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The crux of the crisis remains

The crux of the crisis remains
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First Published: Wed, Sep 24 2008. 12 14 AM IST

Illustration: Jayachandran / Mint
Illustration: Jayachandran / Mint
Updated: Wed, Sep 24 2008. 12 14 AM IST
It’s ironic that a regulatory system born during the Great Depression is being wound up during the biggest crisis since then. The conversion of Goldman Sachs and Morgan Stanley into commercial banks is being proclaimed as the end of investment banking, with some accounts declaring it the end of Wall Street. In 1933, concerns about the stability of the commercial banks had led to the passing of the Glass-Steagall Act in the US, which separated the business of the stodgy commercial banks from that of the risk-taking and more glamorous investment banks. Under the Act, while the commercial banks were more closely regulated, more freedom, and more leverage, was allowed to investment banks.
Illustration: Jayachandran / Mint
The wheel has come full circle. The survival of these investment banks was at stake, and perhaps the only way out was to grant them the status of bank holding companies. They will now get access to Federal Reserve lending facilities and, in the longer term, be able to source deposits directly from the public. They will, however, have to submit to closer regulation — they will have less leverage, and profitability will be much lower. When it came to the crunch, the independent broker/dealer model, funded from the wholesale markets, was found to be unsustainable. Whether the investment banks will be able to survive in their new avatar, or will have to merge with other commercial banks a la Merrill Lynch, remains to be seen. What matters is that they will survive for now.
The end of independent investment banks doesn’t mean, of course, the end of investment banking, which will continue to flourish in commercial banks. In any case, the investment banks had diversified into all kinds of activities, including consumer finance. Now these will be part of a commercial bank’s activities.
That raises a big question. If banks’ activities remain the same, and they get access to retail funding, won’t it exacerbate risk? That is exactly why the Glass-Steagall Act was passed — to keep these risks away from commercial banks and depositors. Also, it is not just the investment banks that got themselves into trouble by gorging on dodgy credit — some of the worst affected have been deposit-taking commercial banks. The combination of assured retail funding, securitization and financially innovative bets can prove to be even more risky.
In short, the conversion does not address the root causes of the crisis, which can only be dealt with by much more stringent regulation.
Is this the end of investment banking? Write to us at views@livemint.com
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First Published: Wed, Sep 24 2008. 12 14 AM IST