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The Role of Investment Banks in Deregulatory Environment
This report examines the impact of investment banks in a deregulated financial environment, highlighting their functions and historical context. It discusses major deregulation events in the U.S. and U.K., and how investment banks contributed to economic bubbles leading to financial crises. The research concludes that recent financial crises were more a result of regulatory failures than actual deregulation.
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The Role of Investment Banks in Deregulatory Environment
- 1. The Role ofInvestment Banks in Deregulatory Environment Term Report Course: Investment Banking and Security Analysis, Section A Submitted to: Sir Nayyar Nizam Submitted by: Aakash Kumar 11723
- 2. Scope The scope ofthis research is to know how investment banks have affected globally in deregulated environment. This report covers some basic functions of investment banking, what is financial deregulation and what are some major examples of deregulation in history of USA and UK. Research method for this research will be analyzing the secondary data. In this report, history of investment banking is described. After that how in deregulated environment investment banks create a bubble, which busted affecting million of lives. Finally a conclusion is drawn from all the information about the role of investment banking in deregulatory environment giving a brief overview of investment banks and deregulation. Introduction If role of investment bankers was to be described in few words it would be like this, 'They create and increase value of a company'. Investment banks issue, distribute and sell securities for the companies approaching them for their services. Investment banks have the expertise to initiate an IPO for big companies to provide them market in which they can sell it. They also under write the securities if the Inv. banks feel that they are reputable securities. Another service which investment banking provides, is consultancy and assistance in mergers and acquisitions (MandA) for companies. On the other hand investment banks are also involved in sales and trading of financial instruments. They buy and sell instruments in order make a profit on each transaction. As derivatives come into play, with highly complex structures products allowing them to offer high margin and returns as compare to cash securities. Deregulation is the process of removing or easing state regulations. Financial deregulation is easing the rules to which allow financial institutions to compete more freely. Whether such changes are beneficial or detrimental is still debatable. It is important to note that financial deregulation does not mean removing all rules or regulations. The best known form of financial deregulation in the United States came in 1999 when Congress repealed sections of the Glass-Steagall Act. This act, passed in 1933 during the depression, meant that any one company could only act as a commercial bank, an investment bank or an insurance company. A commercial bank offered savings and loans services to customers, while an investment bank carried out functions such as selling securities, trading in foreign currencies and assisting firms in mergers. Another form of financial deregulation took place in the United Kingdom involving building societies. These are financial institutions which were owned by their customers rather than shareholders and specialised in mortgage lending. After building societies began to compete more directly with banks in the 1980s, the government changed the law to allow them to demutualize. This meant that, if the society’s members agreed in a vote, it could change into a limited company. Since that time, every building society which demutualized has either been bought out by a bank or has been taken over by the government after experiencing financial difficulties.
- 3. Research Method Due totime constraints, this research will be conducted behind the desk, by searching and analyzing secondary data. Various articles, blogs and research papers are used to reach conclusion. Data was easily available on the internet, and the collected data was used to gather the information and for the completion of research. Synthesis History of Investment Banks The investment banking industry consists of firms engaged in activities related to issuing, distributing, and selling securities. They also provide merger and acquisition (M&A) advisory services and research coverage. This paper focuses on the major players in this industry. These have historically been Morgan Stanley, Merrill Lynch, Goldman Sachs, Bear Stearns, Salomon Brothers (merged with Smith Barney and later acquired by Citigroup), Lehman Brothers, Warburg (now UBS Warburg), and First Boston (now Credit Suisse First Boston). Relatively new competitors include JP Morgan Chase, American Express and Citigroup. Top foreign banks competing in the US market are Deutsche Bank and Dresdner Kleinwort Wasserstein. Investment banking in America evolved gradually out of the hodgepodge of financial services first available in the early 1800s. American Developments during the Civil War era The American need for capital attracted representatives of such European houses as the Barings, the Rothschilds, and the Speyers. Soon thereafter, a number of German Jewish immigrants with commercial, if not directly financial, family backgrounds – most notably the Seligmans, the Lehmans, Solomon Loeb, and Marcus Goldman – moved from assorted mercantile activities into private banking. American Developments during the Civil War era The American need for capital attracted representatives of such European houses as the Barings, the Rothschilds, and the Speyers. Soon thereafter, a number of German Jewish immigrants with commercial, if not directly financial, family backgrounds – most notably the Seligmans, the Lehmans, Solomon Loeb, and Marcus Goldman – moved from assorted mercantile activities into private banking. Post-Depression Era Following the great crash of 1929, public confidence in the system evaporated. Revelations of stock waterings, bank mismanagement, and slipshod practices on the stock exchanges finally broke the terms of the long-implicit compact between bankers and society. Fevered speculation in overpriced paper further tarnished the industry’s reputation. Industry self-regulation was no longer enough. Demands for external regulation could no longer be avoided. After years of functioning without stringent external regulation, the industry became, in the course of the decade, one of the most heavily regulated industries in the country. Post-WWII Era For nearly twenty years after WW II, not enough new business existed to strain the industry’s traditional pyramid structure, reinforced as it had been by the provisions of Glass-Steagall. The slow jockeying for position among established houses continued at its normally unhurried pace. With minimal real growth in the volume of securities to be underwritten and retailed, therefore, the
- 4. smaller houses hadlittle on which to base an upward move. In fact, six of the top eight firms in 1950 remained among the top eight firms three decades later. The 80s and 90s Few business benefited from the almost continuous eighteen-year period of economic prosperity from 1981-1999 as the U.S. securities industry did. At a time when US GDP increased at a compound (nominal) rate of 7%, U.S. and world equity market capitalization and trading volume increased at about twice that rate. The worldwide volume of new issues of equity securities increased at 19% and debt securities at 25%. The volume of worldwide mergers and acquisitions also increased by more than 25% per annum during the period. Deregulation and Investment Banking The story begins with mortgage lenders such as WaMu, which loaned money to home buyers and then sought to move those loans off its books. That activity spawned an ever more-complex market in mortgage-backed securities, a market that for a while worked pretty well. But then things turned upside down. The fees that banks and Wall Street firms made from their securitization activities were so large that they ceased to be a means to keep capital flowing to housing markets and became ends in themselves. Mortgages and mortgage-backed securities began to be produced for Wall Street instead of Main Street. Wall Street bond traders sought more and more mortgages from lenders in order to create new securities that generated fees for their firms and large bonuses for themselves. Demand for securities prompted lenders to make more and riskier mortgage loans. Making and packaging new loans became so profitable that credit standards plummeted and mortgage lenders began making risky, exotic loans to people with little chance of making the payments. Wall Street designed increasingly complex financial products that produced AAA ratings for high-risk products that flooded the financial system. As long as home prices kept rising, the high risk mortgages posed few problems. Those who couldn't pay off their loans could refinance or sell their homes, and the market for mortgage-related financial products flourished. But the party couldn't last, and we all know what happened. Housing prices stopped rising, and the bubble burst. Investors started having second thoughts about the mortgage backed securities Wall Street was churning out. In July 2007, two Bear Stearns offshore hedge funds specializing in mortgage related securities suddenly collapsed. That same month, the credit rating agencies downgraded hundreds of subprime mortgage backed securities, and the subprime market went cold. Banks, securities firms, hedge funds, mutual funds, and other investors were left holding suddenly unmarketable mortgage backed securities whose value was plummeting. America began feeling the consequences of the economic assault. Goldman Sachs was an active player in building this mortgage machinery. During the period leading up to 2008, Goldman made a lot of money packaging mortgages, getting AAA ratings, and selling securities backed by loans from notoriously poor-quality lenders such as WaMu, Fremont and New Century. Of special concern was Goldman's marketing of what are known as "synthetic" financial instruments. Ordinarily, the financial risk in a market, and hence the risk to the economy at large, is limited because the assets traded are finite. There are only so many houses, mortgages, shares of stock, bushels of corn or barrels of oil in which to invest. But a synthetic instrument has no real assets. It is simply a bet on the performance of the assets it references. That means the number of synthetic instruments is limitless,
- 5. and so isthe risk they present to the economy. Synthetic structures referencing high-risk mortgages garnered hefty fees for Goldman Sachs and other investment banks. They assumed an ever-larger share of the financial markets, and contributed greatly to the severity of the crisis by magnifying the amount of risk in the system. One of the claimed “deregulations” resulting from the mixing of investment and commercial banking was the increase in leverage by investment banks allowed by the SEC. After many investment banks became financial holding companies, European regulators moved to subject European branches of these companies to the capital regulations dictated by Basel II, a set of recommendations for bank capital regulation developed by the Basel Committee on Banking Supervision, an organization of international bank regulators. In order to protect its turf from European regulators, the SEC implemented a similar plan in 2004. However the SEC’s reduction in investment bank capital ratios was not simply a shift in existing rules. The SEC saw the rule as a movement beyond its traditional investor protection mandates to one overseeing the entire operations of an investment bank. The voluntary alternative use of Basel capital rules was viewed as only a small part of a greatly increased system of regulation, as expressed by SEC spokesman John Heine: “The Commission’s 2004 rule strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies.” The enhanced requirements gave the SEC broader responsibilities in terms of the prudential supervision of investment banks and their holding companies. Conclusion The past few decades have witnessed a significant expansion in the number of financial regulators and regulations, contrary to the widely held belief that our financial market regulations were “rolled back.” While many regulators may have been shortsighted and over-confident in their own ability to spare our financial markets from collapse, this failing is one of regulation, not deregulation. When one scratches below the surface of the “deregulation” argument, it becomes apparent that the usual suspects, like the Gramm-Leach-Bliley Act, did not cause the current crisis and that the supposed refusal of regulators to deal with derivatives and “predatory” mortgages would have had little impact on the actual course of events, as these issues were not central to the crisis. To explain the financial crisis, and avoid the next one, we should look at the failure of regulation, not at a mythical deregulation.
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