Size Matters: Commercial Banks And The Capital Markets
Cornell Law School
Last year was a bumper year for hedge fund launches. According to a Hedge Fund Research report released towards the end of March, 614 new funds hit the market in 2021. That was the highest number of launches since 2017, when a record 735 new hedge funds were rolled out to investors. What’s interesting about Read More
The conventional story is that the Gramm-Leach-Bliley Act broke down the Glass-Steagall Act’s wall separating commercial and investment banking in 1999, increasing risky business activities by commercial banks and precipitating the 2007 financial crisis. But the conventional story is only one-half complete. What it omits is the effect of change in commercial bank regulation on financial firms other than the commercial banks. After all, it was the failure of Lehman Brothers—an investment bank, not a commercial bank — that sparked the meltdown.
This Article provides the rest of the story. The basic premise is straightforward: By 1999, the Glass-Steagall Act’s original purpose — to protect commercial banks from the capital markets — had reversed. Instead, its main function had become protecting the capital markets from new competition by commercial banks. Once the wall came down, commercial banks gained a sizeable share of the investment banking business. To offset lost revenues, investment banks pursued riskier businesses, growing their principal investments and increasing the amounts they borrowed to finance them. In effect, they assumed the features of commercial banks — a reliance on short-term borrowing to finance longer-term (and riskier) investments. For the investment banks, combining the two was lethal and eventually triggered the financial meltdown.
The divide between two sets of regulators, those regulating commercial banks and those regulating investment banks, enabled the change. The need for greater regulatory coordination has grown with convergence in the financial markets. Although new regulation has addressed some of the concern, the gap between regulators continues today — raising the risk of repeating mistakes from the past. Acknowledging the role of bank regulation (and de-regulation) in reshaping the capital markets is a key step in the right direction.
Size Matters: Commercial Banks And The Capital Markets – Introduction
For decades, the Glass-Steagall Act erected a wall between commercial and investment banks, largely by restricting a commercial bank’s (or its affiliate’s) ability to underwrite, trade, and sell securities. The separation was intended as a shield: To protect commercial banks and their depositors against risks that would arise if a bank or bank affiliate began to do business in the capital markets. It was no surprise, then, that when the Gramm-Leach-Bliley Act took down the final bricks in the wall in 1999, the principal concern was whether commercial banks would increase financial risk-taking and, later, whether that risk-taking precipitated the 2007 financial crisis. No doubt, the banks’ (and their affiliates’) ability to enter the capital markets changed the nature and extent of the risks they incurred, and greater risk-taking contributed to losses that arose during the financial crisis. What the conventional story omits, however, is the effect of the Gramm-Leach-Bliley Act on financial firms other than commercial banks. That failure has resulted in a gap in our understanding of what led to the financial crisis. After all, it was Lehman Brothers-an investment bank, not a commercial bank—that sparked the meltdown leading to the crisis. And, not having learned from our mistakes, we risk repeating them.
This Article provides the rest of the story-a facet of bank regulatory reform and its effect on the capital markets that legal scholarship has largely overlooked. The basic premise is straightforward: By the time the Gramm-Leach-Bliley Act passed in 1999, the Glass-Steagall Act’s principal original purpose-to protect commercial banks from the capital markets-had reversed. Instead, its main function had become protecting the capital markets from new competition by the commercial banks.
Once the Glass–Steagall Act’s wall came down, commercial banks gained a sizeable share of business in the capital markets, displacing the role of investment banks. The size of a bank’s balance sheet-its ability to extend credit through traditional lending—became a decisive factor for borrowers in determining who would win capital markets mandates. Commercial banks offered a package of products and services that competed with those traditionally provided by investment banks. To offset lost revenues, investment banks grew their principal investments and the amounts they borrowed to finance them. In effect, as commercial banks entered the investment banking business, investment banks began to assume the features of commercial banks-in particular, a reliance on short-term borrowing in order to finance longer-term (and riskier) investments. For investment banks, combining the two-greater risk-taking and leverage-was lethal and eventually triggered the financial meltdown.
To illustrate, consider what occurred around Lucent Technologies’ decision to spin-off its optical network subsidiary, Agere Systems, in 2001. Goldman Sachs and Credit Suisse First Boston (CSFB), both investment banks, were originally tapped to lead Agere’s initial public offering (IPO) before Lucent found itself in need of $6.5 billion in short-term credit.20 In order to procure the additional funding, JPMorgan and Citigroup, two commercial banks, each committed $1.25 billion to Lucent and arranged for others to make up the shortfall. Goldman Sachs and CSFB declined to join the lending group and were dropped as co-managers of the IPO, positions that were picked up by the investment bank affiliates of Lucent’s new principal creditors, JPMorgan and Citigroup.
Morgan Stanley was also a co-lead manager of the Agere IPO. To be selected, Morgan Stanley agreed to purchase up to $2.6 billion in Lucent debt, a portion of which it exchanged with Lucent for up to 90 million Agere shares. For Morgan Stanley, the risks were significant. Prior to the IPO, Lucent’s credit rating dropped to one notch above “junk” (below investmentgrade) status. When the deal became public, Morgan Stanley’s stock price plummeted by over twenty percent, principally due to concerns over the risk Morgan Stanley had assumed—the possibility of Lucent’s credit rating dropping further or the value of the Agere shares being less than the Lucent debt Morgan Stanley had agreed to exchange. In the end, Morgan Stanley earned roughly $75 million in fees, but only following billions of dollars in lost market capitalization and at the risk of incurring significant loan-related losses.
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