BYLINE: By Martin
Mayer; Martin Mayer, author of "The Bankers" and "The Fed," is a
guest scholar at the Brookings Institution.
DATELINE: SHELTER ISLAND, N.Y.
BODY: Three years after the much longed-for repeal
of the Glass-Steagall Act, the 1933 law that prohibited commercial banks from
owning brokers and underwriters, investors are beginning to wonder whether maybe
the New Deal had got it right after all. There is speculation that Citigroup is
pondering the separation of the commercial bank and the investment bank now
conjoined in a financial conglomerate that became entirely legal only in
1999.
Bankers have been aghast as the Enron stain
spreads and touches the great names of finance. Last week, for example, Michael
J. Kopper, a former Enron executive, pleaded guilty to money laundering and
fraud. He gave up nearly $4 million in fees from a limited partnership that
served no purpose other than concealment of Enron's debt, and his partners
included Citigroup and J.P. Morgan Chase.
Deception is
invited by "structured finance," in which a bank's loans are broken into
different marketable assets -- each with its own risks, repayment schedules,
accounting treatment, tax consequences, even names. Organizing these
arrangements, as Citibank and J.P. Morgan Chase did for Enron, facilitates other
deceptions. If an institution is both a bank lending its own resources and a
broker selling its loans to the public -- and also includes an insurance company
with premium income to invest -- its senior officers and its favorite clients
are forever under the temptation once felt by the railway conductor who took in
cash fares.
It wasn't always this way, of course.
Neither the dot-com nor the telecom disasters could have occurred in a world
where basic financing for small and ambitious companies had to be funneled
through the lending officers of banks, who were trained to ask boring questions
about how the investment of the money they lent would pay back the loan and to
follow up at regular intervals. An expanding business had to return repeatedly
to its bank to finance its growth. Banks expected to have long-term relations
with the businesses to which they lent money. And the conditions of the loans
forbade the entrepreneur from cashing in his stock while the bank stayed on the
hook.
Segue to the modern world, where start-ups are
financed by venture capitalists. Once they and their entrepreneurs polish their
story to a high shine, both of them get a chance to take a lot of money out of
the company with an initial public offering. But the earnings of the business
itself are not the source of the repayment of the initial investment in the
venture. That money comes out of the pockets of the brokerage customers who buy
the stock in the I.P.O. And those customers then sell to those who know even
less than they do.
How did this happen? Faith in the
mantras of financial engineering bred contempt for the New Deal legislation,
which was designed to ensure that publicly traded companies and the financial
institutions that dealt with them would have to tell investors what and how
their businesses were doing. Legal walls were built to separate functions -- to
make commercial banks specialize in short-term loans and investment banks in
long-term ones, to insure saving deposits and to leave equity investments at
risk -- in the hopes of enforcing clarity.
As the world
grew more complicated, these separations became increasingly expensive.
Regulators collaborated in finding ways around the law, and eventually Congress
removed major restraints that had forbidden firms to mingle apples and oranges
and to move important activities "off the balance sheet." Over the counter and
behind closed doors, banks and investment banks "shifted their risks" by selling
complicated partnerships and derivative instruments to mutual funds, pension
funds and especially insurance companies.
It is
unrealistic to think we can go back to a time when banks did banking and
broker/dealers did markets. Technology has destroyed the information advantages
that kept each group profitable in its own area. But that same technology makes
it possible for corporations and financial institutions to live up to the spirit
of disclosure that was at the heart of the New Deal reforms.
We need legislation and regulation that will guard against more
unpublicized over-the-counter derivatives trades, against more
unreported sales of stock by chief executives to their own companies, against
more off-the-books creation of "special purpose vehicles" for which the special
purpose is concealment of losses or invention of revenues, against more
unreported giant loans to insiders, against more tie-in deals in which bank
secrecy hides favors that will be repaid later with lucrative work on mergers or
underwriting.
Most of these scandalous activities were
legal, and many still are. (Loans to insiders are now prohibited.) The vice in
each is that only the insiders know what is happening. The guiding principle of
the New Deal legislation was that sunshine is the best disinfectant, and that's
still true. Chanting the mantra that big boys can take care of themselves,
Congress in the 1980's and 1990's made it possible for consenting adults to do
financially awful things behind closed doors.
The new
legislation passed just before Congress left for recess improves disclosure in
only one area, closing some shelters that allowed insiders to postpone reporting
their trades of their own stock. Congress and the president should stop patting
themselves on the back and get to work restoring what is still viable in the
intelligent protections put in place during the New Deal.
