If there was any benefit from the recent banking crisis and great recession, it was to increase public knowledge of financial markets. The world learned the hard way about bankers’ greed and incompetence and began to understand the power conferred by the market information they possess. The collapse of the US investment bank Lehman Brothers in 2008 and the disastrous knock on effects for the world economy of the demise of this apparently peripheral institution brought home the central role played by investment banks in our financial ecosystem. Their influence is immense and any discussion of information flows within public markets needs to start in their dealing rooms.
The deregulation of Wall Street in 1975 and the City of London in 1986 introduced an integrated model of investment banking that channeled powerful information flows into these financial institutions. Single firms were able to provide advisory services for investors who buy shares and also for the corporations who issue them giving them the privileged position of working on both sides of a trade. These same institutions were also allowed to trade for clients and for their own profit. It thus became possible for them to work for the buyer and the seller in a single deal and simultaneously to make a proprietary trading profit.
Regulators have tinkered with this model over the years but the investment banks’ information advantage remains intact, giving them a birds’ eye view of markets. This privileged position is at the heart of an asymmetrical financial system in which the dice are loaded against the end users. Every line of market business that is tradable flows through the investment banks’ dealing rooms and with that information comes extraordinary market power. Sometimes the temptation to abuse that privileged position proves irresistible and insider trading and market manipulation occur but cheating is scarcely necessary for there are rich pickings for legitimate operators who obey the rules.
There is a paragraph in Den of Thieves[i], the journalist James B Stewart’s classic account of the Wall Street’s scandals of the 1980s, which reveals this advantage. Stewart describes a conversation between Robert Freeman, at the time head of arbitrage at Goldman Sachs, and another trader. Freeman reflects ‘that when he was younger, he loved to go to Las Vegas to gamble. But now, he says, he doesn’t like casino odds. “It’s not fun anymore. I guess I’ve been in this business too long” he says, “I’m used to having an edge.”’
Freeman had put his finger on it. The financial behemoths’ edge is knowledge and integration. At any given moment in time, giant investment banks know more about the state of the world economy than any other public or private organization. The remarkable thing is not that sometimes they abuse this power but that they fail to take more advantage of it.
This last quarter of the 20th century was the golden age of investment banking and revealed what the model could produce. In that period, profits in the US securities industry grew by a towering twenty six times, quadruple the rate of increase in America’s corporate profits and GDP over the same period. Extending the analysis to 2004 and smoothing profits to adjust for annual volatility, securities industry profits grew at a compound growth rate of 10% per annum. This compares with a compound growth rate of 7% per annum in both US nominal GDP and corporate profits and 4% per annum consumer price inflation.[ii]
Whilst practitioners believe that this performance was achieved as a result of their own genius, the reality is that it was produced by legitimately exploiting generous rules that gave them superior knowledge and the ability to borrow heavily to leverage their bets. All they had to do to preserve this model was not to get too greedy but that was a temptation that Wall Street’s alpha males could not resist.
The work of the New York State Attorney General, Eliot Spitzer in 2001-2, exposed the scams that the investment banks had been running during the dot.com initial public offering bubble. Following Spitzer’s revelations, tougher rules were brought in to create internal barriers between the different departments of investment banks. Undeterred by the rising tide of regulation in one area of their business, the banks looked for new places that they could use their edge, adopting such tactics as selling over-valued mortgage backed securities to less knowledgeable clients and secretly betting against them in a ‘heads we win, tails you lose’ trade. The banking crisis of 2007-8 exposed this malpractice and prompted regulators to dig deeper into banks’ activities, revealing various other dark corners including the manipulation of market benchmarks such as the LIBOR and other inter-bank borrowing rates.
The investment banks had spoiled their own party. By over-leveraging they were financially ruined in the crash and by cheating, they created such a tide of adverse public opinion that traditionally friendly regulators and legislators had no option but to tighten the rules. Where does that leave information flows and probity within public markets now?
As a result of more intense supervision, new regulations and the deterrent effect of punishments, markets are currently in a relatively clean phase. Light touch regulation, the non-intrusive trusting approach pioneered by British regulators in the later 20th and early 21st centuries, has been replaced by more intense scrutiny. Structural changes such as the post-Spitzer separation of investor-oriented research from issuer-oriented corporate advice have cleaned up new issues. The dismantling of dedicated proprietary trading units after the US Volcker Rule banned short-term proprietary trading with effect from 2014 has prevented the most egregious practices of trading on the back of client order flow. Jail time for inside traders and current court cases for some of those involved in benchmark manipulation are likely to have a powerful deterrent effect within the financial community. Proving this is difficult but one barometer is the movement of share prices ahead of takeover deals, which has recently been in decline.
But it is too early to claim victory in the war against financial corruption. As the veteran British journalist Christopher Fildes has remarked, the time of greatest danger is when the last person to have experienced the previous crisis retires. In an industry where senior people usually retire in their forties, this creates a very short corridor in which people have firsthand experience of how bad behaviour breaks out and what happens to people and institutions that break the rules. Meantime, financial markets are highly skilled at regulatory arbitrage, the practice of obeying the letter if not the spirit of the law by means of new techniques to exploit gaps in the rule book.
Let us assume, however, that practitioners are mindful of the rules and are resolved to obey them. Even under those circumstances, the integration of conflicted services into single banks and the complexity of today’s deals mean that price sensitive information is bound to leak. A small army of people is required to make deals happen. A relatively small stock exchange deal in which the author was recently involved had around one hundred people on the approved ‘insiders’ list’. The chances of one of those people inadvertently giving away the secret were high and so it proved as the deal leaked to the press a few days before it was due to be announced.
In addition many deals require legitimate market activity ahead of any public announcement making it possible for seasoned market watchers to work out what is going on. For this reason, the UK’s Financial Conduct Authority are probably correct to say that reducing pre-deal suspicious movements to below one case in ten is probably a target that will be beyond the world’s financial markets.[iii]
And what of the investment banks? A combination of cyclical downturn in market activity and tougher regulations requiring them to hold more capital and curb proprietary trading have led many to trim their business model. There is a new focus on the cost of capital and unproductive assets and businesses are being shed. This has led some commentators to proclaim the secular decline of the industry. But the investment banks and their hedge fund and private equity cousins retain huge market power and a permissive business model. This advantage seems likely to protect their informational advantage and ‘caveat emptor’ will remain the best advice their customers can ever receive.[i] James Stewart, Den of Thieves, Simon & Schuster 1991, page 352 [ii] Philip Augar, The Greed Merchants, Penguin 2006, page 52 [iii] Financial Times, 2 July 2015