Common Cents

Exile on Wall Street

Ralph Murphy

(1/2019) Last May, Congress passed a partial repeal of the controversial Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The Act was made law with the President’s signature two days later. Dodd-Frank was a legal attempt to "promote financial stability and transparency in the nation’s financial system".

Its net effect was a lopsided, controlling win for large banks and corporate finance divisions, often out of touch with investment needs tied to growth. The partial repeal restored an element of balance, particularly to banking. But, if not better founded, the underlying legal structures could permit a return of self-regulating big banks.

The Dodd-Frank Act was introduced by two Democratic Congressmen following a scare based on misunderstandings linked to a downturn in several New York investment banks whose assets were tied to mortgages. While this event was probably just a correction of the lending market and the money was still available to other owners, it was billed as the 2008 financial crisis. Investment banks are different from commercial banks in that they can lend and borrow from the central bank for investing in equities or debt instruments tied to security trades.

Commercial banks were limited to drawing assets from depositors by the 1933 passage of the Glass-Steagall Act, until its partial repeal in 1999. After this, their options expanded for investment and fund access at the expense of the larger investment banks. Investment bank definition is limited to their role in the economy. but lately, a numeric value was ascribed to the banks as asset levels rose over $250 billion. That group of banker investors seem to have been largely unchallenged from the 1933 Glass-Steagall era to the partial repeal in the late Clinton administration.

The Glass-Steagall Act sought to keep investment in a very tight group of New York’s Wall Street financiers who were then also able to combine their interests in various cartel-like arrangements, controlling lending rates and other assets such as mortgages. The 1999 partial repeal of Glass-Steagall had the unintended effect of also empowering corporate finance divisions to assume bank functions that were largely unregulated. It gave rise to self-styled CEOs with overnight and enormous income earnings. These earnings seemed to be tied to their finance divisions and the central bank or federal reserve funds from which they could suddenly borrow.

The point here is that following the 1999 legislation, small banks and corporate finance divisions started to control deposit and investment interests that had been the domain of the larger bank groups and Dodd-Frank was reestablished. Small banks were almost choked out of business because of the vast control that large banks had seized. The partial repeal which occurred last spring eased regulatory restrictions on the smaller banks, as well as access to the larger investment banks which were divorced from the floor-lending required for lower grade investments.

The issue now is between arbitrary description of investment bank versus commercial bank. The 2018 Dodd-Frank partial repeal didn’t adequately address the Glass-Steagall reforms that had caused new investment concerns. Corporate finance divisions seem to have been the real winner since 1999, in that they were relatively self-regulating and the asset levels had become awkwardly large. General Electric stood out as the leader of this phenomenon until the CEO was changed in 2015. Asset access peaked at a reported $499 billion. The organization was so unwieldy that it was forced to divest into mostly large banks and pension funds just after the CEO arrived.

There has been a Volcker Rule linked to the 2010 Dodd-Frank Act that favored the investment banks in the old status quo of the original Glass-Steagall Act. However, once again, the definition of commercial and investment banks hasn’t been well established beyond their perception of size, and historic national or regional interests. Asset ascription is too static for that dynamic and has remained subject to variables such as earnings or other factors, including inflation. An investment bank could become a commercial bank overnight and then be measured by different standards.

The bank laws should encourage investment competence and return on project money, not on its size or alliances. The investment banks project cash recently has been out of touch with conventional bank returns, and the money often paid for overseas infrastructure or social programs with limited chance of investor returns. Interbank lending facilitates or almost guarantees collusion or stalled program maintenance. Corporate finance groups were arguably the biggest winners since the 1999 change. Beyond the fund access, they enjoyed FDIC federal bank insurance tied to their common, sudden failures.

The central banks primary function in the current system is to afford new money when the economy needs to expand or the means to withdraw surplus cash if there is a contraction. This is accomplished with buying or selling government securities for the respective expansion or contraction. Since Dodd-Frank, this regulatory role has quietly been largely usurped by the Treasury Department’s Comptroller of the Currency. This must be reevaluated, as it has been a Federal Reserve Bank prerogative since the 1913 Federal Reserve Act was created. Investment-linked securities trade tied to the monetary policy regimen has historically been the domain of New York bankers. But, they have recently proven to be so erratic and divorced from the older collusive, but predictable, investment frameworks that the whole access affordance is being reviewed.

It might also be a good time for broader inclusion of security traders based on need and ability for returns, not just an ill-defined size ascription. Banks should be able to attract deposit money and invest it as regulated based on their personnel’s competence, given their unique backgrounds or capacity. Regional institutions seem to be more in touch with local smaller businesses.

The current systemic problem is that investment losses are based on project money that is loosely monitored by an impersonal control authority. The laws are vague or their power is limited when a breach of the accords is recognized. There cannot be interbank lending and lack of collusion if precedent serves. All bankers should be able to borrow or sell government securities, but that likely would be the domain of larger concerns. The corporate finance division system also must be reviewed and limited to their own company’s investments- not an impersonal outsourced bank role void of real insight or competence.

If any good has come from recent economic turmoil, it does seem that transparency for collusive dealing has about run its course with its exposure to an archaic, crony system that prospered in obscurity. But, this collusion has been broken down when exposed to the light of day. A framework for investment based on returns requires a regulatory authority that can police it while not otherwise intruding. Fundamental curbs can afford that investment stratagem, but presumes an ability and laws that broadly permit them.