1999 - Financial mayhem: blame the players not the tune

By Philip Bowring

Hongkong: Until this week it seemed nirvana for the financial services world. The Dow was flirting with five digits, the US House of Representatives banking committee had finally just (March 12) approved a bill to enable "one stop" combines of banking, securities, insurance and fund management. Mega banking mergers had broken out all over Europe.

But there are bigger dangers in all this than a collapse of the internet stock bubble. Vertical and horizontal integration in financial will be increase systemic risk and reduce investor protection.

Ironically the House decision came as Wall Street's currently pre-eminent investment bank, soon-to-be-listed Goldman Sachs, was making a grovelling apology to the Thai government for a securities analyst's report critical of the leading local bank. The row had led to calls for Goldman to be barred from lucrative investment banking opportunities.

This was only the latest in a series of instances in Asia where analysts have been made to recant -- and in some cases fired -- for speaking their minds when these have been unpopular with investment banking clients.

But don't think this is just an Asian problem caused by government-business links. Bangkok may seem a world away from Washington but the Goldman issue went to the heart of the conflicting interests which often exist between the clients of investment banks, usually companies and countries which want to raise money, and those of the securities houses which are supposed to advise investors.

Most who have worked in firms which combine the two will readily admit that the "Chinese Wall" which is supposed to exist between them is often more like a bamboo curtain. There are formal compliance rules but information and influence flow freely if informally. The investment banking side makes more money and has more clout.

Even firms which 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. Even in such a diverse marketplace as the US. Barrons magazine recently noted how the investment banking arms of securities firms whose analysts have been sceptical of the internet craze have been failing to get high-tech IPO mandates.

Matters become even worse for shareholders (who ought to want to buy low) when bullish analysts get preferred access to information the basis of which they make further bullish comments. Those very worried about this include SEC Chairman Arthur Levitt. Trading based on privileged access to information is "all too evident in today's marketplace. And its crime", says Levitt.

It is hard to imagine that ever bigger financial agglomerations are going to anything but reduce the competition and transparency that are the best investor protection. Though universal banking has long existed in Europe, the big European institutions in the past have been driven by their commercial banking arms while the investment banking and other services have lacked the innovation and trading fervour of their US counterparts.

As the Long Term Credit Management case showed, the greater the danger to the whole system should one go down. The closer the links between trading and commercial banking, the more likely that bank capital is put at risk to generate trading profits.

There are other dangers to the system and to public. Take derivatives, in themselves a legitimate part of the system. It is now well enough established that (in the past) well known houses were devising and selling (very profitably) fiendishly complex derivatives designed to get around regulators. In the US they enabled pension funds to take big risks while nominally staying within requirements to buy government securities. In Japan banks used them to hide foreign exchange losses.

The greater the degree of combination in financial sector intermediation the less the transparency. Yet transparency is supposedly the key to good market regulation. Moral hazard increases with vertical integration, systemic risk with size. Though the structures of western institutions are very different from those of Japan, the ultinate effect may be very similar to the "convoy" system which has caused such damage and made change so difficult because groups become "too big to fail".

There are plenty of other conflicts of interest in the marketplace. Big investment banks make much of their money from trading, taking positions in currencies, stock futures, devising "vulture funds" etc. In theory, it is possible to reconcile this with advising governments on foreign exchange policy, privatisation, etc. In practice it is almost impossible. Separation of powers needs to exist in financial services just as much as in government.

Even the most scrupulous institutions can get caught out. US accounting standards are constantly being improved -- often in the face of suggestions that high standards are "anti- business". But as SEC's Levitt has pointed out "accounting has imply failed to keep pace with this exponential growth" (of derivatives). On March 10 the SEC, Federal Reserve and three other federal agencies saw fit to issue a joint letter to financial institutions urging enhanced disclosure and increased credit loss provisions. Surely a sign of worry.

At the retail level other dangers lurk. It is doubtful whether there is really synergy between retail banking and sales of mutual funds and life insurance. Banks want into these more because their traditional business is being eroded. For clients it may be neutral -- but only if there is never a word spoken, never a knowing glance exchanged between the managers of the life and mutual funds and the wholesale banking business. Mutual back scratching between securities traders, fund managers and investment banks has been a common enough feature of foreign participation in some Asian markets.

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

Trends in the US and Europe seem to be compunding mistakes made in Asia. Meanwhile, enquiries into last year's near melt- down 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. Indeed, despite liberalisation and technology advance net cross border capital flow is smaller relative to GDP than it was 100 years ago. The difference is that frenetic activity has increased at the expense of longer term flows. The number of players is decreasing while the number of short term instruments to play with is growing.

OECD countries need to make a more radical examination of global financial architecture, to apply the principles of transparency and competition they are urging on Asia. And Congress would do well to put its banking "reform" back on hold till this bull market is over and the public is again demanding that Main Street get control of Wall Street.

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