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Now let me in the end of this week say a few words about the IB regulation.
Now we know that the need and the economic efficiency of regulation comes at
the point when without that you could see that the market does not develop in a good way.
Remember that we talked about bank regulation.
We said that people who deposit their cash with the banks,
they have to be insured and when they're insured that
creates an potential temptation for the bank to engage in riskier projects.
And in this case,
if the bank is not regulated namely,
if there are no limitations imposed on the bank then it can indeed engage in
actions that will be exposed harmful for the whole market.
Not only for the government in terms of the high check and for the taxpayers.
Now in investment banking,
clearly there is part of that that goes back to
the times when there was no Glass-Steagall and then banks were universal.
We will say a few words about that in just a moment.
But for now we said that the key need for regulations
in investment banking comes from the idea of fighting against these crisis.
And the first question arises, why regulate?
Why wouldn't we ignore this and say,
well the market will do it by itself?
Now the key story here is very simple.
We can say, these are the investors and here
is the investment bank and then there's obviously
the market and what happens is that if
we do not regulate,
so these people have an advantage in some of these instruments.
So if they gain,
but we lose, so we can go ahead and wait until the market clarifies that.
But that's unlikely to happen because these people will
always find new loopholes and find new ways because they are better prepared.
They have more experienced personnel,
they have much more money and they have much more incentives.
So we have to somehow limit the greed of these guys and we have to support these guys,
because what if we did nothing?
Then at some point in time these investors said well,
you know what I'll stay out.
I understand that I can no longer participate profitably in this market,
and I prefer to stay out and see what's going on until,
and unless there is some kind of regulation that limits the power of these people.
Now, so we can see that the famous market and
sometimes may be too slow or may protect not the ones who really need protection.
And strictly speaking, we are not talking
about specifically regulating of the investment banking activity.
There are special kinds of things that are
required there because you're dealing with issuing stocks,
dealing you have stocks,
these are public instruments.
So you talk about information disclosure and some others.
But here we talk about the overall spirit of
that and that's why we are back to the year 1933,
when it was Glass-Steagall Act.
Let me remind you of that the Glass-Steagall we talked a lot in banking regulation,
and it broke up the activity of large universal banks in two parts.
One was investment banking,
namely issuing securities and trading them.
The other was commercial banking or selling retail deposits.
So what was the key here?
Why was Glass-Steagall an important part of the introduction of deposit insurance?
Because if there was no Glass-Steagall,
it would go like this.
As a commercial bank,
I sell retail deposits and they are all insured.
Then I take this money,
and I use this money in order to speculate in my investment banking activities.
So for example, I buy issues in some,
let's say I engage in foreign commitment,
so I use not only the money of my investors but my own money.
So, and I am sort of induced to go after riskier and riskier projects,
because if I use this huge amount of money and I've gained a lot,
I make a great profit.
If however, some of these projects or maybe many of them,
they prove losing then who pays? The government does.
So the government said,
that I cannot afford to take such huge risks.
So I have to break up these activities.
Now the Glass-Steagall Act was the main spirit
of banking and investment banking regulation for over 60 years.
And all this period of time investment banks would
always complain that you are limiting competition,
you're not allowing us to do certain things that we're well prepared to.
And moreover, they found lots of loopholes to circumvent the letter of Glass-Steagall.
And by the late 90s,
people kept claiming that the act is outdated,
that it does not provide the efficiency actually it hinders efficiency.
And then they also said that now the markets
had developed to such a way that you no longer need it.
Well, as a result, as all of you know,
in 1999 the act was repealed.
Now a lot of people believe that that
played a significant role in the fact that in less than a decade,
a huge global crisis occurred that is still not fully overcome.
Now it's difficult to- well some very well-known specialists,
they just openly blame the absence of
this piece of regulation as the key component of the crisis.
Others are less sure,
but the story is again the same.
We're talking about the spirit of regulation.
The fact that something is not allowed sends a strong signal.
What should be the guidelines of your behavior?
If you find some loophole and if it's not illegal and if you can't enjoy that, great.
But if you just lift this,
you repeal the act and as a result you
say you can do everything and then people go off rails.
And that is what happened in
the overall atmosphere of entrepreneurial and risk taking spirit.
Let's go back for the moment to the time of the S&L crisis.
Again, the fact that the economy in the 80s United States,
was sort of entrepreneurial,
and active, and energetic, that was positive.
But at the same time,
it played a really provoking and negative role in the development of the S&L crisis,
because people started to take risky and riskier projects.
Well, they enjoyed some kind of protection by the deposit insurance in S&Ls.
So that was the key story and that was rough,
as we remember more than half a trillion US dollars.
Now the mechanics of the latest crisis was a little bit different,
and we will study the instruments that played
the key role in the scale and the damage produced,
starting from the beginning of the next week.
But for now it's important to say that
still there's a need to get some kind of regulation,
not only in terms of the spirit which
is the most important but also in terms of the letter.
And we saw and we talk about that in some detail later in our sixth week,
that very quickly some of these pieces were,
well, they were not brought back,
but people started to argue very widely that we need
some regulation that would sort of replace Glass-Steagall.
Now it would not be just the direct replacement,
it was more fine tuned.
But the story here is very important
because we can really learn a great lesson from that.
That often oftentimes when something seems to be obsolete,
and when you remove the obstacle then you damage
the spirit of regulation and the spirit that brings discipline to the overall market.
And one of the important things in capital markets in general,
especially keeping in mind the global character right now,
it is this discipline and the understanding of what might result in large scale damages.
So we are wrapping up our study of investment banking for right now.
And although clearly we were a little
bit more descriptive compared to what we did with banking.
But again, the main message
that concludes this week is that the investment banking business
is the key part of global capital market that opened
the deals with the same problems with different faces.
And these problems are primarily caused by
the existence of private information at the global scale and that is why
we see both huge championship results there and also spectacular crisis.
Please pay attention to your assignments,
that again require some logic and understanding and are not so trivial.
Good luck with them and I'll see you in our next sixth final week.
Konstantin KontorDirector and Professor of Finance and Strategy
