DIVEST INVESTMENT BANKING FROM FINANCIAL INSTITUTIONS. by
Hrishikesh D. Vinod, August 12, 2002
Professor of Economics, Fordham University, Bronx, New York Director: Institute of Ethics and Economic Policy
E-Mail: Vinod@fordham.edu This paper is also posted at:
http://www.fordham.edu/economics/vinod/cie/divest-inv-bk.pdf ABSTRACT
Congress must be applauded for the corporate governance reforms enacted in Sarbanes-Oxley Act of 2002, although some areas involving Banks and Brokerage houses need further reform. This paper argues that we need to cancel the spirit of the 1999 repeal of the 1933 Glass-Steagall Act by forcing Banks and Brokerages to divest their investment banking divisions. The repeal was justified in 1999 during the bubble phase of the stock market on the grounds that the Glass-Steagall Act was outdated in the era of the Internet and new derivative financial instruments. In light of Enron and numerous accounting scandals we argue that a divestiture of financial institutions will benefit (i) the
stockholders of financial institutions, (ii) employees of financial institutions, (iii) stockholders of other corporations, (iv) management of other corporations, and (v) general public. It will curb some powers of the top management of financial
corporations, and hence we expect them to oppose any breakup. We ague that the divestiture will be simpler, low cost and much easier to enforce than complex “Chinese Wall” type separations and self regulations proposed by the top management of financial corporations. Divestiture will remove a basic conflict of interest embedded in their structure. It will let SEC focus on finding the crooks and not get bogged down in micromanaging internal memos going back and forth within financial institutions. JEL Categories: G34, G28, D21, D43, D73, F36, M41
1. Introduction.
After the great depression started in 1929, over 11,000 banks had failed and
Congressional hearings in early 1933 showed that bankers and brokers had abused the public trust, not much different than recent hearings. Senator Carter Glass and
Congressman Henry Steagall’s efforts led to the passage of Banking Act of 1933. Senator Glass strongly believed that dealing in corporate securities by banks was detrimental to the federal deposit insurance and wanted banks to stick to the basics of taking deposits and making loans. Steagall was more interested in helping farmers and rural banks and his amendment created authorized bank deposit insurance for the first time. It is the sections 16, 20, 21 and 32 of the Banking Act that separate securities operations and investment banking from other activities of banks that are commonly understood as Glass-Steagall Act.
In 1971 US Supreme Court held that banks cannot offer mutual funds and that the Act was intended to protect the depositors from unsafe speculations and conflicts of interest. More recent regulatory rulings have softened the 1971 Supreme Court decision to disastrous consequences. Also, the Act did not prohibit banks from selling securities outside US.
Glass-Steagall Act was repealed in 1999. Currently, commercial banks are allowed to provide investment advise, brokerage activity, underwriting, investment and trading in mutual funds, joint ventures, etc. The erosion of Glass-Steagall provisions started in 1985 when the Federal Reserve decided to allow commercial banks be advisers and agents in private placement of commercial paper and have highly profitable investment banking divisions. The power and influence of these divisions has steadily grown within large money center banks. Buying of original issues of corporate paper for commercial resale is the investment banking activity permitted since 1999. It was supposed to help one-stop shopping for consumers leading to great convenience. It was also argued that European countries do not have Glass-Steagall-type separation.
Three abuses were mentioned in 1971 Supreme Court arguments. (i) Banks speculating with depositor money by investing in securities. (ii) unsound loans made to corporations to shore up the stock market prices. (iii) Bank officials pressed their banking customers to buy those securities that were underwritten by the bank. The idea was simply to erect a firewall so that if the investment-banking side caught fire (suffered losses), it will not burn the deposits insured by taxpayers.
2. Recently Revealed Abuses by Financial Institutions.
In modern times savers are not only depositors in banks but invest in Savings and Loan Associations (S&Ls). A significant number of common people now hold common stocks and bonds either directly or in . The saver is ultimately protected up to a limit (e.g., $100,000) by the taxpayers through FDIC, FSLIC, and SIPC insurance, either directly or indirectly. We can credit these insurance schemes for preventing a major panic leading to anything like the great depression of 1929 during the recent stock market downfall. American public knows that major financial institutions will not be allowed to fail. This section indicates evidence that financial institutions have become abusive, reckless and arrogant.
The $30 billion IMF bail-out of Brazil in early August 2002 is also designed to help US lenders to Brazil and follows a long history of taxpayer bail outs including S&Ls,
sovereign lending in the 1980s and others. According to recent revelations, CEOs of now bankrupt firms like Enron received active participation from financial institutions in
schemes designed to defraud ordinary shareholders, while enriching the CEO cronies and some financial firm executives and select clients. Merrill group of 96 executives led by Mr. Tilney invested $16 million of their own money in lucrative off-balance sheet partnerships for Enron. Enron’s four so-called Yosemite deals with the Citibank recorded future deliveries of oil were booked as cash flow instead of debt, misled the investors and rating agencies, with full knowledge and participation by Citibank. J. P.
Morgan Chase was involved with Enron in Mahonia derivative deals. If investment-banking divisions were separate legal entities, these questionable deals would not have hurt investors and preserved the reputation of these financial institutions, not to mention the cost of defending the firms against potential criminal liability.
Recent revelations since the Enron bankruptcy have indicated the continued presence of the three problems mentioned at the end of the last section. Perhaps the only difference is that the newer problems appear under more sophisticated and complex clothing. In April 2002 Merrill Lynch and New York Attorney General Eliot Spitzer reached an agreement that imposed a hefty fine of $100 million on Merrill. The fine was imposed because several E-mails showed that Merrill gave high ratings for stocks for which Merrill was acting as the investment banker, despite serious doubts expressed by Merrill’s own research analysts. The evidence showed a lack of independence of research analysts from Merrill’s investment banking division. On May 8, 2002, Harvey Pitt, the chairman of SEC adopted new ethics rules for stock analysts to deal with the conflicts of interests with the personal holdings of the analysts requiring full disclosures. I believe that the conflict of interest between investment banking and research analysis is at the level of corporate interest of Merrill itself and this is not fully addressed by Mr. Pitt’s ethics rules. For example, a bond analyst Mr. Scotto at a French securities firm BNP Paribus, which had investment banking relation with Enron, lowered Enron’s rating from “buy” to
“neutral” in his August, 23, 2001 research report. He even noted that Enron did not have hard assets. Enron complained about Mr. Scotto’s report, he was immediately demoted, put on family leave and fired on Dec. 5, 2001. Another example of how Enron was able to intimidate analysts follows. Mr. Chung Wu of UBS Paine Webber wrote the opinion to take some money off the table by selling Enron stock at $36.88 on August 21, 2001. Mr. Patrick Mendenhall of Paine Webber wrote back to Enron that Paine Webber continues to have buy recommendation and fired Mr. Wu in less than three hours on that same day. Similarly John Olson at Merrill Lynch criticized Enron and caused “visceral” dislike from Enron upper management leading to his dismissal.
These examples show that seemingly independent securities analysts were actually promoters of securities, handsomely compensated by the investment banking divisions of these financial institutions. An ‘independent’ analyst named Jack Grubman of Salomon Smith Barney helped fuel the telecommunications balloon, which has now burst causing losses in billions. Why did he get insider information and attend meetings of the boards of directors of these companies?
So called “Chinese Wall” requirements state that Wall Street firms receiving information in their capacity as investment bankers cannot share it with other parts of the firm. The intent of this law obviously excludes information about serious accounting fraud by company. American accounting firms advised Veba the utility company in Germany to not go forward with a 1999 merger with Enron due to accounting fraud; they failed to alert the investors about it. The “Chinese Wall” requirements prohibiting information exchange have clearly failed and did not help prevent Enron or a long list of other frauds and bankruptcies.
A July 15, 2002 letter by Sandy Weill for Citigroup proposed to prohibit four types of activities: (i) research analysts attending meetings with investment bankers. (ii) analysts form attending sales road shows to investors. (iii) investment bankers from
recommending analysts for changed compensation. (iv) investment bankers from
previewing research reports. These are window-dressing attempts to avoid the potential strictures of Glass-Steagall Act by appearing to do something to enhance investor confidence. Unfortunately, these kinds of information barriers are merely an attempt to extend failed “Chinese Wall” regulations which have proved to be impossible and costly to enforce. They do not address a deeper conflict of interest at the corporate level. 3. A proposed Solution consistent with Glass-Steagall Act
Our solution is an extension of Vinod (2002). That paper had called for a divestiture of investment banking division from the remaining financial institution back in January to prevent future Enrons. The more recent events since January have further confirmed that investment-banking divisions should be split apart from the rest and receive no taxpayer protection, giving them the necessary incentive to be diligent. It should be made clear that investment bankers are fundraisers who design (complex derivative) financial
instruments for corporate clients. They can go bankrupt if they fail to satisfy their clients and deserve no taxpayer bailouts. The important point is that the buying and selling side of risky portfolios should be represented by distinct legal entities. The delegates to an anti-corruption seminar held on August 7 and 8 at Fordham university hosted by Vinod expressed satisfaction about the recent Sarbanes-Oxley Act and supported the view that we need to bring back Glass-Steagall Act provisions if we are to protect common investor and improve the level of confidence in US stock markets.
The licensed security analysts should work only for the interests of the buyers of risky security instruments, that is for the savers. Their clear mandate should be to inform the savers about the true financial condition of corporations selling the instruments, its
prospects, its risks, etc. The sellers of securities should compete in convincing the buyers that they are offering the best deal. The sellers should not have any inside tract to the savers’ moneys. The analysts deserve “freedom of expression” and should be judged on the basis of their own skills at carefully studying the balance sheets and bringing out any hidden secrets materially affecting the prospects of the corporation.
Financial institutions like Merrill Lynch and Citigroup should not be allowed to pretend to represent the interest of ordinary savers, while secretly serving the corporations by providing them with more lucrative investment banking business. The conflict of interest between the buying and selling sides is too huge and obvious to be solved by tough talk and self-regulation. It cannot protect the depositor, saver, investor or shareholder. Even the shareholders of financial institutions depend on the reputation of these institutions and will not be well-served in the long run by abusing their fiduciary role and unloading worthless stocks on unsuspecting savers for making quick profits from investment banking divisions.
Upon breakup, the current shareholders financial institutions will receive appropriate number of shares of the divested investment banking divisions. We claim that divestiture of investment banking divisions of most financial institutions can be easier than the 1982 creation of Baby Bells. Now we argue that the proposed divestiture of investment banking divisions will benefit almost all stakeholders.
(i) The stockholders of financial institutions will most likely see the value of their shares increase. This did happen when Baby Bells were created. There are many other examples where the sum of values of parts exceed the value of the whole.
(ii) Employees of financial institutions will benefit since their mission will be more clearly defined. They will either sever the individual saver or corporate client.
(iii) Stockholders of other nonfinancial corporations will get efficient investment banking service and proper investment advice regarding viability of their expansion plans by experts.
(iv) The management of other nonfinancial corporations will benefit from more focused investment banking advice.
(v) The general public will benefit from superior allocation of savings to best-yielding activities leading to higher living standards, greater trade, and greater investment. The general public will also benefit from reduced costs of regulation of financial institutions. The four regulations proposed in Weill’s August 2002 letter are difficult and costly to enforce. A divestiture will independent create arms-length organizations. To the extent that there are economies of scale in financial services to consumers, they will not be affected. Investment banking activities also enjoy economies of scale. Some economies in jointly providing the two will be lost. But it is the price we have to pay to avoid future Enrons.
The people most likely to oppose the divestiture are the top management of financial corporations, since their powers will be reduced. We ague that the divestiture will be simpler, low cost and much easier to enforce than complex “Chinese Wall” type separations and self regulations proposed by the top management of financial corporations. Divestiture will remove a basic conflict of interest embedded in the structure. It will let SEC focus on finding the crooks and not get bogged down in micromanaging financial institutions.
No institution can simultaneously represent the best interests of both buyers and sellers of financial instruments. It is impossible for the left hand to do anything that hurts the right hand. As we found out with Enron, its board of directors allowed top executives to do what they wanted and readily granted timely “exemptions” against legal codes of
conduct. If millions of dollars in profits are at stake, does anyone doubt the ability of top executives to get any exemptions from internal codes of conduct? Prof. Amita Shankar Director of Research of NJBIZ, the leading business weekly in New Jersey, suggested at the Fordham seminar that the corporate names of divested investment banking divisions should be distinct to avoid any impression that they enjoy FDIC-type protection.
References:
Vinod, Hrishikesh (2002) "Winners and Losers in Multiple Failures at Enron and Some Policy
Changes," Social Science Research Network (SSRN), Jan. 2002. http://papers.ssrn.com/paper.taf?abstract_id=300542
