WASHINGTON, May 7 (UPI) -- As the great stock market bubble has unwound, it has become clear that the late 1990s business model on Wall Street, of financial supermarkets offering one-stop shopping to consumers and businesses alike, was nothing more than an overheated incubator for conflicts of interest. The Wall Street that emerges from the long recession will look very different.
The Sarbanes-Oxley Act and the settlement by New York State Attorney Eliot Spitzer have only attacked the edges of the problem of conflicts of interest, and their effects are likely to be both blurred and exacerbated by three factors going forward:
-- The expected tsunami of class action suits (most of which will fail, but enough of which will prove lucrative to lawyers to be a major financial drain on the industry);
-- A continuing lengthy revenue drought in all areas of the financial services industry except possibly commercial banking, with low share trading volumes, low corporate finance activity, and reduced portfolio values leading to lower asset management fees;
-- An increasingly hostile political climate, with a likely Democrat Congress and maybe president after 2005 seeking someone to blame for the ongoing economic difficulties.
It is of course to be expected that the class action suits and the Congressional activity will be poorly aimed in terms of reforming the financial services industry, putting entities out of business that ought to survive and imposing restrictions like the 1934 Glass-Steagall Act's separation of commercial and investment banking that fail to address real problems and severely affect the industry's health. (One of the reasons why the 1930s depression became the Great Depression is that following the separation of commercial and investment banking by Glass-Steagall, the U.S. capital markets were moribund, with tiny new issue activity, throughout the middle and late 1930s.)
The conflicts of interest that need to be sorted out are of several types:
-- Investors/issuers. They are on opposite sides of the fence without question; issuing houses shouldn't be selling investment advice. Nor should merger and acquisition advisers.
-- Retail investors/institutional investors. The latter are more sophisticated, and individually more important to the investment banks (which effect is magnified by Institutional Investor magazine's all-star analyst poll, a crucial determinant in analyst compensation.) Hence retail investors will get treated badly in a house which has a large institutional investor business, with accompanying analyst teams.
-- Mutual funds and retail brokers. Retail brokers sell "load" mutual funds, with a front-end sales charge, rather than the "no-load" funds that are more advantageous for investors.
-- Derivatives traders/shareholders. The advent of derivatives has led to a host of accounting and valuation games that can be played, whereby positions appear profitable but contain hidden dangers or losses, so that traders and management benefit at the risk -- and normally, ultimately, cost -- of shareholders.
-- Management/shareholders. In large investment banking institutions, management seeks to attract inordinate amounts of shareholder capital in good markets, because the returns on that capital can be used to justify ever-increasing bonus payouts.
-- Proprietary trading/customers. If an investment bank is heavily engaged in proprietary trading, it is very difficult for its customers to be sure they get the best trades and advice, since they are competing with the bank's own book.
-- Proprietary trading/deposit insurance. If management or traders are rewarded by a percentage of profits on proprietary trading (which may be in a "commercial banking" product like foreign exchange) then the deposit insurance system is endangered by their propensity to take additional risks.
You will note that the original conflict of interest that Carter Glass and Henry Steagall worried about, between deposit taking and underwriting, is not on this list. As the London merchant banks demonstrated for centuries, it is perfectly possible to combine commercial and investment banking without a significant conflict of interest; the conflict arises when proprietary trading and brokerage are added to the mix.
From the above list, it is clear that a sound financial services industry would include a number of structural changes:
-- Institutions whose deposits are insured should not be permitted to engage in proprietary trading, issue underwriting or institutional block trading. There is however no reason why banks with insured deposits could not engage in retail investment management and brokerage.
-- Issuing houses should not be permitted to engage in investment advisory work or retail brokerage. They will often be small firms, concentrating on issue management and merger and acquisition advice. Issue underwriting will primarily be undertaken by market participants with substantial amounts of risk capital (but without deposit insurance).
-- Institutions that engage in proprietary trading should not be permitted to engage in brokerage, issue business or investment banks -- essentially, they will be pure hedge funds, probably including a derivatives business and an issue underwriting capability.
-- Institutional and retail brokers will be separated; the latter will often but not always be part of banks, and may also sell insurance, real estate, and of course mutual funds, both load and no load.
-- Sell-side analysts will be separated into institutional and retail, the former being generally better paid and more famous.
-- Fund management companies may manage money for both institutional and retail investors; in the latter case, they will have no brokerage operation and will normally be of the "no-load" mutual fund variety.
The resulting financial system would look somewhat like a much better regulated version of the U.S. financial system before 1929, but with elements of pre-1986 London and of Switzerland.
-- There would be retail banks, with deposit insurance -- think Bank of America with some or all of a retail brokerage, retail fund management and analysis capability.
-- There would be institutional banks, without deposit insurance, which would not be permitted to accept retail deposits but would have a large capital to undertake corporate lending, corporate finance, trading, analysis, institutional brokerage and underwriting business -- think the pre-1929 JP Morgan.
-- There would be specialized corporate finance houses, without a lending business or an underwriting capability, undertaking issues and mergers and acquisition business on a fee basis -- think the Morgan Stanley of the 1960s.
-- There would be specialized analysis houses, offering high quality analysis on a fee basis, to institutions and private banks.
-- There would be large mutual fund companies -- a species that did not exist before 1929 -- which would undertake retail no-load mutual fund management, retail fee-based financial advice and retail brokerage -- think Vanguard or Fidelity.
-- There would be specialized "private banks" offering a full range of international banking, analysis, brokerage and fund management services to high net worth individuals, but doing no institutional business -- think Switzerland.
-- There would be big hedge funds, engaging in proprietary trading, arbitrage and issue underwriting, which would generally be partnerships, perhaps with some outside institutional money -- think Kohlberg, Kravis and Roberts.
The resulting system would be free from conflicts of interest -- or at least far freer than the current system on Wall Street. It would also be "ecologically" much more diverse than the current system, with a greater degree of specialization in each of the different types of institutions.
Getting from here to there, unfortunately, will require an ability to let the market work, and to restrain the courts and the regulators, which may well be beyond us in the short or medium term. But by 2025, when the 1990s bubble and its practitioners have passed into history, it's likely that a new Wall Street along these lines will be emerging.
