The Rush to 'Bigger' Contains Seeds of Disaster

Commentary IHT March 24 1999

By Philip Bowring

Hong kong: It seems like nirvana for the financial services world.

The Dow Jones industrial average if flirting with five digits, persuading even the most staid private investment bank on Wall Street, Goldman Sachs & Co, to sell stock to the public. The Banking Committee of the US House of Representatives has finally approved a bill to enable "one-stop" combinations of banking, securities, insurance and fund management. Big banking mergers have even spread to Europe.

But the "bigger is better" euphoria should really be seen as a warning sign of possible disaster. For while deal-makers may applaud full-throttle consolidation, the process will only exacerbate conflicts of interest that are already inherent in the global financial system.

If US Legislators need any hint of the potential concerns, they need only look to Asia The House committee decision two weeks ago, for example, came as Goldman was apologizing to the Thai government for a securities analyst's report criticial of the leading local bank. The row had led to calls for Goldman to be barred from lucrative investment banking opportunities.

Securities firms have always had to walk the fine line between advising clients and the more lucrative business of investment banking. And Bangkok may seem a world away from Washington. But these conflicting interests can only grow with further consolidation and cannot be brushed aside as simply an Asian problem.

Many people in the industry readily acknowledge that the "Chinese wall" that is supposed to exist between the investment banking and research operations of a securities firm is more often like a bamboo curtain. There are formal compliance rules, but information and influence flow freely, if informally, and the investment-banking side makes more money and has more clout.

Even firms that 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 because that is where the investment banking opportunities lie.

Even in such a s diverse marketplace as the United States, such conflicts occur Barron's magazine recently noted that the investment banking arms of securities firms whose analysts have been skeptical of the Internet craze have been failing to win business related to high-tech companies' initial public offerings.

It is hard to imagine that even bigger financial agglomerations are going to do anything but reduce the competition and transparency that are the best investor protection.

Universal banking - investment and commercial banking under one roof - has long existed in Europe. But the big European institutions, in the past at least, have been driven by their commercial banking arms as their investment banking and other services have lacked the innovation and trading fervor of their US counterparts. That has kep their power in check.

The closer the links between trading and commercial banking - and the congressional banking bill would speed the blending process in the United States - the more likely bank capital is to be put at risk to generate trading profits.

There are other dangers to the system and to the public.
Take derivatives, in themselves a legitimate and necessary part of the financial system. It is now well enough established that, in the past, well-known houses were devising and very profitably selling fiendishly complex derivative securities designed to get around regulatory barriers.

In the United States they enabled pension funds to take big risks while nominally staying within requirements that they buy safe government securities. In Japan, banks used them to hide huge foreign exchange losses.

The greater the degree of combination in the financial services sector, the less the transparency. Yet transparency is supposedly the key to good market regulation. The bigger the combination, the greater the temptation of conglomerates to throw more capital at the riskier sides of the business. Moral hazard increases with vertical integration, systemic risk with size.

Though the structures of Western institutions are very different from those Japan, the ultimate effect may be similar to the Japanese "convoy" system - in which banking problems are difficult to root out because of the intricate financial couplings that link banks deemed "too big to fail".

There are plenty of other conflicts of interest in the marketplace. The big investment banks make much of their money from the trading of securities. In theory, it is possible to reconcile this with advising governments on issues such as foreign-exchange policy or privatization. In practice, it is almost impossible to separate the two. Can one really give advice on how to bolster asset prices and limit bank losses while operating "vulture funds" designed to acquire distressed assets at the lowest possible prices?

Separation of powers needs to exist in financial services just as much as in government.

Even the most scrupulously run institutions can get caught out. While accounting standards are constantly being improved -- often in the face of suggestions that such moves are "anti-business" - improved standards alone cannot keep up with the furious growth of sophisticated instruments such as derivatives. This month the US Securities and Exchange Commission, the Federal Reserve and other federal agencies saw fit to issue a joint letter to financial institutions urging enhanced disclosure and increased credit-loss provisions for such activities. Surely that should have been a sign of worry.

At the retail level, too, dangers lurk. It is doubtful whether there really is synergy - as supporters of financial services bill have contended - between retail banking and sales of mutual funds and life insurance. Banks simply want to get more into these businesses because their traditional business is being eroded.

For clients it may be neutral - but only of there is never a word spoken, never a knowing glance exchanged, between the managers of the insurance and mutual fund operations and the wholesale banking business.

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 the consultancy, executive search and other roles where they are the clients of management.

Trends in the United States and Europe seem to be compounding mistakes made in Asia. Meanwhile inquiries into last year's near-meltdown 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. Despite liberalization and technology advances, net cross-border capital flow is smaller relative to gross domestic product than it was 100 years ago. The difference is that frenetic activity has increased at the expense of longer-term judgment. The number of players is decreasing while the number of short term instruments to play with is growing. Institutional size is decreasing transparency and increasing risk and volatility.

The western industrial powers need to make a more radical examination of the global financial architecture to apply the principles of transparency and competition they are urging on Asia.

And the US Congress would do well to put its banking "reform" back on hold until this bull market is over and the public is again demanding that Main Street get control of Wall Street.

 

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