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As a result of more than 9,000 banks failing during the Great Depression years of 1930-1933, bank regulation was greatly tightened in the United States. The legislature felt the unethical actions from the integration of commercial and investment banking aided in these failures for three main reasons: banks invested their own assets in risky securities, unsound loans were made to boost the price of securities of companies whom the bank had invested in, and the commercial banks interests in the price of securities tempted bank managers to pressure customers to purchase risky securities that the bank was trying to sell. As a result, President Roosevelt felt that the best remedy to the situation was to pass the Banking Act of 1933, which established two new provisions to financial regulation: deposit insurance and the separation of commercial and investment banking activities. Sections 16, 20, 21, and 32 of the act are referred to as the Glass-Steagall Act. These sections forbid deposit-taking institutions from engaging in the issuing, underwriting, selling, or distributing of securities. Since the provisions of the Glass-Steagall Act did not apply to foreign banks operating in the United States, they could engage in insurance and securities activities. This put the American banks at a disadvantage. |
As a result of the pressure on the legislature and the constant talks of overturning the act, it was finally repealed. On November 12, 1999, President Clinton signed the Gramm-Leach-Bliley Financial Services Modernization Act, which repealed the Glass-Steagall Act. This allowed securities firms and insurance companies to purchase banks and commercial banks to underwrite insurance and securities. From this repeal, the financial services industry has undergone a consolidating phase of commercial banks and investment banks becoming one. However, this has not always proved beneficial for these companies. My hypothesis is that the culture clash stemming from the different risk tolerance levels between investment banks and commercial banks is the main reason why such mergers and acquisitions have not resulted in the expected synergies the financial markets were anticipating. |
Investment banks, by nature, have higher risk tolerance levels than do commercial banks. The principal reason for this is that investment banks are not financial intermediaries in the sense that they take deposits and lend them out. Therefore, default risk is not a concern for these institutions. They focus on assisting corporations in the issuance of securities, principally stocks and bonds. Since investment banks receive fees for their service at the issuance of these securities, the future successes or failures of these corporations is not a large concern of these banks. Indeed, the reputation of investment banks will be hindered when they assist companies that perform poorly, but the receipt of revenue not being tied to the performance after issuance makes these firms relatively risk tolerant. This risk tolerance was quite visible during the dot.com crash, in which I argue that investment banks were responsible for creating the dot.com bubble in the first place. |
These institutions took under performing firms public that no longer exist and took in millions in revenue. In fact, “they (investment banks) bagged a total of more than $600 million directly related to IPO’s involving just the companies whose stocks are now under $1.” (Sorkin, Andrew Ross, “Just Who Brought Those Duds to Markets?” NYTimes.com (Copyright 2001 The New York Times Company)) Commercial banks, on the other hand, are more risk averse. They are greatly concerned about default risk since their traditional line of business is accepting deposits and making loans with the profits resulting in the interest rate spreads between the deposits and loans. These banks will only receive profit if the borrowing corporations repay. If the borrowing corporations struggle financially, there is a much smaller likelihood of the commercial bank receiving its interest and principal payments. Therefore, the risk tolerance of these banks will be significantly lower than for investment banks. With these differences in risk tolerance, it comes to me as no surprise that the cultures of these banks do not mix. In fact, I feel that they will never mix. While most firms involved with mergers and acquisitions go through a temporary transition phenomenon where performance is below expectations, the large difference in risk tolerance between commercial and investment banks will result in the water and oil occurrence: they will not mix. The examples of the J.P.Morgan Chase & Co. merger and the embarrassing failure of the FleetBoston Financial Corporation with Robertson Stephens investment banking will demonstrate instances of the Glass-Steagall repeal failing to result in financial powerhouse conglomerates due to the risk and culture differences of investment banks versus commercial banks. |
The most well documented example of a commercial bank and an investment bank merging together as a result of the repeal is J.P.Morgan and Chase Manhattan Bank merging together in late 2000. At the time of the merger, it was believed by many analysts that the merger would prove beneficial for the newly created firm of J.P.Morgan Chase & Co. "It's a good potential fit because there are quite a lot of areas where the two are complementary," said Ron Mandle, a banking analyst at Sanford C. Bernstein & Co. (“Morgan, Chase Dance Ends With Merger.” 18 Sept. 2000. http://www.clubs.org/jpm.merger.htm) Douglas Warner, former J.P.Morgan chief executive and chairman and now current chairman of J.P.Morgan Chase & Co, was very optimistic about the merger. In his words: "This merger is a breakthrough for J.P.Morgan and Chase that will position the new firm as a global powerhouse. With a formidable client franchise and a potent array of capabilities to address the full spectrum of clients' needs, we see exceptional prospects for sustained growth and profitability.”(“Morgan, Chase Dance Ends With Merger.” 18 Sept. 2000. http://www.clubs.org/jpm.merger.htm) Despite the support of many analysts, there were plenty of critics, including myself, who felt that the clash of styles would prevent the company from performing to its potential. I believe the culture clash is related to the risk tolerance differentiation between the two firms by the nature of their businesses. Based on the results of J.P.Morgan Chase & Co. since the merger, the critics are correct as the company’s stock price has lost over a third of its value, a total of 10,000 people have been laid off, and the company has only been able to post one quarter of positive earnings. While one could argue the transition period phenomenon, I feel that that the difference in the risk tolerance levels will prevent the new firm from ever achieving the synergies the financial world was expecting. |
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