A little while back, in the run-up to the Bank of America takeover of Merrill Lynch and the collapse of Lehman Brothers, I posed the question of whether this was the end of "bulge bracket" investment banking as we know it. With news yesterday that the last two remaining independent bulge bracket firms – Goldman Sachs and Morgan Stanley – are to become fully regulated commercial banks, the answer can now be given as an unambiguous yes. The revelation that Mitsubishi UFJ, part of the once bust Japanese banking system, is to take a stake of up 20 per cent in Morgan Stanley further underlines the point.
Just about every superlative and cliché invented has been used in the context of this unfolding crisis, butit really is no exaggeration to say that these actions mark the end of an era, the end of a period of rampant expansion in the capital markets when investment banks such as Goldman Sachs reinvented themselves as largely unregulated, highly leveraged hedge funds generating billions of dollars in profit by trading on their own account in the instruments they themselves had helped to create.
For the time being, the changes being enacted on Wall Street are being driven by market necessity rather than regulatory diktat. With the collapse in confidence, investment banks were finding it ever more difficult to get the funding they need to stay in business. Lehman eventually found itself unequal to the task, while Merrill Lynch had to seek shelter in the balance sheet strength of Bank of America to survive.
By becoming commercial banks, Goldman Sachs and Morgan Stanley gain permanent access to the Federal Reserve's discount window, enabling them to solve some of their funding difficulties by borrowing from the Fed in return for collateral. They also gain access to Hank Paulson's $700bn federal bailout fund, allowing them to sell bad debts to the American taxpayer for cash. And finally, they get the right to raise retail deposits, which should further bolster balance sheet funding.
As I say, it is market necessity rather than regulatory edict which is driving these changes. Yet when the dust settles and the politicians come to rake over the lessons of this extraordinary implosion, I wonder if anyone will be quite so keen on the "solution" now being crafted. Indeed, it may only be piling up problems for the future.
That said, it is obviously right that investment banks be brought into the heart of the supervisory net. By so doing, a level playing field is created. All banks become regulated in the same way, they all have to put up the same level of regulatory capital, they all have to obey the same limits on leverage, and in return they all enjoy the same privileges. It is presumably only a matter of time before many of the leading hedge fund groups, most of them even less regulated than the investment banks but some of them carrying far bigger counter-party risk, are obliged to do the same thing.
Yet though it may make these organisations a bit safer in their own right, it won't solve the problem of excessive risk-taking. To the contrary, it may make them even more prone to excess once the lessons of the present crisis are forgotten, as inevitably they will be within a generation or two. Some of the biggest clowns in this entire mess were already universal banks encompassing both investment and commercial banking activities, in particular Citigroup and UBS. Both these banks are still just about alive but they have sustained far bigger losses on securitised debt than either Goldman Sachs or Morgan Stanley, and have also had to raise considerably more in the way of new capital. Size and balance sheet is no defence against incompetence and poor risk management. They might even encourage it.
And this really is the nub of the problem. The causes of the present crisis are many and varied, but one of the main culprits was the progressive mixing allowed in recent years of the bonus-driven rainmakers and financial innovators of Wall Street and the lending prowess of the commercial banks. As securitisation of debt grew, those who originated the lending allowed themselves to think they had become insulated or even completely divorced from the risk of repayment, and therefore originated more and more of the stuff. Only in practice it turned out that their traders and treasury departments were buying this unmonitored debt in growing quantities too, or in some cases they were lending to others to buy it.
In the 1930s, policymakers reacted to the disastrous way in which the snake oil salesmen of Wall Street had plundered the savings of ordinary Americans by enforcing a rigid separation between commercial and investment banking, confining the latter to the business of advice and securities trading as agents on behalf of clients. With deregulation, most of investment banking's capital and effort came to be devoted to trading on the bank's own behalf. The more debt they created and securitised, the fatter the bonuses.
Today, policymakers are reacting to the crisis in the opposite way to which it was tackled in the 1930s, by encouraging investment banks to be taken over by commercial banks or convert to the same status. It may make them a bit safer in the short-run, but it doesn't look like the way to go to me. As for hedge funds, they seem to be even more dangerous than banks. The sooner they are brought within the regulatory net, the better.
Credit crisis? Trust us. We can get you out of it
Don't blame us, blame Wall Street. The Government remains determined to avoid all admission of guilt in the gathering banking crisis. Over the past few days, both the Prime Minister and the Chancellor have again insisted they are the right people to steer us off the rocks, as if they somehow played no part in getting us on to them in the first place. Their stance is broadly summarised by that terrible New Labour expression "we are where we are, now let's move on".
To be fair on both of them, it is perfectly true this is an international crisis in confidence born not directly of these shores but out of the US sub-prime lending debacle. They cannot be blamed for that, nor can they be held responsible for sky-high energy prices. Few people saw this crisis coming and nobody forecast its length and depth.
It is also true that Gordon Brown has indeed been banging on for years about the need for international reform in the regulatory infrastructure. His particular hobby horse has been that the IMF and World Bank should be turned into a kind of international Federal Reserve to deal with crises, supplemented by a beefed-up Financial Stability Forum to act as an early warning system. Yet he has been frustrated, largely because of the Americans, who fatally, as it has turned out, thought their system the best. In any case, it seems unlikely it would have done any good, even if the type of institution envisaged by Mr Brown had existed.
The root causes of this crisis lie in the global liquidity boom generated by rapid growth in the developing world and then fanned by Western central bankers in reacting to shocks by repeatedly bailing out the system with easy money. It is not in the nature of politicians or the organisations they preside over to halt the party when it is in full swing.
Yet that is where the apology stops. The idea that ministers were somehow passive observers of developments this past 11 years in government is laughably ridiculous. Ultimately, it is the Government's responsibility to avoid crises in the first instance and, when they are unavoidable, to be adequately prepared for them. On both counts it has failed. Labour has maintained a deliberately light-touch regulatory regime throughout its term in office. In return for the City's tax dividend, it has allowed bankers to run riot. Virtually no thought has been given to the sort of contra-cyclical, macro-economic management and regulation that you might have expected from a centre-left ruling party.
Worse, the Government trusted to luck and the City to keep the public finances on the straight and narrow. Both are now gone, leaving Britain facing the prospect of the biggest budget deficit as a proportion of GDP of any of the G7 nations, including the US, which has just committed $700bn to bailing out the banking system. Enough said.Reuse content