Diversified financial conglomerates are a bad idea. Shareholders become victims of the organisational tensions that follow, customers suffer the resulting conflicts of interest, and taxpayers see government guarantees used as collateral for speculative trading.
The Obama administration’s plan to limit the remuneration of employees of publicly supported financial institutions to $500,000 has the simplicity of genius. A limit on pay is an effective way to reinstate the Glass-Steagall Act’s separation of commercial and investment banking.
The proposal sets the cap at about the right level. Retail banking is administered by people who earn less, mostly much less, than that. But no professional would join an investment bank unless he or she expected to earn far more. So the present dispute over pay and bonuses is more than a focus for populist anger about the cost of taxpayer bail-outs. Fundamental questions about the future structure of the financial services industry lie behind the controversy.
Some believe that conflicts of interest in financial conglomerates were at the heart of both the financial follies of the past decade: the new economy bubble of 1998-2000 and the credit expansion of 2003-2007. For such people it is essential to revisit the issues raised by Senators Glass and Steagall in the Great Depression.
Others claim that a basically sound structure of wholesale finance was upset by rogue mortgage brokers in America’s inner cities and the public’s love affair with housing and credit cards. Those who hold this view think it is important to keep top executives and traders in their posts. Only by doing so can failed banks be restored to their healthy state and weaned from dependence on the public purse.
The latter view was expressed last week by Deutsche Bank’s Josef Ackermann, who explained that it was necessary to pay the going rate for talent even as his bank reported substantial losses. But German shareholders, taxpayers and depositors might take the alternative position. They might want such talent to be kept well away from their savings.
The growth of financial conglomerates in the past two decades followed different paths. In the US, the route was the successive relaxation and final repeal in 1999 of the Glass-Steagall Act. In Britain, restrictions on the activities of banking institutions disappeared as a result of market liberalisation and the regulatory “Big Bang” of 1986. Continental Europe always had universal banks, but only recently did they become aggressive in wholesale markets and securities trading in imitation of Anglo-American models. Globalisation of capital markets led to the convergence of institutional arrangements around the world.
But the good senators of 1933 were right. Diversified financial conglomerates are a bad idea. They are bad for their shareholders, victims of the organisational tensions that follow. The culmination of Sandy Weill’s aspirations at Citibank was a behemoth that neither he, nor anyone else, was capable of running. They are a bad idea for those who work in them. Tension between the buccaneering culture appropriate to trading and investment banking and the meticulous processing and caution needed for retail banking is perpetual.
Diversified financial conglomerates are a bad idea for customers because they are riddled with conflicts of interest. Most of all, they are a bad idea for taxpayers. Banks used the retail deposit base, with its effective government guarantee, as collateral for speculative trading. They created internal hedge funds, with fabulous leverage relative to their own capital.
The failure of these businesses has proved costly to shareholders and to innocent employees who have discovered that the apparently rock solid institutions they joined must eliminate their jobs to survive. Bank failure has proved costly to customers caught up in the collapse, and above all to the public purse. The growth of financial conglomerates served only the ambitions of the greedy men who ran them and the financial interests of traders, who were allowed to play with sums of money that should never have come into their hands.
These are the issues which President Barack Obama and Tim Geithner, the US Treasury secretary, seem willing to face – and which Gordon Brown and Alistair Darling in the UK, by setting up an inquiry, are desperate to kick into the long grass.