Real Risks in Big Banks’ ‘Merchant Banking’ Activities
In a recent Deal Professor column, Steven Davidoff Solomon gives the Federal Reserve a symbolic “F” for failing to justify its recommendation that Congress repeal existing statutory provisions allowing big Wall Street banks to run in-house private equity funds.
Of course, if the Fed were writing an exam on a typical question of basic corporate law, then it might make sense to defer to a corporate law professor’s judgment on its merits. But this is a question of banking law. And, on a banking law exam, his critique of the Fed would not pass muster. Let me explain.
In banking law terms, the Fed is simply asking Congress to take back a specific authorization to conduct so-called merchant banking activities, which was originally granted to bank conglomerates in 1999 as part of the Gramm-Leach-Bliley Act that famously ended the Glass-Steagall era. This is an important point. Before 1999, American banks were prohibited from acquiring equity ownership of commercial companies, with certain minor exceptions (such as holding less than 5 percent of a voting stock class of any company or taking equity in satisfaction of a defaulted borrower’s debt). That general prohibition on banks’ equity investments reflects the longstanding principle of separating banking from commerce, which early Americans brought here from Britain.
The Gramm-Leach-Bliley’s merchant banking provisions created a broad exception to this principle by allowing banking entities to acquire up to 100 percent of equity in any commercial company they deemed a profitable investment. The reason for this exception, however, was not any objective scientific research showing that private equity was a risk-free business for banks; it was big banks’ barely concealed eagerness to get into the Silicon Valley speculative stock bubble. Only a few limitations were placed on this newly created merchant banking authority at the time, and policing banks’ compliance with those limitations subsequently proved to be inherently difficult.
It’s even more difficult to maintain the separation of banking from commerce — which is still the foundational tenet of United States bank regulation — in the face of banks’ extensive private equity operations. Once a banking entity acquires full control of a commercial company, it becomes impossible to determine whether that bank is a passive financier or an actual commercial actor in, for example, oil drilling, uranium mining or arms trading.
And how is the Fed supposed to monitor and control the overall levels of risk present in big, systemically important banks’ operations if those operations include all kinds of nonfinancial activities?
Even though the Fed’s report emphasized its traditional concerns with the banks’ safety and soundness, the full range of risks that such extensive merchant banking operations pose includes heightened conflicts of interest, unfair competition, misallocation of credit, more complex forms of market manipulation and fraud and excessive concentration of economic and political power. These are all real risks that are rarely invoked in a basic corporate law exam but lie at the heart of banking law and policy.
The Fed’s extraordinary step of recommending legislative repeal of merchant banking authority for bank conglomerates must be evaluated in this broader legal and historical context.
“Merchant banking’s storied past” is irrelevant here. The original European merchant banks were small private partnerships that took a lot of risk with a lot of their own capital. They did not take federally insured demand deposits from the general public who had no means of policing their affairs. They did not run a nation’s payments system. And their failure could hardly have pushed the global economy into a severe crisis followed by protracted recession.
For the same reasons, free-standing investment banks, like Goldman Sachs and Morgan Stanley before their conversion into bank holding companies in 2008, were never subject to limitations on their equity investments and risk-taking. Just like the Italian Renaissance merchant houses, pure investment banks were fundamentally different from the publicly insured deposit-taking banks and, as a result, were treated differently for regulatory purposes.
What the Fed is proposing is to restore that market to its pre-1999 state of fair, free-market play: Publicly guaranteed banks would not be able to compete with private equity firms, and private equity firms would not be able to piggyback on big banks’ public guarantee to shift their risks over to taxpayers. These are fundamentally different business models, and the law should simply revert to acknowledging that basic fact.
True, the Fed’s report does not cite specific amounts of actual losses or gains to individual banks, or to the nation’s economy, from specific merchant banking investments. It’s also true that no bank’s portfolio has yet been shattered by an environmental catastrophe. But those are not proper reasons to dismiss the Fed’s conclusions as the Deal Professor column does.
The Fed is not a hyper-populist agency with a penchant for inexplicable “bank-shaming.” The absence of granular portfolio-level data on individual banks’ merchant banking investments may be partially explained by the sheer difficulty of collecting it. If the Fed requested such portfolio-level data, banks would predictably attack it for unnecessarily increasing their compliance burden.
Perhaps banks should produce such specific data voluntarily, so that we actually see that their private equity investments do, in fact, generate significant public benefits with no appreciable risks. Let them show to all of us how many specific new nonfinancial technology start-ups they have financed since 1999, and how much their merchant banking activities have actually contributed to the growth of the real American economy and the welfare of ordinary Americans.
I trust Professor Davidoff Solomon would also welcome such data. It would provide a more solid basis for debate than banks’ self-serving assertions that they should be allowed to benefit from extraordinary public guarantees, while also reaping the extraordinary private rewards of high-risk finance.