Glass-Steagall, The Fed & Investment Bank Access- Part 2

Last week, exactly a week ago, I wrote my initial thoughts on what I consider to be the most important single US financial services event since FDR- Bernanke's Fed opening the discount window to non-commercial, investment banks.


In the week since, if anything, my conviction on how much of a watershed event this was has grown.


Paradoxically, my sense of the importance of the 'rescue' of Bear Stearns has shrunk, if it could. Yesterday, I wrote about the implied capacity in the market of various investment banking functions- underwriting, trading and M&A advice. I omitted asset management, but that is clearly a sector with nearly-unlimited capacity.

Looking beyond simply Bear Stearns, can anyone truly justify the existence of all four of Goldman Sachs, Merrill, Lehman and Morgan Stanley? Especially in the modern world of large private equity firms and hedge funds? The former provide additional underwriting, M&A advisory and asset management, while the latter focus on providing trading capacity and investment management.

Other than emotional reaction of former employees seeing their old firm's name vanish, what would be different if one or more of those names were bought by or merged with a commercial bank?

Contrary to Andy Kessler's view, in the Wall Street Journal this past January, about which I wrote here, it's unlikely now that an investment bank will do the buying. With their high leverage and dependence upon commercial banks for funding, I suspect the investment banks are the more vulnerable. Now having access to the Fed discount window, it's only a matter of time before the regulators get around to levying a new regulatory framework on the investment banks.

I suppose, in light of the new developments, Kessler might now be correct in hypothesizing that a Goldman Sachs might backward integrate, and merge with the commercial bank of its choice. But, absent the recent development with the Fed window's opening to non-commercial banks, I would not have thought that likely.

What puzzles me is how many people, when I comment on last week's watershed event, respond with,

'Oh, yes, the Bear Stearns bailout.'

It seems that the bulk of investors, institutional and retail, don't yet fully grasp the incredibly large step toward socialized finance that the Fed took on Monday of last week. Unless they can actually retract this access at some point, and close the window to investment banks, and make investors and financial service providers believe it won't ever happen again, then the industry's structure has now changed irrevocably.

From such landmark change must logically follow changes in the structure of firms and regulation. Whether a Republican or Democratic Congress and/or President, the next few years pretty much require the follow-up explicit regulatory finish to the implicit structural changes that led to this point, i.e., Sandy Weill's breach of Glass Steagall by merging Travelers with Citibank.

It's unlikely, but still possible, that a Democratic Congress would repair the breach and resurrect some version of Glass Steagall, perhaps even legislatively prohibiting the Fed's jurisdiction over non-commercial banking.

However, I think the more likely avenue, now that the breach has been widened to actually level the wall entirely, is to simplify regulation and, consequently or in tandem, see a streamlining of service providers and their composition.

Specifically, I would expect fewer separate publicly-held, regulated entities such as commercial banks, investment banks, and brokers. Instead, I think you will finally see the integration of these functions into fewer, larger and more diversified European-style universal banks, with larger shares of more financial services businesses.

Of course, with this 'bulking up' will probably come even more anemic, inconsistent total return performances. Again, just like that of European universal banks.

Seen from a more distant vantage point, does this not all make some sense? We had a concentration of financial capacity and risk taking among lightly-regulated firms specializing in peddling ever-more opaque, complex products to investors. When the value of these complex 'structured finance' instruments became difficult to discern, and the concentrated risk came home, capital shrank as losses among commercial and investment banks caught holding these instruments had to account for the newer, dramatically lower values.

It's a sad commentary on the acumen of the CEOs and senior managements running these firms: Citigroup, BofA, Merrill Lynch, Morgan Stanley, and Bear Stearns. The natural, if erratically-timed governmental response, is to save the financial system, and, thereby implicitly restructure the sector.

Risk and capacity are likely to be further concentrated, but, in exchange, more tightly overseen and regulated.

A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk.

Now that the public is absorbing the brunt of the losses, via equity ownership of these firms, the logical next step is for the better executives to join the early-adopters in forming new, or joining existing private equity and hedge fund shops.

And the wheels continue to turn......