Corporate Governance

The Elimination of Glass Steagall, the Harm to the US Capital Markets, and the Decline in IPOs

By J Robert Brown Jr.

As Congress debates how to handle derivatives by large financial institutions, lost in the debate is the structural harm to the capital markets that resulted from the repeal Glass Steagall. 

Glass-Steagall separated commercial banking and securities activities.  Essentially, investment banks received a monopoly on equity offerings and had every incentive to promote active capital markets.   The end of Glass Steagall allowed commercial banks to enter the securities markets essentially without limit. 

As was easy enough to predict, commercial banks would eventually oust investment banks from the area.  Commercial banks have inherent advantages including access to deposits and the discount window.  This financial crisis left only two large free standing investment banks in place (Goldman and Morgan Stanley, although both have converted to commercial banks).  Gone were Lehman, Merrill (now a sub of BofA) and Bear Sterns (acquired by JP Morgan). 

Why does it matter?  Commercial banks are more conservatively managed (particularly given the regulatory oversight of the Federal Reserve Board) and have a conflict of interest.  They have an incentive to encourage lending relationships rather than equity offerings.  Mostly, though, they are not singularly committed to the capital markets and more risk averse.  

Where might this disappearance of the investment banks show up?  In the market for equity IPOs.  Numbers have improved from last year but are still anemic, nowhere near the levels of 2007.  Many are trading in the secondary market at prices below the offering price.  One source recently described the IPO market in the US as "just plain broken." Perhaps the decline in the number of large independent investment banking firms is part of what is broken in the equity markets. 

The reality is that sometimes regulation helps the markets function better.   A knee jerk position that regulation is always bad and must be minimized is not particularly consistent with vibrant capital markets.  Repealing Glass Steagall may be a good example of that mistaken view. 

Full post as published by The Race to the Bottom on June 21, 2010 (boomark / email).