Think Twice Finance

The Future Structure of Financial Institutions: Will the Fed Swallow the Investment Banks?

In the June 24^th WSJ (“Maybe It’s Time to Put the Banks and the Investment Banks Back Together.”) Dennis Berman forecasts the demise of investment banks. I could not disagree more with his thesis, that transaction-based institutions have become obsolete, since their ratios of risk to anticipated return have become excessively large. But I do suspect that if he waits a few years (perhaps less) it will appear that he’s right.

But that is because appearances deceive. What happened in the wake of the banking crisis was a naked power grab by global bank regulators, who have rewritten history in real time as this financial crisis has unfolded. They have created a convenient fiction - “The Shadow Banking System,” – an imaginary entity including some financial instruments and markets and some institutions, notably the investment banks, that regulators contend are “outside their purview.”

Nonsense. As I and several others have pointed out, the legislation that followed the Enron fiasco gave the accountants authority to eliminate the “variable interest entities” that gave the large banks the ability to take near-infinite leverage against mortgage vehicles. The accountants passed rules eliminating this practice, only to be thwarted by Federal Reserve lobbying to protect the banks’ ability to take what turned out to be unconscionable risks.

The investment banks had this power as well, but it is quite clear that the leveraged vehicles that precipitated the crisis were to be found primarily at the former “money center” banks that have been flopping around on the shores of finance for decades being kept alive by dubious regulatory decisions of this sort. Imagine the regulators’ glee when they discovered that a couple investment banks, whose philosophy more generally has always been anti-inventory, were so poorly managed that they held large inventories of these securities. Indeed in the case of Bear Stearns, management near-indifference to their problems, along with direct pressure from the Treasury, resulted in Federal Reserve assisted closure of the firm, sold to JP Morgan for a token amount.

This little slight-of-hand provided the opportunity to assign blame for excessive leverage to the investment banks, not the banks, and to give the whole idea of an unregulated shadow banking system some credibility. All you have to do is imagine that the regulated banks were not riskier than the unregulated investment banks, forget that the large banks have been unprofitable for a decade, and ignore the exodus of the quality banking talent from investment banks to the hedge funds and private equity firms, where bankers can still make money by being creative rather than by taking new government-subsidized risks.

So I think the days of a separate business called investment banking are indeed numbered, a belief that predated Bear Stearns, based on comments of bank regulators. But the investment bankers themselves will find a way to do their thing.