Monday, September 22, 2008

The King is Dead, Long Live the King: On the Fall of Investment banking (and its potential rise)

So Goldman Sachs (GS) and Morgan Stanley (MS), the last surviving global investment banks, have become regulated banks! That is to say, they are now subject toregulation by the Fed.

In addition to giving GS and MS the ability to take deposits from savers, thus reducing their reliance on funding in the short-term repo market, both GS and MS can now take advantage of loans from the Fed against the various kinds of collateral that are acceptable to the Fed.

It is worth recollecting that investment banking started as a separate industry following the consensus, after the Depression, that the "mixing" of insurance, mortgage, investment banking type activities with much more mundane banking activities, was at least one key cause of the Depression. The Glass-Steagall Act separated the two kinds of financial activities, till the Gramm-Leach-Biley Act stripped away towards the end of 1999 the regulations separating banking from investment companies, insurance companies and mortgage guarantee companies.

The Glass-Steagall Act's separation had been removed for only a few years before the current collapse, and many (including myself) would argue that the inter-relationship of investment, insurance, mortgage and banking industries that the Gramm-Leach-Biley Act allowed, was one key factor that led to the collapse.

If this analysis is correct, bringing GS and MS into the regulation of the Fed is only a partial solution.

Morever, there must always be room for creativity and innovation in the financial services industry as in every other industry.

I am not convinced that the current plans by the US government are adequate - though I hope and would like to think so! However, if and when, and for whatever combination of reasons, we recover from the current crisis, I have no doubt that innovative investment bank type activities outside the regulation of the Fed will reappear significantly. That would be altogether healthy.

However, one key regulation should be put in place now. Unregulated financial activity must never again be allowed to become many times the size of the regulated activity.

What should be the limit? We can argue about it. We need innovation but we also need system stability. Here is my offer, as an initial stab the limit: how about 25% of the regulated activity?

What should happen if unregulated activity starts exceeding such a limit? The top 10 firms involved in unregulated activity should be immediately made subject to regulation.

Innovation and creativity are important, and they have their place. Sphere: Related Content

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