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Financial system reform

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Financial system reform

I would have gone further than Paul Volcker and Barack Obama in limiting what bank holding companies that accept deposit insurance can do. I would have proposed a return to Glass-Steagall (G-S) for bank holding companies. Banking should be dull and boring.

Since the collapse of G-S in the late 1990s, there has been no evidence that the greater freedoms allowed the banks have contributed in any positive way to the performance of the U.S. economy. There are no signs that productivity growth rates have increased during the past decade. The U.S. economy does not appear to be any more competitive. Job creation has been stagnant in the decade following the repeal of G-S. So what was the upside, other than temporarily larger profits and rocketing compensation for bankers?

In Canada the banks have been able to engage in all types of investment banking activities for more than two decades. Here too there are no signs whatsoever that the freedoms for the banks have contributed anything positive to the Canadian economy. Mark Carney, the Governor of the Bank of Canada, continues to warn about the country’s dismal productivity performance.

Now let me give two examples where banks’ involvement in investment banking has not contributed positively to the economy — merger and acquisition advice, and underwriting.

A company should retain a financial advisor based solely on her/his ability to provide sound and objective advice regarding acquisitions, mergers and/or divestitures.  The banks quickly learned that they could win advisory assignments and the associated fees by allowing their investment bankers to use their balance sheets. Bank owned investment banks could and did offer prospective clients the certainty of financing for an acquisition.

Thus, CEOs, unconstrained by their boards, and eager to expand their empires, chose the banks’ investment banks as their financial advisors. So too did private equity firms which came to dominate acquisition activity in the latter half of this decade. Good objective advice was not wanted. Money and the ability to consummate a deal were wanted.

It should come as no surprise that most so-called strategic acquisitions have proved to be failures. It also should not be surprising that many highly leveraged, private equity deals during the past few years also have been failures. By the way, several of the major U.S. financial institutions have lost tens of billions of dollars on their loans to clients who bought companies.  And the financial institutions backing the acquisition of BCE were ecstatic when the deal fell through.

Similar problems are apparent in the case of underwriting. Prior to the entry of the banks, the independent investment banks had to put up their capital – the equity of the partners – at risk if they accepted an underwriting assignment. When you have your money on the line, you are going to be much more careful in assessing the merits of the deal.

Along came the banks, and the investment bankers put the balance sheets at risk in order to win the underwriting assignments. They did not see the risks because they expected to sell the equities or bonds very quickly, with the retail customers being the last resort – the ultimate suckers. All the bankers could see were the fees. They did not see the risks; apparently, neither did the boards of directors.

The ability to underwrite securities also allowed the banks to greatly expand the market for securitizations. The subprime fiasco might not have been as severe if the banks had not been able to peddle the garbage backed by the exploding mortgages.

I believe the onus should be on the bank holding companies to demonstrate how the repeal of G-S actually improved the performance of the economy. Their failure to do so should serve as a wake-up call to reinstate G-S. But even this will not prevent bankers from periodically making very stupid loans. There must be something in the water they drink.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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