The Rush to 'Bigger' Contains Seeds
Commentary IHT March 24 1999
By Philip Bowring
Hong kong: It seems like
nirvana for the financial services world.
The Dow Jones industrial
average if flirting with five digits, persuading even the most staid
private investment bank on Wall Street, Goldman Sachs & Co, to sell
stock to the public. The Banking Committee of the US House of Representatives
has finally approved a bill to enable "one-stop" combinations
of banking, securities, insurance and fund management. Big banking mergers
have even spread to Europe.
But the "bigger is better"
euphoria should really be seen as a warning sign of possible disaster.
For while deal-makers may applaud full-throttle consolidation, the process
will only exacerbate conflicts of interest that are already inherent
in the global financial system.
If US Legislators need any
hint of the potential concerns, they need only look to Asia The House
committee decision two weeks ago, for example, came as Goldman was apologizing
to the Thai government for a securities analyst's report criticial of
the leading local bank. The row had led to calls for Goldman to be barred
from lucrative investment banking opportunities.
Securities firms have always
had to walk the fine line between advising clients and the more lucrative
business of investment banking. And Bangkok may seem a world away from
Washington. But these conflicting interests can only grow with further
consolidation and cannot be brushed aside as simply an Asian problem.
Many people in the industry
readily acknowledge that the "Chinese wall" that is supposed
to exist between the investment banking and research operations of a
securities firm is more often like a bamboo curtain. There are formal
compliance rules, but information and influence flow freely, if informally,
and the investment-banking side makes more money and has more clout.
Even firms that scrupulously
observe the spirit as well as the letter of the rules easily find themselves
subject to pressures to be "bullish" about certain countries
or sectors because that is where the investment banking opportunities
Even in such a s diverse
marketplace as the United States, such conflicts occur Barron's magazine
recently noted that the investment banking arms of securities firms
whose analysts have been skeptical of the Internet craze have been failing
to win business related to high-tech companies' initial public offerings.
It is hard to imagine that
even bigger financial agglomerations are going to do anything but reduce
the competition and transparency that are the best investor protection.
Universal banking - investment
and commercial banking under one roof - has long existed in Europe.
But the big European institutions, in the past at least, have been driven
by their commercial banking arms as their investment banking and other
services have lacked the innovation and trading fervor of their US counterparts.
That has kep their power in check.
The closer the links between
trading and commercial banking - and the congressional banking bill
would speed the blending process in the United States - the more likely
bank capital is to be put at risk to generate trading profits.
There are other dangers to
the system and to the public.
Take derivatives, in themselves a legitimate and necessary part of the
financial system. It is now well enough established that, in the past,
well-known houses were devising and very profitably selling fiendishly
complex derivative securities designed to get around regulatory barriers.
In the United States they
enabled pension funds to take big risks while nominally staying within
requirements that they buy safe government securities. In Japan, banks
used them to hide huge foreign exchange losses.
The greater the degree of
combination in the financial services sector, the less the transparency.
Yet transparency is supposedly the key to good market regulation. The
bigger the combination, the greater the temptation of conglomerates
to throw more capital at the riskier sides of the business. Moral hazard
increases with vertical integration, systemic risk with size.
Though the structures of
Western institutions are very different from those Japan, the ultimate
effect may be similar to the Japanese "convoy" system - in
which banking problems are difficult to root out because of the intricate
financial couplings that link banks deemed "too big to fail".
There are plenty of other
conflicts of interest in the marketplace. The big investment banks make
much of their money from the trading of securities. In theory, it is
possible to reconcile this with advising governments on issues such
as foreign-exchange policy or privatization. In practice, it is almost
impossible to separate the two. Can one really give advice on how to
bolster asset prices and limit bank losses while operating "vulture
funds" designed to acquire distressed assets at the lowest possible
Separation of powers needs
to exist in financial services just as much as in government.
Even the most scrupulously
run institutions can get caught out. While accounting standards are
constantly being improved -- often in the face of suggestions that such
moves are "anti-business" - improved standards alone cannot
keep up with the furious growth of sophisticated instruments such as
derivatives. This month the US Securities and Exchange Commission, the
Federal Reserve and other federal agencies saw fit to issue a joint
letter to financial institutions urging enhanced disclosure and increased
credit-loss provisions for such activities. Surely that should have
been a sign of worry.
At the retail level, too,
dangers lurk. It is doubtful whether there really is synergy - as supporters
of financial services bill have contended - between retail banking and
sales of mutual funds and life insurance. Banks simply want to get more
into these businesses because their traditional business is being eroded.
For clients it may be neutral
- but only of there is never a word spoken, never a knowing glance exchanged,
between the managers of the insurance and mutual fund operations and
the wholesale banking business.
Nor does the continuing shrinkage
in the number of major accounting firms provide much assurance to the
public. Fewer means less competition. And the larger they are the greater
the potential conflicts of interest between their auditing functions
- where their duty is to the public shareholders - and the consultancy,
executive search and other roles where they are the clients of management.
Trends in the United States
and Europe seem to be compounding mistakes made in Asia. Meanwhile inquiries
into last year's near-meltdown of the system seem to have concluded
that there is nothing much wrong with it that a little more transparency
and improved information systems would not solve.
Contrary to the claims of
its promoters, bigness is not helping long-term capital flows. Despite
liberalization and technology advances, net cross-border capital flow
is smaller relative to gross domestic product than it was 100 years
ago. The difference is that frenetic activity has increased at the expense
of longer-term judgment. The number of players is decreasing while the
number of short term instruments to play with is growing. Institutional
size is decreasing transparency and increasing risk and volatility.
The western industrial powers
need to make a more radical examination of the global financial architecture
to apply the principles of transparency and competition they are urging
And the US Congress would
do well to put its banking "reform" back on hold until this
bull market is over and the public is again demanding that Main Street
get control of Wall Street.
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