Global Banking: The Head Winds Of Regulation

It’s easy to argue that the global financial system is biased in favor of the banking industry. After all, the largest international financial entities have actually grown larger since the 2008 / 09 economic crisis, while benefiting from the now-institutionalized presumption that our governments consider them “too big to fail.”

But there are times when an entire industry finds itself facing the head winds of governmental oversight. Recently, for instance, a wide variety of news stories in the United States and across the globe addressed new proposals for the banking industry. And none of them – not a single one – proposed a policy in favor of deregulation.

Last week, for domestic banks that operate within the United States, three American financial regulators proposed doubling (yes, doubling) the capital reserve requirements of the financial institutions. Although the proposed standards would greatly surpass the reserve levels that are currently required under the global Basel system, the regulators asserted that they would provide reasonable protections against future fiscal crises.

Then another American financial regulator proposed that mysterious “dark pools” of trading activities, now operated by private organizations, should be required to disclose their activities. Finally, a trio of United States Senators announced an effort to reincarnate the Depression-era Glass Steagall prohibitions that separated traditional banking lines of business from speculative trading activities.

Meanwhile, on the global stage, Great Britain’s banking system stripped its own British Bankers Association (BBA) of authority over the deeply flawed London based Libor rate setting mechanism and handed it to NYSE Euronext. And the Swiss authorities agreed to move one step closer to the elimination of tax haven benefits within its once secretive banking industry.

Even the single news story that appeared to contain a glimmer of good news for the banking industry was, in fact, a story that pleased proponents of government oversight. The American financial regulator that sought to extend domestic bans on derivatives trading activity to foreign banking subsidiaries agreed to delay this extension for six months. Although lobbyists favored the outright cancellation of these extension plans, they were forced to accept a six month delay instead.

On the one hand, these news stories will likely fail to satisfy the Wall Street critics who continue to complain that very few financial professionals went to prison or were otherwise punished in the wake of the global economic crisis. On the other hand, though, the global financial industry is clearly tacking against the prevailing winds of regulation.

Wall Street And The Public Trust

Three weeks ago, JP Morgan announced that it lost $2 billion on a single hedging position. Then, one week later, the firm released information that suggested that the transaction might have been more of a reckless gamble than a conservative hedge.

And last week, the financial community was even more concerned about Facebook’s botched Initial Public Offering (IPO) than about JP Morgan. Bloomberg named it the worst IPO of the decade; others speculated that it might be the worst IPO ever.

Government officials are now investigating the JP Morgan and Facebook transactions. Indeed, they may discover that the public trust has been badly damaged, whether or not there were any legal transgressions.

We’re In The Money!

In the Depression era film Gold Diggers of 1933, Ginger Rogers zinged Wall Street with the sardonic anthem We’re In The Money! While that film played on screens across America, President Franklin Roosevelt busily signed laws to ensure that another Wall Street crash (like the debacle of 1929) would never occur again.

The Glass Steagall provisions of the Banking Act of 1933, for instance, banned commercial banks from engaging in many proprietary trading activities. And the Securities Act of 1933 prohibited publicly traded firms from “playing favorites” by requiring them to disclose relevant information to all parties simultaneously.

These regulations were designed to protect the interests of small investors. Thus, banks that accepted savings and checking deposits were prohibited from putting those funds at risk, and from selectively sharing insider information with wealthy investors.

Such regulations became bedrock principles that generated a level of trust in the American financial system that helped the United States maintain its pre-eminent position in global finance for decades. Last week, however, JP Morgan and Facebook did much to damage the public trust in the system.

Hedging Activities

JP Morgan’s black eye involved what CEO Jamie Dimon initially called a “terrible, egregious mistake.” He originally claimed that the recent $2 billion loss resulted from a poorly designed hedging contract that should have shielded the firm from incurring losses, but that inadvertently generated mammoth losses instead.

The Volcker Rule of the Dodd Frank Act is designed to reimpose certain Glass Steagall policies that prohibit banks from engaging in speculative profit-seeking proprietary trades. But the Volcker Rule doesn’t prohibit hedging transactions, which are defensive strategies that are designed to function as insurance policies by limiting trading losses.

Hedging positions are desirable activities, from the perspective of government regulators, because — when designed and executed properly — they minimize the risk of losses. But two weeks ago, we learned that the division that designs JP Morgan’s hedging contracts may have been striving to generate significant profits instead of (or in addition to) focusing on minimizing losses.

A hedging function that attempts to generate sizable profits? Under traditional banking guidelines, it shouldn’t be considered a hedging function at all. And yet JP Morgan decided to define it in this manner, which arguably allows it to continue to engage in proprietary trading activities.

Valuation Disclosures

Meanwhile, last week, the first day of public trading for Facebook got off to a bumpy start. The NASDAQ experienced technical problems and was forced to delay trading activities for approximately 30 minutes.

After that, Facebook’s embarrassment grew worse. The value of Facebook’s stock began the day at $38, an amount established by the firm and its IPO advisor Morgan Stanley, and ended the day at virtually the same level. But it reportedly only remained at that level because Morgan Stanley and its team of underwriters bought back the stock to prevent it from dropping below $38.

By the end of the week, Facebook’s stock was trading at $31.91, 16% below its initial $38 value. Clearly, the firms established an initial value that was too high. But did Facebook and Morgan Stanley simply make a mistake by asking investors to pay an inflated value? Or were they — in the words of former General Electric CEO Jack Welch, according to his Twitter posting on May 21st — “piggish”?

Furthermore, we recently learned that Morgan Stanley warned its major clients in advance that it had reduced its revenue estimates for Facebook. Thus, preferred clients were warned that the opening valuation might be too high, but the general public did not receive this information.

Although the Securities Act requires firms to disclose relevant information to the general public, Morgan Stanley decided to define its warning as “guidance” and not as “disclosure,” which arguably allows it to engage in selective communication activities.

An Issue of Trust

It is indeed possible that JP Morgan, Facebook, and Morgan Stanley may have complied with government regulations. If they have not broken any laws, they will certainly not be prosecuted for breaching the public trust.

Yet public trust in the American financial system may well be damaged if JP Morgan’s trading activities are permitted to be defined as hedging transactions, and if Facebook’s and Morgan Stanley’s selective disclosures are permitted to be defined as guidance. And without the public trust, the financial system cannot endure.

Glass Steagall: Is Breaking Up So Hard To Do?


That’s where the Dow Jones Industrial Average has been hovering for the past two weeks. Since surpassing 10,000 for the first time in over a year on October 14, America’s most watched indicator of market health has been flirting with 10,000, moving above and below that level but never straying far from it.

So what’s keeping the Dow from resuming its meteoric rise from the depths of the Great Recession, when it collapsed below 6,500 just seven months ago? Why is it suddenly pausing after soaring over 50% in less than a year?

Mervyn King believes that he knows the answers to those questions. In fact, he believes that the primary answer is embedded in a strategy that was first implemented 75 years ago.

Mervyn? Who’s Mervyn?

Mervyn King, of course, is the Governor of the Bank of England (BoE), which makes him the British equivalent of Ben Bernanke, Chairman of America’s Federal Reserve Bank. Mervyn, though, might prefer to describe the Fed as the American equivalent of the BoE, given that it was first established in the 1600s and actually served as a model for the Fed’s creation.

So why rely on a British central banker for advice about the American financial system? Well, as compared to the immense economic pain felt by Americans after the collapse of its banking system, the British have experienced even worse suffering. In fact, just last week, the British government revealed that its economy is continuing to contract even though the economies of the United States, China, and the Euro Zone have begun to heal.

Unfortunately, the British economy has been far more reliant on the financial services industry than the economies of most other industrialized nations. Although a soaring banking sector transformed the stodgy British Isles into Cool Britannia for several decades, its recent collapse has generated a level of economic malaise that reflects and amplifies the contemporary American experience.

The World According to King

Thus, the advice of Britain’s central banker may indeed be worth considering for insight into the challenge of jump starting America’s economy as well. After all, America itself is a child of the British Empire, and shares a special relationship with its ancestral parent that spans centuries of economic development.

King’s primary recommendation, though, might strike American economists as an oddly “retro” prescription. Namely, he believes that banks that are “too big to fail” should be broken into independent pieces, with low risk commercial banking functions segregated from high risk investment banking activities.

In other words, Mervyn wants to return us to the days of Glass Steagall, an American law that was enacted during the darkest days of the Great Depression. Its primary purpose was to mandate the very segregation that King is now espousing, even though it was overturned a decade ago as a quaint relic of ancient economic history.

Toasters vs. Supermarkets

Even today, the assumptions that supported Glass Steagall seem quite reasonable. Namely, Americans had a right to expect that their low risk savings and checking accounts were safe, even though their commercial banks might act rashly and go bankrupt. The federal government guaranteed the safety of these accounts, up to a reasonable limit, and was prepared to assume control of any bank whose survival became doubtful.

However, Americans had no right to expect the federal government to bail them out if they deposited their funds in other investment vehicles. Thus, investment banking organizations were allowed to fail, and citizens who invested in them were expected to deal with the consequences of their own financial choices.

Under Glass Steagall, commercial banks were thus restricted to a world of limited risk and limited returns, where the most daring growth strategy involved offers of free toasters as gifts for opening checking accounts. But these restrictions collided with Citibank’s vision of becoming a financial supermarket; the Republican Congress and the Democratic Clinton administration thus decided to abolish Glass Steagall in 1999. Around this time, Citigroup acquired the insurer Traveler’s, and the race to create global banking organizations was on.

Can It Be Done?

To be sure, many now argue that any new government restrictions on the financial services industry would do far more harm than good during this period of nascent recovery. They assert that such restrictions would impede banking institutions in their efforts to raise new capital, hire new talent, and pursue new business opportunities in their quests to repair their balance sheets.

Furthermore, even those who agree with King are silent on how the government would actually manage any banking breakups. Many believe that Citigroup, for instance, is simply too complex an institution to be dismantled quickly. And others accurately note that our federal government has been encouraging the development of new financial supermarkets through such mergers as the Bank of America and Merrill Lynch.

Nevertheless, as the Dow slows to a halt at 10,000, and as economists warn that future economic growth will be nothing like what we usually expect during times of economic recovery, it is reasonable to wonder whether a more drastic approach to government regulation is required. That is precisely the position taken by Mervyn King; only time will tell whether he is proven right or wrong.

Glass Steagall: A Protection Against Time Itself?

Are you curious about the events that sunk Bear Stearns and other financial institutions, kicking off a series of financial catastrophes that torpedoed the global economy? You might want to read William D. Cohan’s House of Cards, which occupies the #3 slot on the New York Times bestseller list for hardcover nonfiction this week. You can peruse the first nine paragraphs at no charge, courtesy of our friends at NPR; unfortunately, you’ll then need to purchase the remainder of the book if you wish to continue reading it!

Those first nine paragraphs, though, say quite a bit about the nature of Bear’s downfall … and they leave us feeling reminiscent about the good ol’ days of Glass Steagall. That particular legislation didn’t simply prevent banks from entering inappropriate lines of business; in a sense, it served to protect bank depositors and investors from the ravages of time itself.

What did Glass Steagall do? Passed into law during the heart of the Great Depression in 1933, it established the FDIC to ensure that money placed in savings accounts would remain protected. It also prohibited bank holding companies from operating investment houses, thereby compelling investment bankers at institutions such as J.P. Morgan to spin off into firms like Morgan Stanley.

The FDIC still exists, of course, but the investment banking prohibition was repealed in 1999. When President Bill Clinton signed the repeal into law, Senator Phil Gramm proclaimed “”We are here today to repeal Glass Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.”

Huh? Was Glass Steagall a law that was anti-freedom, anti-competitive, anti-growth, and anti-stability? From the post-meltdown perspective of today’s environment, a more nuanced view emerges.

Timing Is Everything

If preventing an organization from “doing whatever it wants” is anti-freedom, then Glass Steagall can certainly be considered anti-freedom. And to the extent that certain investors do face less competition when commercial banks are constrained from entering their investment space, then Glass Steagall can be considered anti-competitive as well.

But anti-growth? Citigroup took advantage of the repeal to enter the investment banking sector, and it certainly isn’t growing today. Instead, it’s shrinking its way to insolvency. And anti-stability? The financial sector is no longer looking very stable as it crashes to the earth, dragging the world economy with it.

One can only speculate what Senator Graham had in mind when he labeled Glass Steagall as anti-growth and anti-stability. Truth be told, Glass Steagall was never designed to preclude banks from operating in all other industries; it simply precluded them from entering the investment banking industry. And, as the first few paragraphs of Cohan’s House of Cards so clearly indicates, the problem that Glass Steagall addressed wasn’t one of competitive instability … it was simply one of timing.

A Time Bomb, Ticking For 30 Years …

Cohan clearly explains why firms like Lehman Brothers and Bear Stearns suddenly collapsed. Namely, for 30 years, these firms financed their operations by borrowing huge sums of money on the overnight debt markets.

The problem was that the collateral they pledged to secure their borrowings suddenly became unattractive to lenders late last year. Much of that collateral was invested in real estate mortgage securities, securities that will eventually recover in value as the real estate markets stabilize and then resume growth. But lenders in the overnight markets aren’t willing to wait years for the value of that collateral to recover. As overnight lenders, they continually demand repayment within 24 hours, and the real estate mortgage securities of Lehman and Bear will remain unmarketable for many years to come.

In a sense, Lehman and Bear faced the same problem that any homeowner would face if his mortgage banker were to demand “You’ve pledged your home as collateral to secure your mortgage. Now prove to me that you could sell your home tomorrow if I decide to call your loan for repayment tonight.” As long as the residential real estate remains healthy, that wouldn’t be a problem. But as soon as the market takes a dip, the homeowner might not be able to meet the mortgage banker’s demand, and might end up defaulting on his debt.

The Glass Steagall Solution

How did Glass Steagall address this problem? Simply enough, the law forced bankers to make a choice. If they wanted to continue to accept savings account deposits from the “man on the street,” deposits that they might need to repay in full at any time, they couldn’t invest those deposits in complex securities that might remain depressed in value for many years.

That’s why bankers like Henry S. Morgan and Harold Stanley spun off and established their own investment houses. They wanted to continue investing in securities that might remain illiquid for many years, and thus they agreed that they wouldn’t accept savings deposits from the “man on the street.” But beginning in 1999, banks no longer needed to make such decisions; instead, they were given the freedom to “do whatever they wanted” with their funds.

And now, what is the federal government’s solution to the problems that were caused by the repeal of Glass Steagall? Apparently, investment houses like Goldman Sachs and Morgan Stanley are being encouraged to convert to bank holding companies to gain access to federal bail-out funds. Such a policy arguably moves our economy even further away from the constraints that were originally established by Glass Steagall.

Is that a wise move? Time was an enemy of Lehman and Bear, and now only time will tell whether Goldman and Morgan will suffer the same fate.