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Corporate Governance: The Race to the Bottom
Glass Steagall, The Capital Markets and the Volker Rule
By J Robert Brown Jr.
Glass Steagall was adopted during the Great Depression. The effect of the legislation was to keep commercial banking (deposits and loans) separate from investment banking (underwriting and M&A activity). One consequence was that commercial banks were mostly kept out of the equity markets, reducing the amount of risk they could undertake. This was not to say that commercial banking was risk free. There were plenty of examples of banks failing because they found themselves over committed to a particular market segment, say energy, and collapsed with the market.
But Glass Steagall had another affect. As set out in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act, Glass Steagall allowed for the rise of a world class, powerful set of investment banks. In effect, the law prevented commercial banks from absorbing and taking over the investment banking industry.
The takeover was inevitable because over time commercial banks have inherent advantages, including access to low cost funds (deposits) and access to the Federal Reserve window. Moreover, as the article pointed out, just before Glass Steagall was adopted, the commercial banks were in the process of taking over the industry. Indeed, Glass Steagall required some banks to separate their commercial and investment banking parts (JP Morgan & Morgan Stanley as one example).
The consequence of separating the two areas meant that investment banks focused not on lending relationships but on relationships that centered around the capital markets. They had an incentive to understand the capital markets and they had an incentive to encourage companies to rely on the capital markets. In short, they were a class of intermediaries that promoted active capital markets.
With the end of Glass Steagall, commercial banks have, for the most part, taken over the investment banking business, just as they were seeking to do in the 1930s, before Congress acted. Before the most recent financial crisis there were five world class investment banks: Goldman, Morgan Stanley, Merrill, Bear Sterns, and Lehman. Bear is part of JP Morgan; Merrill is part of BofA. Lehman, of course, is gone. Only Morgan Stanley and Goldman remain (afer both converted to commercial banks).
Does it make a difference? First, as one can see from the latest problems at JP Morgan, commercial banks engaging in market activities take on enormous risk. But there is a deeper problem. First, commercial banks can offer companies both lending and underwriting services. In other words, they are not completely dedicated to the capital markets. Second, at least historically, commercial banks, because of more extensive regulatory oversight, were more conservative. They could be counted on not to push the capital markets envelope as hard as a traditional investment bank. Both are bad for the capital markets.
The Dodd-Frank Act added the Volker Rule, a provision that prohibits banks from engaging in proprietary trading and from sponsoring a hedge fund. This is not Glass Steagall. Banks can still engage in market activities with their client's money. Moreover, it does not guarantee a source of business for investment banks that do not want to engage in commercial banking activity. Those subject to the Volker Rule can farm out their proprietary trading activity to another commercial bank.
But this Blog will over time discuss the impact of the Volker Rule on the investment banking industry and the US capital markets.
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