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Limits of Regulation

Omkar Goswami

We felt the ill winds. But few could have anticipated what has happened since Black Monday, 15 September 2008. Lehman Brothers became history after filing for bankruptcy on 14 September. John Thain sold Merrill Lynch lock, stock and barrel to the Bank of America for $50 billion. With AIG about to tank, US Treasury Secretary Henry Paulson eschewed high morals of “no more bailouts” for sensibility, and extended $85 billion credit to acquire 79.9 per cent of the company — thus nationalising it in the short run.

That didn’t help. Washington Mutual was teetering; Morgan Stanley’s and Goldman’s stocks were being hammered down. And there was real fear in the air. So, Paulson announced the mother of all bailouts — $700 billion to create a ‘bad bank’ that would sequester ‘toxic’ assets, create liquidity, clean up dud paper and shrink the financial sector’s balance sheets. But the US Congress turned down the proposal. While realising the need for this bailout to save the system, there were many Congressmen and Senators who were appalled at sinking such vast sums of taxpayers’ money to throw a lifeline to institutions whose employees behaved like fat cats.

Simultaneously, realising that the days of independent Wall Street institutions are over, Morgan Stanley and Goldman Sachs have opted to become bank holding companies instead of investment banks — thus agreeing to be supervised by the Federal Reserve as well as the SEC (Securities and Exchange Commission). This hasn’t helped Morgan, whose Chairman and CEO John Mack is still desperately seeking suitors for the battered bride. Lloyd Blankfein of Goldman, a canny mogul who exited mortgage-backed paper at the right time with tidy profits, has been luckier. He has found a groom in Warren Buffett, who has agreed to invest $5 billion.

In hindsight, it is all too easy to crow, “I told you so”. Instead, we should be asking two questions: will being banks help the last three standing — JP Morgan Chase, Morgan Stanley and Goldman Sachs? And second, will there be more stringency in governmental and regulatory supervision?

To understand why these institutions became investment banks, we need to go back to the Glass Steagall Act, 1933. Major bankers and brokers were indistinguishable in the late 19th and early 20th centuries. With the Great Depression, the US Congress was convinced of severe conflicts of interest between banks and their broking arms to the detriment of ordinary depositors, and passed Glass Steagall. It created major legal barriers to the mixing of these activities, separated banks according to their business, and founded the Federal Deposit Insurance Company for insuring bank deposits up to a limit.

Glass Steagall was repealed in November 1999, but many investment banks chose to remain where they were because it kept them outside the stricter regulatory supervision of the Federal Reserve. And in the heady last nine years, the constraints of non-deposit financing were overcome by the kind of astronomical leveraging that no regulator worth his salt would have permitted any bank to do. Taking on various forms of debt up to 75 times equity was considered great business.

Becoming commercial banks will give the Big Three access to cheaper depositor funds. But that won’t help unless they learn to discipline themselves. That’s unlikely. For one, there are no Chinese walls in the world of integrated finance. For another, smart, greedy, testosterone injected investment bankers and brokers, whose compensations depend on the money they make on other people’s money, will find myriad ways of using depositor funds for riskier businesses. Such excess risk taking won’t happen immediately due to the present milieu and because there will be stricter US laws and greater governmental supervision — as it was with the Sarbanes Oxley Act. Expect tough regulations and witch hunting in the near future.

History tells us that regulatory toughness disappears in good times. Smart Wall Street cookies with their lawyers and rating agencies will find ways of circumventing regulation to promise gold. We know that the rating agencies are a joke. A few years ago, S&P had given Fannie Mae a higher corporate governance rating than Infosys! Just as it gave AAAs to funny paper.

So, while the geography of Wall Street will change, never believe that greed won’t rear its hydra head. And don’t be taken in by the notion that having both commercial and investment banks under a holding structure will mitigate risks. Innate prudence mitigates risks. Where that doesn’t exist, nothing does.
Published: Business Standard, October 2008


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