The History of Glass-Steagall
The famous Glass-Steagall Act enacted in 1934 erected barriers between commercial banking and the securities industry.
A piece of Depression Era legislation, Glass-Steagall was created in the wake of the stock market crash of 1929 and the subsequent collapse of many commercial banks. At the time, many blamed the securities activities of commercial banks for their instability. Dealings in securities, they claimed, upset the soundness of the banking community, caused them to fail, and crippled the stock markets. Therefore, separating securities and commercial banking seemed the best solution to provide solidity to the U.S. banking and securities' system.
Today, a different truth seems evident. The framers of Glass-Steagall claimed that a conflict of interest existed between commercial and investment banks. The conflict of interest argument ran something like this:
- A bank that made a bad loan might try to reduce its risk of defaulting by underwriting a public offering and selling stock in that company;
- The proceeds from the IPO would be used to pay off the bad loan and;
- Essentially, the bank would shift risk from its own balance sheet to new investors via the initial public offering.
Glass-Steagall today
While the Glass-Steagall Act has not officially been repealed, we have witnessed an abundance of commercial banking firms making forays into the I-banking world. The mania reached a height in the spring of 1998, and continues to simmer. In 1998, NationsBank bought Montgomery Securities, Societe Generale bought Cowen & Company, First Union bought Wheat First and Bowles Hollowell Connor, Bank of America bought Robertson Stephens (and then sold it to Bank Boston) and Deutsche Bank bought Bankers Trust (which had bought Alex Brown months before).
While some commercial banks have chosen to add I-banking capabilities through acquisitions, some have tried to build their own investment banking business. J.P. Morgan stands as the best example of a commercial bank that has entered the I-banking world through internal growth. Chase Manhattan, which is aggressively pursuing investment banking businesses, has made some progress as a bond underwriter, but still hasn't truly tapped the equity arena. Interestingly, J.P. Morgan actually used to be both a securities firm and a commercial bank until federal regulators forced the company to separate the divisions. The split resulted in J.P. Morgan, the commercial bank, and Morgan Stanley, the investment bank. Today, J.P. Morgan has slowly and steadily flawed its way back into the securities business, and Morgan Stanley has merged with Dean Witter to create the biggest I-bank on the Street.
Even with the increasing number of commercial banks offering securities, the government must still approve any combination of commercial banks and investment banks. Also, there have been logistical and political problems. For example, the FDIC and the Federal Reserve regulate commercial banks, while the SEC regulates securities firms. Therefore, until a combined regulator can be determined, security and banking activities must continue to be operated separately. That is, an investment bank with commercial banking operations must operate such activities in the form of a separate subsidiary or division within the firm.
Globalization
As banks place increasing priority on size, international mergers and acquisitions in the financial services industry have become more and more common. In recent years, Deutsche Bank bought Bankers Trust, ING bought Barings, and Merrill Lynch bought a significant stake in Yamaichi Securities in Japan. Large mergers within countries other than the U.S. have also been fast and furious. In France, Bank Paribas and Societe Generale planned a merger in early 1999 in an attempt to build sufficient size in order to duke it out with the other big European banks, notably SBC (which was formed by the combination of Swiss Bank and U 3S) and Deutsche Bank. Banks are scrambling to add I-banking operations worldwide, and are only hindered by a limited pool of acquisition candidates and troubled economies in Asia.
Most industry observers say that merger mania has taken hold for two reasons. One, financial institute ns want to become global, and two, they want to establish one-stop-shopping for consumers and investors. A good example of the second rationale is the Travelers-Smith Barney-Salomon combination. ‘Travelers’ provides insurance products; Smith Barney provides an I-banking operation with historical strengths in equity; and Salomon provides an I-banking operation with historical strengths in debt. (Travelers then merged with Citibank, which provides commercial banking operations.) These types of combinations can be enormously profitable if the firms' cultures can be successfully combined.
Mergers of Buy-Side and Sell-Side Firms
Adding fuel to the consolidation fire is the recent frenzy to snap up mutual fund companies, or buy-side firms that manage huge sums of money. Many major investment banks have made major asset management acquisitions in recent years: Merrill Lynch bought Britain's Mercury Asset Management, Morgan Stan By Dean Witter bought Van Kampen American Capital, Credit Suisse First Boston bought Warburg Pincus Asset Management, and J.P. Morgan bought a significant stake in American Century Investments.
One of the reasons for this trend is the same consolidating force that is driving combinations of investment banks and commercial banks - institutions want to be able to offer more products to sell to existing customers. Perhaps as importantly, investment management fee income is much more stable in nature than trading and underwriting business, which can exhibit huge swings in volatility and also depend significantly on bull markets. For example, as a newly public company, Goldman Sachs is thought to be eyeing an asset management acquisition to help bring stability to its earnings.
Interestingly, the traditional Wall Street firms have been unable to grow money management businesses internally. Firms such as Merrill Lynch, Smith Barney and Morgan Stanley have all offered mutual funds, but have underperformed the market and the rest of the fund industry. Thus the race to acquire good money management firms is a race to acquire people and expertise that the investment banks have not been able to build organically.
Online Brokerages
As more and more individual investors become knowledgeable about financial markets, and depend less on hand-holding from full-service brokers, they are looking to make decisions on their own and perform trades on their own - at the least cost possible. This has made possible the success of discount brokerages like Charles Schwab, and most recently, do-it-yourself online brokerages such as E-Trade and Ameritrade. A larger and larger portion of stock market trades is being enacted online daily and Wall Street is finally joining the game. In 1999, brokerage leader Merrill Lynch and many other leading brokers such as Paine Webber and Prudential Securities announced that they would offer online brokerage services. Because their businesses were for years based on their armies of financial advisors (brokers), these firms were initially hesitant to go online, but have responded to the market's demands. At one point in 1999, for example, the market capitalization of Charles Schwab was greater than that of Merrill, primarily because of the success of its online brokerage business. It should be noted that online brokerages are at the same time beginning to offer more full-service advice.
Not only is the brokerage business moving online, but so is investment banking. The best known online I-bank currently is Wit Capital, but other ventures are starting, including WR. Hambrecht founded by the former chairman of high-tech boutique Hambrecht & Quist.
