1999 - Financial mayhem: blame the players not the tune
By Philip Bowring
Hongkong: Until this week it seemed nirvana for the financial
services world. The Dow was flirting with five digits, the US
House of Representatives banking committee had finally just
(March 12) approved a bill to enable "one stop" combines of
banking, securities, insurance and fund management. Mega
banking mergers had broken out all over Europe.
But there are bigger dangers in all this than a collapse of
the internet stock bubble. Vertical and horizontal integration
in financial will be increase systemic risk and reduce
Ironically the House decision came as Wall Street's currently
pre-eminent investment bank, soon-to-be-listed Goldman Sachs,
was making a grovelling apology to the Thai government for a
securities analyst's report critical of the leading local
bank. The row had led to calls for Goldman to be barred from
lucrative investment banking opportunities.
This was only the latest in a series of instances in Asia
where analysts have been made to recant -- and in some cases
fired -- for speaking their minds when these have been
unpopular with investment banking clients.
But don't think this is just an Asian problem caused by
government-business links. Bangkok may seem a world away from
Washington but the Goldman issue went to the heart of the
conflicting interests which often exist between the clients of
investment banks, usually companies and countries which want
to raise money, and those of the securities houses which are
supposed to advise investors.
Most who have worked in firms which combine the two will
readily admit that the "Chinese Wall" which is supposed to
exist between them is often more like a bamboo curtain. There
are formal compliance rules but information and influence flow
freely if informally. The investment banking side makes more
money and has more clout.
Even firms which 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.
Even in such a diverse marketplace as the US. Barrons magazine
recently noted how the investment banking arms of securities
firms whose analysts have been sceptical of the internet craze
have been failing to get high-tech IPO mandates.
Matters become even worse for shareholders (who ought to want
to buy low) when bullish analysts get preferred access to
information the basis of which they make further bullish
comments. Those very worried about this include SEC Chairman
Arthur Levitt. Trading based on privileged access to
information is "all too evident in today's marketplace. And
its crime", says Levitt.
It is hard to imagine that ever bigger financial
agglomerations are going to anything but reduce the
competition and transparency that are the best investor
protection. Though universal banking has long existed in
Europe, the big European institutions in the past have been
driven by their commercial banking arms while the investment
banking and other services have lacked the innovation and
trading fervour of their US counterparts.
As the Long Term Credit Management case showed, the greater
the danger to the whole system should one go down. The closer
the links between trading and commercial banking, the more
likely that bank capital is put at risk to generate trading
There are other dangers to the system and to public. Take
derivatives, in themselves a legitimate part of the system. It
is now well enough established that (in the past) well known
houses were devising and selling (very profitably) fiendishly
complex derivatives designed to get around regulators. In the
US they enabled pension funds to take big risks while
nominally staying within requirements to buy government
securities. In Japan banks used them to hide foreign exchange
The greater the degree of combination in financial sector
intermediation the less the transparency. Yet transparency is
supposedly the key to good market regulation. Moral hazard
increases with vertical integration, systemic risk with size.
Though the structures of western institutions are very
different from those of Japan, the ultinate effect may be very
similar to the "convoy" system which has caused such damage
and made change so difficult because groups become "too big to
There are plenty of other conflicts of interest in the
marketplace. Big investment banks make much of their money
from trading, taking positions in currencies, stock futures,
devising "vulture funds" etc. In theory, it is possible to
reconcile this with advising governments on foreign exchange
policy, privatisation, etc. In practice it is almost
impossible. Separation of powers needs to exist in financial
services just as much as in government.
Even the most scrupulous institutions can get caught out. US
accounting standards are constantly being improved -- often in
the face of suggestions that high standards are "anti-
business". But as SEC's Levitt has pointed out "accounting has
imply failed to keep pace with this exponential growth" (of
derivatives). On March 10 the SEC, Federal Reserve and three
other federal agencies saw fit to issue a joint letter to
financial institutions urging enhanced disclosure and
increased credit loss provisions. Surely a sign of worry.
At the retail level other dangers lurk. It is doubtful whether
there is really synergy between retail banking and sales of
mutual funds and life insurance. Banks want into these more
because their traditional business is being eroded. For
clients it may be neutral -- but only if there is never a word
spoken, never a knowing glance exchanged between the managers
of the life and mutual funds and the wholesale banking
business. Mutual back scratching between securities traders,
fund managers and investment banks has been a common enough
feature of foreign participation in some Asian markets.
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 consultancy, executive search and other roles where they
are clients of the management.
Trends in the US and Europe seem to be compunding mistakes
made in Asia. Meanwhile, enquiries into last year's near melt-
down 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. Indeed, despite
liberalisation and technology advance net cross border capital
flow is smaller relative to GDP than it was 100 years ago. The
difference is that frenetic activity has increased at the
expense of longer term flows. The number of players is
decreasing while the number of short term instruments to play
with is growing.
OECD countries need to make a more radical examination of
global financial architecture, to apply the principles of
transparency and competition they are urging on Asia.
And Congress would do well to put its banking "reform" back on
hold till this bull market is over and the public is again
demanding that Main Street get control of Wall Street.
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