Arthur J. Rolnick - Senior Vice President and Director of Research, 1985-2010
Published April 1, 1988 | April 1988 issue
Edited by Samuel L. Hayes, Ill
Harvard Business School Press
The rapidly changing U.S. financial sector, along with the deregulation that has accompanied this change, is the focus of five essays presented in Wall Street and Regulation by Professor Samuel L. Hayes, Ill, of the Harvard Business School. Each essay is authored or coauthored by Harvard colleagues. The common thread running through this book is that dramatic changes have occurred in the finance industry, which for many years had been one of the most stable sectors of our economy. The essays document the major changes, and each raises questions and concerns about the erosion of the regulatory structure that has been in place since the 1930s.
The 1930s was clearly a watershed for financial regulation. The first essay in Wall Street and Regulation, written by Professor Richard Vietor, attempts the ambitious task of documenting how the legislation that emerged from the financial problems of the 1930s has helped define the finance industry over the next three decades. After a brief history of U.S. banking through the 1920s, Vietor discusses the raft of legislation passed as a result of the financial instability the U.S. economy suffered in the early 1930s. This legislation included the Federal Home Loan Bank Act of 1932, the Banking Acts of 1933 and 1935, the Securities and Exchange Act of 1934 and the Federal Credit Union Act of 1934, to name some of the most important. All were aimed at promoting stability in previously very unstable markets. Vietor argues that by setting operating standards, separating asset and liability markets, limiting branching, fixing some prices and guaranteeing some deposits, such legislation had dramatic effects on the structure of the U.S. financial services sector. He convincingly supports his position by presenting a complex diagram showing the interactions of government regulatory agencies with the financial institutions and the markets they regulate.
But change is his theme, and change there has been. While for some 30 years after the reforms of the 1930s the structure of financial markets was relatively stable, the winds of change were in the air by the mid- sixties. Vietor identifies three major forces that have blurred the lines of distinction between different types of financial institutions and led to recent reforms and deregulation. He points to rising interest rates that brought in new competitors that were not subject to rate ceilings. He points to financial innovation that developed to circumvent geographic and rate restrictions that had become very costly. And he points to new technology that dramatically changed the cost structure of the whole industry.
He goes on to argue that these forces will continue to reshape the financial services industry and erode the regulatory structure for many years to come. That erosion, though, according to some studies, may not necessarily be bad. The fragmented financial services sector created in the 1930s may not fit the needs of the 1980s. But while a less-regulated environment is to be encouraged, he warns that the problems of excess risk and monetary instability still exist. Some amount of financial regulation is required, although specific suggestions are missing from his conclusions.
Professor David M. Meerschwam, in the book's second essay, is also concerned with the changing financial landscape, but he focuses on a particular change in bank behavior: the switch from what he calls relationship banking to price banking. This shift, he argues, increases the instability in banking and may require some new regulatory safeguards.
Relationship banking is defined by Meerschwam as the provision of banking services that are considered part of a continuing and unfolding relationship between financial intermediaries and their customers. The prices of these services are either of secondary importance to the customer or regulated so they are uniform across competitors. With the passage of the Banking Acts of 1933 and 1935, bank deposits became highly regulated and relationship banking emerged as the dominant mode of operation.
According to Meerschwam, however, relationship banking weakened considerably between the 1960s and the 1980s as interest rates climbed to double-digit levels. For example, the development of the Certificate of Deposit (CD) market in the early sixties and the Eurodollar market in the late sixties allowed banks to compete directly on price terms only. This shift to price banking wasn't complete, though, until the passage of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) in 1980, which called for the elimination of virtually all deposit rate ceilings over the next several years.
Meerschwam recognizes the benefits of allowing banks to offer market rates of interest on their deposits. However, he is concerned about the increased instability such competition might bring as funds that can be quickly gained by competitive pricing can also be quickly lost. He recommends that new safeguards be considered and offers an asset-based deposit insurance scheme as one possible remedy where the deposit insurance premium would relate to the quality of the bank's assets.
In the third essay, Professors Jay 0. Light and Andre F. Perold are concerned with the growth in institutionalized wealth and the dramatic effects that a relatively few institutional investors can have on capital markets. They point out that this change has occurred over a comparatively short period of time. Pension funds, for example, held only 2 percent of all outstanding U.S. equities in 1955, 14 percent in 1980, and a startling 22 percent by 1985.
The authors address two main questions regarding this growth. How has it affected institutional transactions and strategies? And, what are the policy implications of fewer and larger players in capital markets?
One of the most significant changes is the adoption of program trading. Institutions used to trade on a stock-by-stock basis only. Today, close to 25 percent of institutional trading is accomplished by program trades, which the authors define as simultaneous or nearly simultaneous trade of a large package of many different securities." They describe how this type of trading occurs when, for example, pension managers decide to shift funding from common stocks to a dedicated bond portfolio. Accomplishing this change may require the selling of hundreds of stocks and the buying of hundreds of bonds. Today such trades would be packaged into one large program trade rather than individually executed.
Other new trading strategies adopted by institutional investors involve the use of so-called derivative securities. In particular, large institutional investors now use both equity index futures and equity index options to implement a variety of portfolio strategies. The strategy of buying and selling part of a stock portfolio to reduce short-term volatility of the portfolio's value, so-called program insurance, is one such strategy discussed by the authors.
Attempting to identify policy implications from the increased presence of the institutional investors, the authors stress that the outlook for capital markets is "murkier" than it has ever been. Those who thought program trading would quickly lead to the demise of the New York Stock Exchange were at least premature and probably wrong. They also note that concerns over index future arbitrage and program trading are not warranted, that these activities generally should help to stabilize rather than destabilize financial markets. Nevertheless, they do point to such strategies as portfolio insurance and other short-term allocation transactions that are potentially destabilizing and may require regulation. (Recall that portfolio insurance is the strategy that some claim helped to cause the October 19, 1987, stock market crash.)
A recently introduced liberalization in the marketing of securities is the focus of the fourth essay by Professors Joseph Auerbach and Samuel L. Hayes, III. In 1982, the Securities and Exchange Commission (SEC) adopted shelf registration, a procedure designed to reduce the cost of marketing new securities. The SEC now permits certain capital issuers who register for public sale a block of new securities to put them "on the shelf" for up to two years. This allows the issuers to time their sales when they feel the best opportunity arises in that two-year period.
The authors explain the motivation for shelf registration in the context of the historical development of regulation of U.S. capital issuers. They carefully describe the legislative history of the securities market, motivating the rationale for legislation requiring disclosure of information on security offerings. Following this history they discuss the economic forces that led to shelf registration, why it was considered a good idea, and how, in effect, it became a liberalization of the disclosure procedures.
The authors suggest that this liberalization, however, may have been too costly. Shelf registration reduces the quality of disclosure because it affects the time available for the underwriter to gather information. Issuers of new securities have to file a prospectus detailing, in accordance with government specifications, all information deemed pertinent to investors. Further, the securities underwriters of these issues usually conduct an investigation of the issuer and the security (colloquially known as "due diligence"); under the SEC Act of 1933, without due diligence, an underwriter can be liable for any problems arising with the new securities.
As the authors point out, though, with the shelved securities, the underwriting investigation seldom occurs. When a security is shelved, the designation of the underwriter to distribute a block of such securities is usually a last-minute decision. The underwriters have little time to take due diligence as the sale to the public usually takes place within hours of their designation. Hence, in many cases the investigative care that was envisioned under the SEC Act of 1933 is not performed.
The authors assume that there is always a need for more and better information about securities issued in public markets. While they recognize that shelf registration has reduced the costs of issuing securities, they question whether it was worth the price. Markets, they acknowledge, are probably very good today at gathering information, but they contend that "the need for some regulation still exists for a broad group of corporate issuers."
Whether capital markets should be regulated at all is the provocative question addressed in the last essay. After reviewing the history of abuses that occurred prior to the legislation passed in the 1930s, Professor Warren A. Law touches on some of the current problems he sees in today's market. Insider trading, hostile takeovers, shelf registration, and price banking are some of his major concerns.
He comes to the somewhat surprising conclusion, though, that regulating these problems may not be an effective solution. He doubts that regulations put in place in the 1930s have been effective, citing studies by some leading economists to support his position. Commenting on a proposal to have Congress regulate takeover activities which have recently become so prevalent, Law expresses considerable skepticism. "It seems better to bear the ills we have than to flee to others we know not of; the mind reels, for example, at the thought of government bureaucrats evaluating the merits of new issues."
Law concludes by suggesting that certain problems are simply inherent in the system. We will, he argues, have to depend on the strength and integrity of individuals running this market machine, rather than on trying to fix a machine that appears to be in good working condition.
The essays in this book have much to recommend. Historical reviews of the development of the U.S. financial sector and the array of regulations that accompanied this development are informative and insightful. Each essay, in fact, can stand on its own. This is a disadvantage to readers who are looking for a single uniform analysis that yields a consistent set of policy recommendations. But it is an advantage to those readers who want to see somewhat different points of view on related issues and who may be interested in only a subset of the issues addressed in this book.
Wall Street and Regulation, however, is missing a critical issue in banking and one that extends to all financial markets. Little mention is made of deposit insurance and the general safety net the U.S. government provides banks and at times extends to the entire financial sector. Reforming the way government provides this safety net is one of the major problems facing policymakers today, and it is disappointing that the editor chose to spend so little time on this topic in a book that otherwise addresses the major issues.