Recovery Advisory Board. The appointment was welcomed by the Republican side of the aisle, given Volcker was Fed chairman under the Reagan Administration and thus supposedly “one of us” in Republican eyes. But relief soon turned to disbelief among the capitalist fraternity when Volcker initially and loosely proposed regulatory changes that would once again see the forced division of commercial bank and investment bank activities. The proposed “Volcker Rule”, as it has become known, looked an awful lot like the same Glass-Steagall Act the capitalists had finally managed to scupper under Clinton.
Work has been going on behind the scenes for a while now and Obama’s health reform attempts have very much stolen the spotlight of late, but the reform process was stepped up to a new level just over a week ago when Obama suddenly launched his scathing attack on US banks, on their risk-taking activities and profits and indecent pay packages. Obama vowed to enact significant changes that would never again allow the American people to be “held hostage” by institutions deemed “too big to fail”, and threw down the gauntlet suggesting, “My message to leaders in the financial industry is to work with us, not against us. If these folks want a fight,” Obama threatened, “then it’s a fight I’m ready to have”.
The Dow Jones average responded by falling 200 points, led by financial stocks. Along with Chinese tightening measures and Greek debt concerns, Obama sparked a stock market correction. The loose intention at this stage is that commercial banks operating under government and Fed protection will not be permitted to, and will be forced to divest of, investment banking divisions such as hedge funds and private equity investment arms.
On Monday, the New York Times published an op-ed essay from Volcker entitled How To Reform Our Financial System. This morning US time Volcker made his first appearance before the bi-partisan Senate Committee charged with instituting regulatory reform procedures. In both cases Volcker’s beliefs were made clear. The bank bail-out of 2008 was completely necessary under the circumstances, but in order to avoid a repetition changes need to be made. Under a healthy capitalist system financial institutions such as hedge funds should be permitted and encouraged to innovate, take risks, and reap subsequent rewards. And under a healthy capitalist system they should also be allowed to fail in that endeavour. But hedge funds and other similar organisations should not be permitted to take such risks and reap such rewards when exploiting a “safety net” of taxpayer protection from failure.
In short, commercial banks and investment banks should be separated under law.
There are few in Congress, and even few on Wall Street, who do not agree something needs to be done. But for the free market protagonists, a return to a Glass-Steagall system is an ill-fated step back in time, and Volcker has defected to the ranks of the “social engineers” within the Obama Administration. From a populist point of view, you won’t get a lot of argument out of Joe Average. Particularly if Joe has recently lost his job and his house.
The Volcker Rule, at first blush (and Volcker readily admits we are only in the early stages of discussion) seems an inherently sensible and perhaps simple one. But realistically it is not at all simple.
If we leave for another day the argument over executive pay in the banking industry, there is a fair argument that the profits generated by banks beyond the simple business of community lending provides ongoing funds for business lending and subsequent job creation. In short, the US economy could never grow strongly without the recycling of such profits.
Another fair argument is that investment banking activities provide the liquidity required for commercial bank customers to enjoy various facilities such as aforementioned wealth management, foreign exchange, the hedging of exposures via derivative instruments and so forth. To delineate between standard commercial banking services and investment banking services would only disadvantage bank customers.
Another simpler argument is where do commercial banking services end and investment services begin? As noted, there is now a very grey area between the two.
An obvious argument from the US perspective is that such regulation must be global, not just national, or otherwise banks will simply re-establish offshore, or worst still US banks will lose business to foreign banks. This point is widely agreed upon, and indeed Volcker has also been asked to advise the equivalent British banking enquiry. There is little disagreement across the globe that any systemic financial regulation must indeed be borderless.
Clearly there are many factors to consider beyond that which a hasty, knee-jerk reaction on reform would sensibly consider. Then aside from the obvious difficulties in coordinating the regulation of many and various national banking systems, whatever Volcker’s committee comes up with as proposed legislation it then has to go to Congress, where it will be met by self-serving and ignorant House representatives, and on to the Senate, in which the Democrats have just lost a seat and certain leverage along with it.
In short, it’s going to be a long road from here punctuated by some seriously heated debate. If Obama’s health reform package is anything to go by, whatever the proposed legislation looks like at the outset, it will likely look a lot different by the end.
And while Australia has its own set of banking regulations, we have all Big Four banks involved in “investment bank” activities and we have a Macquarie Group which no one’s sure how to label at all. There is little doubt Australia will be part of any global regulatory reform package and the implications which come along with it.
But we’ve got a long way to go yet.
