Investment Banking Analysis
An Industry Analysis
Investment Banking: From Whence to Where?
Abstract
The purpose of this paper is to analyse the investment banking industry. The title, “From Whence to Where” clearly expresses the difficult in analysing an industry that has changed diametrically from a traditional posture as a group of firms that had as their most obvious function the raising of capital for businesses and acting as agents and advisors for those business that were their clients. Their second functions was working with or creating markets for the securities they created and sold. There was a clear and well-defined industry with identifiable participants located at easily identifiable addresses. It has evolved into a mass of gigantic financial institutions that provide insurance, take deposits, make loans, trade securities and create new securities they sell through public offerings. There are still “boutique” firms that can be considered part of the Investment banking market, but they are small and highly specialised.
How is one to analyse an industry that simultaneously creates a product, a new security and then sell it to its investment advisory and insurance arms as an investment. The insurance company has clients, as does the investment advisory operation. The investment banking operation has clients that want to sell their securities at the top possible price. The investment advisory and insurance operations have the obligation to purchase securities at the most advantageous possible price. With all three owned by the same parent corporation all are clients of the parent. The company selling new securities may also have its pension fund managed by the investment advisory arm and have insurance taken out with the insurance are. It would appear at first glance that there could be a conflict of interests, but then the question arises, which interest and of whom?
To make the analysis still more complex it is obvious that all financial institutions deal with money. The underlying question is that all money is either US dollars or based directly or indirectly on dollars as the world’s reserve currency. The on-going viability of the US dollar as a reserve currency in view of actions like the current US program of quantitative easing, so called QE2, is questionable. There is a possibility of inflation pressures and even hyperinflation. This is by no means a prediction or forecast, only identification of a possible risk.
From this point an analysis is attempted that indicates that the future will produce changes in the “so-called investment banking industry” that are even greater than those that have converted a relatively simple concept to a single element in the highly complex structure of today’s financial institutions.
Table of Contents
Section Page
Abstract 2
Introduction 5
Definition of Investment banking 7
A brief history of the investment banking business 8
Risk Management 10
New Products 13
Summary and conclusions 14
Recommendations 15
References 17
Appendix 1. 19
Appendix 2. 19
Appendix 3. Current Account Balances as % GDP 20
Appendix 4. Selected Sections of the Banking Act of
1933, approved June 16, 1933, commonly
known as the Glass Act. 21
Appendix 5 Graham and Dodd quotation 23
Appendix 6 Excerpt from Morris and Linda Tannehill’s
The Market for Liberty 23
Appendix 7 The US Money Supply and its implications 25
Introduction
Depending on which author one is reading at the moment the world is either emerging from or still embroiled in a major financial crisis, perhaps the greatest in history. No less than the bank for international settlements dates the onset of the financial crisis with the bankruptcy of Lehman Brothers, a large and well-respected Wall Street investment bank. The impact of the financial crisis has been widespread and challenging for central banks, the world economy and the underlying financial system. (Mohan, 2009) The result has been almost chaotic as illustrated by the graphic in Appendix 1. The graph above demonstrates the sharp decline in US stock market prices in the period following the demise of Lehman Bros. The graph below illustrates the concomitant decline in overall US economic activity in the same 2008 onward time period. The use of US Federal Reserve data is based on its availability and convenience and the assumption that US economic activity is a reasonable proxy for global economic activity. (Federal Reserve, 2011)
The Lehman Brothers debacle was hardly the cause of the global problems, only an event that market the beginning of the results of the underlying crisis. It is however significant that the first domino to fall was an investment bank. A raft of other financial institutions rather quickly followed it from Royal Bank of Scotland to AIG. The proximate cause usually cited for the financial crisis was the so called “sub-prime mortgage market” in the United States. Even Dr Rakesh Mohan, Deputy Governor of the Reserve Bank of India questions this however and points out that the crisis could be better ascribed to persistent long-term global financial imbalances. These imbalances were the outcome of protracted periods of financial excesses built around major advanced economies such as the US, the UK and others that in turn encouraged excessively loose monetary policies that were put in place to permit huge governmental budget shortfalls to be financed. Nations such as China and Japan with large positive trade surpluses balances bought the debt of the nations with unbalanced trade and government deficits. (Mohan, 2009) ((Taylor, 2009)
Why is the foregoing discussion relevant to a study on investment banking? The investment banking industry is the conduit through with much of this debt based on national trade and budget imbalances is created and distributed. For years prior to the crisis the industry had been developing creative new classes of securities such as derivatives and mortgage back bonds, which they sold to investors and made large profits. This only became possible as financial markets worldwide were progressively deregulated permitting investment banks to create new incredibly complex products, which were sold to investors including the creditor nations. (See Appendix 1) What the data clearly illustrates is that there were wide swings in the current account balances particularly of the Asian emerging and developed economies such as Japan, China and Korea. The situations of Switzerland and Germany are also in stark contrast to the economies of the US and UK. While some of the other Eurozone nations such as Ireland and Greece are excluded they would show even greater disparities over time. These sharp disparities provided opportunities for the investment banking houses to aggressively develop and market product.
Definition of Investment banking
There are effectively two major categories of banking, commercial banking and investment banking. A commercial bank accepts deposits and makes loans. An investment bank is a financial institution that, at least in theory, does not accept deposits or make direct loans. Its function is to underwrite financial instruments, primarily stocks and bonds and market them to investors. It may also assist clients, primarily corporations, in terms of financial structuring and in operations such as mergers, acquisitions and divestments of assets. Most investment banks also act as stockbrokers bringing together buyers and sellers of existing securities. To facilitate this element of their businesses in most cases they are also members of one or more exchanges and have an over the counter (NASDAQ) securities trading operation. In the course of this activity they also presumably provide advice to investors. (InvestorWords.com, 2011)
One of the first things to understand in terms of the investment banking business is the overall morality of the industry. (See Appendix 3, Graham & Dodd quotation) Historically, there has been a “Chinese Wall” between underwriting activity and security analysis as a part of the investment advisory activities of the firm. “Today, the so-called Chinese wall that is supposed to prevent conflicts of interest between the two sides of an investment bank is hopelessly porous–no surprise there, as it is based almost entirely on the honor system.” (Frieswick, 2002) The article this is quoted from is from 2002, and presumably there have been “changes” to reinforce the wall. What follows is another quote from a judge’s statement concerning a statement by a Citigroup employee concerning a case which Citigroup eventually won. However, the final statement included the following, “Mr Monaci’s entire statement was the result of reflection by him in hindsight which he did not take into account in the particular circumstances that arose on 19 August 2005. The 83-page statement was prepared for him in draft by his solicitors and adopted by him. In my respectful view, Mr Monaci’s evidence would have been more convincing if he had personally involved himself in its preparation.”
What is clear here is that there is reason for at least some portion of the public anger and outcry at the banking industry. As shown in the following section the distinction between investment and commercial banking has been largely erased in the past few decades.
A brief history of the investment banking business
In 1933 in the United States legislation know as the Glass Steagall act was passed as a reaction to the widespread problems in the banking industry following the great depression of 1929. Some of the relevant law is included in Appendix 2 below (see section U.S.C., title 12, sec. 592). Further detail on the prohibition of an organization being simultaneously a commercial and investment bank or there being any overlap in the management of two such concerns is detailed in section 32 of appendix 2. This law remained in force in the United States until 1999 with the passage of the Gramm-Leach-Bliley Act that effectively cancelled the important regulatory provisions concerning an institution acting as a commercial and investment bank simultaneously. While this is obviously a US law, it pretty accurately reflects to move away from regulatory control that has or had occurred in most developed economy nations. In the “good old days” (or bad old days in the view of many banking executives) there was complete segregation between investment and commercial banking in most developed countries. If they were no legal prohibitions on a single organization operating in both milieus they were at least usually less active in one area and more so in the other. The end of this division, particularly in the United States was at least in some part responsible for the financial crisis of 2008.
The Glass Steagall act of 1933 mandated the unequivocal separation of investment banking with it high risks from commercial banking where the accounts of bank customers was guaranteed by the US government. For some time the concept of Glass Steagall was under fire, and there was considerable pressure from the political right. This was rooted in the end of the Reagan administration with the “objectivism” proposed in Ayn Rand’s work and particularly in Atlas Shrugged. This was the embodiment of the “objectivist” philosophy and found fulfillment in the replacement of Paul Volker in 1987. This culminated in the 1999 signing by president Clinton of the Gramm-Leach-Bliley Financial Services Modernization Act that ended both Glass Steagall and the 1956 Bank Holding Company Act and left the door open for banks, both investment and commercial, to do almost anything they wished. The final step occurred in 2004 when the SEC ruled that investment banks could essentially determine their own net capital. (Galani, 2009)
The question of government regulation is multifaceted. At one extreme are liberals and socialists that feel that business should be regulated, and particularly that the banking industry requires regulation as was provided in the Glass Steagall act and similar regulations that existed in other Western economies. The opinions range all the way from left wing regulatory excess to the libertarian right typified in the anarcho-capitalistic works of Morris and Linda Tannehill that still have some political impact at least in the United States as espoused for example by Ron Paul (Paul, 2011)
Risk Management
One of the elements of investment banking that is very important but seldom included in discussion of investment banking is risk management. Over the years this has evolved from a simple exercise in areas such as commodity inventories and the purchase of sale of forward contracts to the use of securitization and sophisticated mathematical modeling of portfolios and markets and sophisticated attempts to quantify risk. The value or success of such mathematical models is brought into question by some of the problems of the financial crisis, but detailed discussion is outside the scope of this presentation. This does not imply that at least part of the foregoing historic discussion, particularly the separation of investment banking from commercial banking in the United States, is not very relevant.
Why is this discussion of the US financial and currency situation relevant to an examination of the global investment banking market? The Underlying fact is that the reserve currency for the world is currently still the United States Dollar. The US economy still accounts for about 20% of global GDP. At the same time the debt of the US government and the GDP of the United States are roughly in balance at US$14.2 in debt compared to an estimated US$14.7 billion in GDP. (CIA World Factbook. 2011) (Federal Budget.com, 2011) At the same time the federal deficit of the US appears to be growing at roughly US$1.3 trillion per year. (Sahadi, 2011) As there is no US budget for the current fiscal year as this is written, only record monthly deficits, a reliable figure is difficult to determine.
To further confuse the situation, there is the question of the Euro. The inclusion of the peripheral economies such as Greece and Ireland in the Euro zone has added considerable complication to the question of the future of the Euro. There has been a substantial amount of Euro financing since its introduction. The government financing of all the Euro Zone nations is obviously denominated in Euros. The vulnerability of the Euro is openly discussed, and the financing problems of the peripheral members and possible even some of the core members such as Italy and France are questioned. The question of the stability of the Euro is simply one additional element in the problem inherent in any analysis of the industry.
This is critical to the investment banking industry as the monetary environment is crucial to the ability to set rates and the rates of return required to induce investment. Any reasonable investor is presumably aware of the risks to the global financial system of depending on a fiat reserve currency whose government and its central bank, the US Federal Reserve, is artificially inflating the money supply in a heroic if not particularly successful attempt to restore economic vigor to its underlying economy. History is replete with examples of the historic success of this strategy such as the Weimer Republic of Germany (1922-23), Argentina (1975-1992), Zimbabwe (2000-2009) and Yugoslavia (1992-1995). It is difficult to differentiate doctor Bernanke’s quantitative easing from the monetary policies of the above examples.
There are very obvious conflicts of interest between the commercial and investment banking operations of the major financial institutions of the world today, and these conflicts are equally present in virtually all major banks today from Citicorp to Deutsch Bank to Barclays and HSBC. The important consideration is that investment banking is one of the first industries to be truly globalized. The proof of this is an article in the Financial Times of 28 March 2011 concerning a financing for Unilever denominated in Chinese currency (Yuan/Renminbi). (Lucas, 2011) In the same article previous Yuan denominated financing from US corporations such as Caterpillar and McDonalds are mentioned. The incentive for Unilever is the strong position already established in China by US rival Proctor & Gamble. A further article in the Wall Street journal explained in more detail the interest of multinational companies in raising Yuan to pay for their expansion plans, reducing the need to hedge if they bring in dollars or other foreign currencies.
The increasing competiveness in international investment banking is made clear by the 1.5% interest rate on the Unilever issue. The Journal article also discusses the growing pool of Yuan in Hong Kong of CNY370 billion or about US$56.4 billion. It is also interesting that the same article quotes Guy Stear, head of Asia research at Sociéteé Générale in Hong Kong and HSBC analyst Donna Kwok. It is further interesting that it is estimated that Hong Kong investors took 58% of the offering and Singapore investors took 34% or combined, 92% of the overall offering. This is a very dramatic illustration of the international nature of the investment banking industry in 2011. (Oster & Brereton, 2011)
New Products
The new products of the investment banking industry are securities that are based on derivatives and so called securitised or collateralised obligations. The valuations of these instruments are based on complex quantitative models whose validity can be brought into question. Much of the quantitative easing referred to above seems to be based on creating reserves (or printing money) with which to purchase these securities at the values at which banks are carrying them on their balance sheets. This is probably the result of the inability of the banks to find public markets at satisfactory prices for many of these assets. When this is combines with the ability of investment banks to determine their own net capital the true financial situation of these institutions is difficult if not impossible for an external analyst to determine with any degree of reliability.
Summary and conclusions
While there are cycles in any industry there is no reason to expect that investment banks will not remain very profitable and probably even grow as they economy continues to globalize which implies an ongoing need for additional investment capital. Investment banks are and will remain the primary conduit for moving this capital from investors to corporate users of investment funds. There are two provisos to this statement.
The first proviso is that investment banking remains unregulated at both the national and global levels. If anything like the Glass-Steagall act were to be reenacted in the United States and possibly some of the other major markets such as London or some of the Asian market this would create a far different “playing field”. As it is, the historical concept of investment banking is totally obsolete, and the function of investment banking is largely carried out by the vast global “megabanks” such as Citicorp, JP Morgan Chase, HSBC, and Barclays. The industry is no longer located in any identifiable places, but deals can originate anywhere from London to Abu Dhabi to New York and points in between.
There is no question that the investment banking industry is absolutely essential to the global economy, will continue to be as long as the capitalistic economic model is paramount in the world. Any meaningful discussion of the thrust or future structure of the industry is almost impossible. There are too many changes of structure and direction underway to make more than guesses at where Investment banking will go.
Recommendations
The assignment requires the inclusion of recommendations in an industry analysis. It is not clear how one makes recommendations to an industry, but one could make recommendations to the management of a specific investment bank. The basic business models of investment banks must all be similar at the underlying level. They are aimed primarily at selling securities to investors. The market comprised of investors can be segmented like any market with differentiation between “domestic” and “foreign” investors or “institutional” and “individual” investors or wholesale and retail business. The contacts between the investment banks and the investors are “brokers” who are in many respects similar to used car salesmen with licenses, better education, and better taste in apparel. There are probably ways to devise more sophisticated marketing schemes or perhaps even more sophisticated products (securities).
Most investment bankers already know how to create securities and sell their products. The recommendation that is most appropriate at the industry level is contingency planning. The basic level of contingency is the “bear market” when security prices fall. This is actually relatively common and occurs on what seems to be a cyclical basis. The more serious contingency in 2011 is a collapse in the currency and financial systems of the world. It is apparent that the Euro bankers are concerned with the credit standings of the peripheral countries with the Irish banking industry the latest area of concern and the most recent recipient of a financial Band-Aid. This is a relatively tiny country with a population of only 1.8 million, which is producing serious concerns for the European Union with a total population of about 500 million in total. The population of Greece, Ireland and Portugal is less than the population of Spain that may well be the next domino to fall.
The financial situation of the United States that provides the global reserve currency is not dramatically different from that of some of the other nations that have serious problems with debt levels and budget shortfalls. A careful examination of the global financial system provides plenty of support for concerns. If these global currency and financial questions are not resolved the investment banking industry along with all the other elements of the financial industry will have serious problems. The most important recommendation would be the development of a contingency plan to meet these eventualities if they were to come to pass. In 2008 there were serious possibilities of the failure of several major investment banks and the financial institutions of which they were parts. The risk in 2011 is probably as great as it was a few years ago, different only in form and detail. Recognition of this risk is the most important recommendation that could be made to the investment banking industry. How to hedge this possibility is far outside the possibilities of this study.
References
CIA World Factbook (2011) “World Economy GDP” Recovered 29/03/2011 from: https://www.cia.gov/library/publications/the-world-factbook/geos/xx.html
CIA World Factbook (2011) “United States Economy GDP” Recovered 29/03/2011 from: https://www.cia.gov/library/publications/the-world-factbook/geos/us.html
Federal Budget.com (2011) “The National Debt is $14.2 Trillion” Recovered 29/03/2011 from: http://www.federalbudget.com/
Federal Reserve Bank of St. Louis, (2011) Economic Data FRED. Recovered 26/03/2011 from: http://research.stlouisfed.org/fred2/graph/?graph_id=38960&category_id=0
Frieswick, K. (2002) “Investment Banking: More bricks in the Wall” CFO Magazine. Recovered 27/03/2011 from: http://www.cfo.com/article.cfm/3006558?f=related
Galani, Shah, (2009) “How Deregulation Fuelled the Financial Crisis” The Market Oracle. Recovered 28/03/2011 from: http://www.marketoracle.co.uk/Article8210.html
Graham & Dodd (2009) “Security Analysis, 6th Ed.” New York, McGraw-Hill
Internet Archives, (2001) Full Text: The Glass-Steagall Act a.k.a. The Banking Act of 1933/.” Recovered 27/03/2011 from: http://www.archive.org/details/FullTextTheGlass-steagallActA.k.a.TheBankingActOf1933
InvestorWords.com (2011) “Investment Banker” Recovered 26/03/2011 from: http://www.investorwords.com/2603/investment_banker.html
Lucas, L. (03/27/2011) “Unilever in ‘dim sum’ bond move.” London. Financial Times. Recovered 28/03/2011 from: http://www.ft.com/cms/s/0/a00f760a-589a-11e0-9b8a-00144feab49a.html#axzz1HscgiFq3
Mohan, R. (2009) “Rakesh Mohan: Global financial crisis – causes, impact, policy responses and lessons.” Bank For International Settlements. Recovered 26/03/2011 from: http://www.bis.org/review/r090506d.pdf
Oster, S & Brereton, N. (28/03/2011) “Unilever Issues Dim Sum Bonds.” New York City, The Wall Street Journal. Recovered 28/03/2011 from: http://online.wsj.com/article/SB10001424052748703739204576228303769941410.html
Paul, R. (2011) “Ron Paul News.” Ron Paul: Decision to run will depend on dollar. Recovered 29/03/2011 from: http://www.ronpaul.com/
Rand, A. (1985) “Atlas Shrugged” London, Signet, Penguin Books Ltd.
Sahadi, J. (06/01/2011) Treasury: Debt ceiling could be hit by end of March.” CNN. Recovered 29/03/2011 from http://money.cnn.com/2011/01/06/news/economy/debt_ceiling_treasury/index.htm?iid=EAL
Tannehill M. & Tannehill, L (1970, 1993) “The Market for Liberty.” Los Angeles, Fox & Wilkes
Taylor, J. (2009) “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, Working Paper 14631, January, National Bureau of Economic Research. Recovered 26/03/2011 from: http://www.nber.org/papers/w14631.pdf
Utz, C. (2007) “Chinese wall holds up at investment bank” The Australian Professional Liability Blog. Recovered 27/03/2011 from: http://lawyerslawyer.net/2007/07/16/chinese-wall-holds-up-in-the-trading-houses/
Appendix 1.
The table below is a graphic depiction of the sharp decline in US stock market prices in the period following the demise of Lehman Bros.
Source: Federal Reserve Bank of St. Louis
Appendix 2.
The graphic on the following page illustrates the concomitant decline in overall US economic activity in the same 2008 onward time period.
Appendix 3. Current Account Balances as % GDP
Appendix 4. Selected Sections of the Banking Act of
1933, approved June 16, 1933, commonly known as the Glass Act.
Section 7 Paragraph (m) of section 11 of the Federal Reserve Act, as
amended (U.S.C., title 12, sec. 248), is amended to read as follows:
Upon the affirmative vote of not less than six of its members the Federal Reserve Board shall have power to fix from time to time for each Federal reserve district the percentage of individual bank capital and surplus which may be represented by loans secured by stock or bond collateral made by member banks within such district, but no such loan shall be made by any such bank to any person in an amount in excess of 10 per centum of the unimpaired capital and surplus of such bank. Any percentage so fixed by the Federal Reserve Board shall be subject to change from time to time upon ten days’ notice, and it shall be the duty of the Board to establish such percentages with a view to preventing the undue use of bank loans for the speculative carrying of securities. The Federal Reserve Board shall have power to direct any member bank to refrain from further increase of its loans secured by stock or bond collateral for any period up to one year under penalty of suspension of all rediscount privileges at Federal reserve banks.
Section 23
Sec. 23 A. No member bank shall:
(1) make any loan or any extension of credit to, or purchase securities under repurchase agreement from, any of its affiliates, or
(2) invest any of its funds in the capital stock, bonds, debentures, or other such obligations of any such affiliate, or
(3) accept the capital stock, bonds, debentures, or other such obligations of any such affiliate as collateral security for advances made to any person, partnership, association, or corporation, if, in the case of any such affiliate, the aggregate amount of such loans, extensions of credit, repurchase agreements, investments,
and advances against such collateral security will exceed 10 per centum of the capital stock and surplus of such member bank, or if, in the case of all such affiliates, the aggregate amount of such loans, extensions of credits, repurchase agreements, investments, and advances against such collateral security will exceed 20 per centum of the capital stock and surplus of such member bank.
Section 24A
” Seventh. To exercise by its board of directors or duly authorized officers or agents, subject to law, all such incidental powers as shall be necessary to carry on the business of banking; by discounting and negotiating promissory notes, drafts, bills of exchange, and other evidences of debt; by receiving deposits; by buying and selling exchange, coin, and bullion; by loaning money on personal security; and by obtaining, issuing, and circulating notes according to the provisions of this title. The business of dealing in investment securities by the association shall be limited to purchasing and selling such securities without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite any issue of securities: Provided, That the association may purchase for its own account investment securities under such limitations and restrictions as the Comptroller of the Currency may by regulation prescribe, but in no event
(1) shall the total amount of any issue of investment securities of any one obligor or maker purchased after this section as amended takes effect and held by the association for its own account exceed at any time 10 per centum of the total amount of such issue outstanding, but this limitation shall not apply to any such issue the total amount of which does not exceed $100,000 and does not exceed 50 per centum of the capital of the association, nor
(2) shall the total amount of the investment securities of any one obligor or maker purchased after this section as amended takes effect and held by the association for its own account exceed at any time 15 per centum of the amount of the capital stock of the association actually paid in and unimpaired and 25 per centum of its unimpaired surplus fund. As used in this section the term
‘investment securities ‘ shall mean marketable obligations evidencing
indebtedness of any person, co-partnership, association, or corporation in the
form of bonds, notes and/or debentures commonly known as investment securities under such further definition of the term ‘ investment securities ‘ as may by regulation be prescribed by the Comptroller of the Currency. Except as hereinafter provided or otherwise permitted by law, nothing herein contained shall authorize the purchase by the association of any shares of stock of any corporation.
(U.S.C., title 12, sec. 592)
Every such holding company affiliate shall, in its application for such voting permit,
(1) show that it does not own, control, or have any interest in, and is not participating in the management or direction of, any corporation, business trust, association, or other similar organization formed for the purpose of, or engaged principally in, the issue, flotation, underwriting, public sale, or distribution, at wholesale or retail or through syndicate participation, of stocks, bonds, debentures, notes, or other securities of any sort (hereinafter referred to as ‘securities company’);
(2) agree that during the period that the permit remains in force it will not acquire any ownership, control, or interest in any such securities company or participate in the management or direction thereof;
(3) agree that if, at the time of filing the application for such permit, it owns, controls, or has an interest in, or is participating in the management or direction of, any such securities company, it will, within five years after the filing of such application, divest itself of its ownership, control, and interest in such securities company and will cease participating in the management or direction thereof, and will not thereafter, during the period that the permit remains in force, acquire any further ownership, control, or interest in any such securities company or participate in the management or direction thereof ;
and (4) agree that thenceforth it will declare dividends only out of actual net earnings.
Sec. 32.
From and after January 1, 1934, no officer or director of any member bank shall be an officer, director, or manager of any corporation, partnership, or
unincorporated association engaged primarily in the business of purchasing, selling, or negotiating securities, and no member bank shall perform the functions of a correspondent bank on behalf of any such individual, partnership, corporation, or unincorporated association and no such individual, partnership, corporation, or unincorporated association shall perform the functions or a correspondent for any member bank or hold on deposit any funds on behalf of any member bank, unless in any such case there is a permit therefore issued by the Federal Reserve Board; and the Board is authorized to issue such permit if in its judgment it is not incompatible with the public interest, and to revoke any such permit whenever it finds after reasonable notice and opportunity to be heard, that the public interest requires such revocation.
Appendix 5 Graham and Dodd quotation
The relaxation of investment bankers’ standards in the late 1920s, and their use of ingenious means to enlarge their compensation, had unwholesome repercussions in the field of corporate management. Operating officials felt themselves entitled not only to handsome salaries but also to a substantial participation in the profits of the enterprise… But it may not be denied that the devious and questionable means were frequently employed to secure these large bonuses to the management without full disclosure of their extent to the stockholders… With publicity given to this compensation, we believe that the self-interest of stockholders may be relied on fairly well to prevent it from passing all reasonable limits (Graham & Dodd, 2009 p. 642)
Appendix 6 Excerpt from Morris and Linda Tannehill’s The Market for Liberty
The following is a quotation from Morris and Linda Tannehill’s The Market for Liberty. The work is obviously anarcho-capitalistic in style and does not represent anything taught in relation to investment banking or finance, but does present an interesting if not necessarily realistic view of the regulatory framework that might evolve with the imposition of governmental control on the banking industry and particularly the investment banking industry. It presents a positive image for self regulation by industry in the absence of government control.
“…government is an extra market institution – its purpose is not to make profits but to gain power and exercise it. Government officials have no profit and loss data. Even if they wanted to satisfy their forced ‘customers,’ they have no reliable ‘error signal’ to guide their decisions. Aside from sporadic mail from the small minority of his constituents who are politically conscious, the only ‘error signal’ a politician gets is the outcome of his re-election bids. One small bit of data every two to six years! And, even this tidbit is hardly a clear signal, since individual voters may have voted the way they did because they liked the candidate’s sexy appearance or fatherly image. Appointed bureaucrats and judges, of course, don’t even get this one small and usually confusing data signal; they have to operate completely in the dark.”
“…the big advantage of any action of the free market is that errors and injustices are self-correcting. Because competition creates a need for excellence on the part of each business, a free-market institution must correct its errors in order to survive. Government, on the other hand, survives not by excellence but by coercion; so an error or flaw in a governmental institution can (and usually will) perpetuate itself almost indefinitely, with its errors being “corrected” by further errors. Private enterprise must, therefore, always be superior to government in any field.”
Appendix 7 The US Money Supply and its implications
The chart below is a clear depiction of the situation in the US Monetary markets. The chart what is called the monetary based which can be defined as, “The total amount of currency that is in the hands of the public or in commercial bank deposits held as reserves by commercial banks in the central bank’s (The Federal Reserve in the US. Commercial banks have the power to effectively create money by making loads that become deposits in the borrowers’ accounts as they are created.
The impact of the recession on monetary policy as the recession progressed is obvious in the chart. When the recession began the monetary base was slightly more than US$800 billion. At the “end” of the recession in late 2009 or early 2010 this had grown to well over US$1.6 trillion or essentially doubled. Since this time to the present it has grown by another 50% or an amount about equal to the total monetary base at the beginning of the crisis.
John Taylor of the National Bureau of Economic Research wrote a paper on, “THE FINANCIAL CRISIS AND THE POLICY RESPONSES: AN EMPIRICAL ANALYSIS OF WHAT WENT WRONG.” His conclusions were, “In this paper I have provided empirical evidence that government actions and interventions caused, prolonged, and worsened the financial crisis. They caused it by deviating from historical precedents and principles for setting interest rates, which had worked well for 20 years. They prolonged it by misdiagnosing the problems in the bank credit markets and thereby responding inappropriately by focusing on liquidity rather than risk. They made it worse by providing support for certain financial institutions and their creditors but not others in an ad hoc way without a clear and understandable framework. While other factors were certainly at play, these government actions should be first on the list of answers to the question of what went wrong.” It should be noted that this work was written in the throes of the crisis, and much has transpired since.
It should also be noted that part of his conclusion, even at this early point was that support of existing financial institutions was provided to certain institutions and not to other. What were traditionally considered “Investment Banks” disappeared as they were either liquidated in bankruptcy (Lehman Brothers) merged into existing commercial banking institutions (Citicorp and Smith Barnet) (JP Morgan Bear Sterns) and (Bank of America Merrill Lynch).
Keeping in mind that one of the traditional functions of an investment bank is risk management there was substantial distortion in the ensuing mergers with traditional commercial banks that employed an entirely different risk profile to protect their depositors and the Federal Deposit Insurance Corporation. Another of the problems emphasized by Dr Taylor was the emphasis on liquidity as opposed to risk management in the response of the US Government to the crisis.