The Hindu Business Line : Investment banks… <br>…and then, there were none

Goldman Sachs and Morgan Stanley are shrewder and have opted to live with regulatory fire to save their future. They would be helping themselves and, in the process, the Treasury and the Fed.

K. Subramanian

The last nail on the coffin of investment banks, as we now know them, was driven when the US Federal Reserve (Fed) approved the applications of Goldman Sachs and Morgan Stanley to change their status into bank holding companies. Rather, they become dowdy deposit-taking banks subject to regulatory authorities.

The demise was signalled a few days earlier when Lehman Brothers declared bankruptcy and Merrill Lynch sought refuge with the Bank of America.

It was becoming more and more evident that what was needed was a new regulatory approach to replace the contradictory patchwork which the Treasury and Fed were trying for some months. When times are out of joint, it is prudence to swallow one’s pride and rework strategies conforming to new regulation, which was on the anvil.

Even earlier, economists had begun to predict the demise of investment banks as an institution. Johan Gapper wrote about the “Last gasp of broker-dealer institution.” (Financial Times, September 15). He had assessed that either they sell themselves to a large commercial bank or scale down their operations and turn into a hedge fund. Indeed, Goldman Sachs and Morgan Stanley are shrewder and have opted to live with regulatory fire to save their future. They would be helping themselves and, in that process, the Treasury and the Fed.

What had happened in recent years was the rise of a ‘shadow banking system’ with investment banks playing the role of bridges between conventional banks and a number of others such as hedge funds, private equity groups, money market funds, etc.

Shadow banking system

Unlike banks which had lender of last resort facility, broker-dealers did not have any firewalls. As Prof Nouriel Roubini of Stern School puts it, “A generalised run on those shadow banks started when the develeraging after the asset bubble bust led to uncertainty about which institutions were solvent.”

The US authorities, due in part to their ideological mindset, misdiagnosed the nature of the malaise and underestimated the magnitude. When the creased in the banking system froze, the Fed began to pump in liquidity in billions of dollars to revive inter-bank flows. This has not been of avail so far and inter-bank money markets have not revived.

Pumping in liquidity

When Fed began to pump liquidity, it was blamed for offering loans through its windows at reduced rates in violation of Bagehot’s rule. Very soon, the Fed began to breach other rules and conventions. It opened windows to non-banks which were not within its regulatory reach. This was because it had to deal with the ground reality where the walls between banks and hedge funds were broken.

Fed also lowered its standards and began to accept dubious assets which could not be valued by established accounting principles. Cleaning up the dubious assets is an unending process and cannot be achieved by merely pumping more and more liquidity.

It was for the same reason that the US Treasury Secretary, Mr Henry Paulson’s plan to create a super vehicle to take over assets did not take off. Participating banks were unwilling to trust the value of assets held by others.

Banking on new approach

It is clear that radical approaches are required to resolve the crisis and the tools available to central banks to deal with them have lost their efficacy. They can deal with runs in conventional banks and not those faced by non-banks. A new regulatory approach is required. Within the Fed there is fear of expansion into other areas. It is not willing to use its portfolio to influence specific markets as it can be accused of yielding to pressure from special interest groups.

There is the apprehension that by enlarging its role, Fed may lose credibility. Thus, the Fed is truly in a dilemma. The rescue plan proposed by Paulson will get Fed out of this dilemma. It shifts the onus to the Treasury and draws on taxpayers’ resources.

The debate on the rescue plan is now national in an election year. The contents of the plan, except for broad purpose, are unclear or not spelt out. It leaves the discretion entirely to the Treasury.

The ‘good’ boys

We get back to Goldman and Morgan. What they are doing is to submit regulation and become ‘good’ boys. More then regulatory reach, their immediate concern is to get capital to ward of bankruptcy. Their condition to turn into deposit-taking banking is a sine qua non to draw on the rescue fund or any of the windows of Fed.

There is an interesting twist to the story. In the earlier years when the crisis erupted, it seemed that sovereign wealth funds (SWF) in China, etc were willing to provide capital. Indeed, CITI, USB, etc got substantial amounts from them. Current trends clearly suggest that SWFs are turning against investment in failing banks. Some of them have lost heavily. It was inevitable that the two should turn inwards and become supplicants to the Treasury. It should be easier for them to deal with Hank Paulson than with mysterious Chinese mandarins! Their action to get changed into bank holding companies was not an act of self abnegation — it was well calculated.

(The author is a former Finance Ministry official. blfeedback@thehindu.co.in)