Felix Salmon

Forcing all broker-dealers to go private

By Felix Salmon
November 2, 2010

I’m back! And I couldn’t be happier with the fantastic set of guest blogs from Justin and Barbara — wonderful stuff. If you haven’t read it, for instance, check out Barbara’s post on rules-based vs principles-based regulation, especially as it applies to the Volcker Rule. Volcker himself advocates a principles-based approach, contra Michael Lewis, who wants some very tough rules:

Here’s a simple, straightforward way… to construe the Dodd-Frank language, and it would reform Wall Street in a single stroke: to ban any sort of position-taking at the giant publicly owned banks.

Our crisis was not drastic enough to enable legislation that ambitious, but in theory I like this idea. Basically, it forces all broker-dealers to be private rather than public companies. That was the case before Bear Stearns went public in 1985, so it’s clearly entirely possible. And Lewis points to Citadel as a good example of a private broker-dealer dealing very successfully in the much larger and faster markets of today.

Broker-dealers as a set might well get smaller if such a rule were enforced, but that’s a feature, not a bug. In fact, if broker-dealers don’t shrink at all, then the Volcker Rule has clearly achieved nothing at all.

More generally, I suspect that a lot of people who blame Gramm-Leach-Bliley (the repeal of Glass-Steagal) for the financial crisis should really be blaming the broker-dealers going public instead. After all, Bear Stearns and Lehman Brothers and Merrill Lynch were both entirely Glass-Steagal compliant, as, for that matter, were Fannie and Freddie and AIG. The problem wasn’t that they were merged with commercial banks; the problem was that they had far more leverage than any private partnership would ever be comfortable with.

The difference between the Volcker and the Lewis view of things is this: Volcker wants to stop banks making proprietary bets when they’re so big that the government will be forced to bail them out if they lose. Lewis wants to stop banks making proprietary bets with other people’s money, period, on the grounds that no one has ever treated external shareholders’ money as if it was their own.

Broker-dealers could still borrow, of course, and would still be active in the repo markets. But bond investors are by their nature much more cautious than stock investors, and so the level of risk that the banks could take would be ratcheted down a lot. And indeed if you look back at the crisis, no privately-owned broker-dealer got into trouble. That’s partly a function of the fact that very few of them exist, of course. But a system of small-enough-to-fail partnerships is in principle much more stable than having a handful of highly-regulated public megabanks.

It’s probably sad we’ll never get there.

20 comments so far | RSS Comments RSS

“Bear Stearns and Lehman Brothers and Merrill Lynch were both entirely Glass-Steagal compliant,” good point Felix!

“The problem wasn’t that they were merged with commercial banks; the problem was that they had far more leverage than any private partnership would ever be comfortable with.”

that was indeed the problem – but you can’t just say “private partnerships wouldn’t have done that.” case in point: LTCM

Posted by KidDynamite | Report as abusive

LTCM was OPM as well

Posted by FelixSalmon | Report as abusive

“But a system of small-enough-to-fail partnerships is in principle much more stable than having a handful of highly-regulated public megabanks.”
Is six partners small enough for you?
That was the limit in Britain, for the so-called country banks, 60 of which went bust in 1825 in what is considered by historians as the very first banking panic and one that nearly sent Britain back to the barter age.

Posted by alea | Report as abusive

Yes but LTCM was a different breed. I doubt they counted on an implicit backstop and I highly doubt that they knowingly capitalized on the rents the backstop provided.

Equity/Position limits on all institutions is the way that I see solving this problem. Sorry that it is a blunt instrument, but any other solution is mired in other problems.

Posted by MRLAMF | Report as abusive

Thanks for having us, Felix! It was a ton of fun. Your readers are great!

Posted by BarbaraKiviat | Report as abusive

Interesting post, introducing the idea of being too small to afford to fail which is what the idea of broker dealers going private leads me to think of.

So. We’ve got too big too fail countered by you have to be too small to fail (for different reasons, naturally) and then you’ve got a financial crisis that is big for any government to deal with, but is small compared to the amount of money that goes around the world in capital markets; then you have the shortage of lending causing businesses to fail and jobs to go countered by banking changes to reduce liquidity by making liquidity less liquid with Basel III and regulators reining in risk taking just when risk taking is the low risk option and traders taking high risks with little personal risk… and I won’t even mention increasing Partisanship.

I wonder if anyone ever thinks that sometimes small reactions are better than big ones? Perhaps it’s time to throw away the economics text books and start again.

Posted by FifthDecade | Report as abusive

alea, and also when Barings nearly went bankrupt over investments in Argentina in the late 19th century ( If I remember correctly ). Also 1907 and 1929 might ring a bell… Also the names in Lloyds in the 80s had unlimited downside which didn’t stop them bankrupting themselves.

If having a billion dollars at stake didn’t stop Jimmy Cayne taking risks with BSC then why would BSC being an LLP stop him?

PS LTCM had a ton of partner money in it. Not only did a significant portion of some senior partners wealth go down the tubes but some also borrowed against that “wealth” so certainly not OPM at LTCM.

Posted by Danny_Black | Report as abusive

alea, Danny_Black,

I think we’d all be fine with the banks, if the CEO’s and other senior management were forced to liquidate their private estates to cover their banks’ obligations the way the banks-owners 1929 and earlier had to. Isn’t it kind of silly to pretend that the fact that almost no senior bankers were financially “ruined” in the current crisis doesn’t matter?

Posted by csissoko | Report as abusive

The Lloyds names in the 1980s did not ‘nearly bankrupt themselves’ – they were for the most part silent partners who left running the business up to the underwriters. It was the underwriters who bore little personal risk, which is perhaps why they, like bank traders today, took on board risks for others in the pursuit of rewards for themselves in the form of huge bonuses.

There has clearly been a disconnect between capital owners and the users of that capital for some time. With today’s multiplicity of small shareholders, none of whom have any power to affect the company as a whole except through participation as an essentially decisionless small cog in the institutional wheel of fortune, management can pay itself what it likes, take huge risks, but take golden parachutes when they leave after causing ruination.

Who’s holding the bankers who caused it all to account? Nobody. So the good bankers get tarred with the same brush as social lepers.

Posted by FifthDecade | Report as abusive

csissoko, the point is the consequences were the same whether the brokers were private partnerships or not. This whole thing is part of the general meme that banks were knowingly taking risks for “short term profits”. I don’t believe for one minute that right up until the end that the senior management of any of the banks considered the possibility of a run on their bank.

FifthDecade, the management shareholding in BSC and LEH was far far far higher than say JPMC and the Lloyds names should have taken a more active management in what was after all an unlimited liability. Exactly what golden parachute did Jimmy Cayne or Dick Fuld get? If having over 1.5 billion USD between the two of them at risk didn’t focus their minds what sum would you suggest would? Did being a partnership stop GS taking risks that nearly killed them in 94? The point I am trying to make is that having your own cash at risk is not a panacea.

As for not holding bankers to account, did you personally lose a billion dollars? Jimmy Cayne did. Did you lost 400+ million? Dick Fuld did. Sure no one is going to break down and cry that either of them has to make do with “only” many tens of millions but to say it had no consequences is simply not true.

Also, you might want to check who actually holds shares in banks. It most certainly is not millions of little guys.

Finally, let me offer the opposite hypothesis. High ownership made these people emotional when it came to finding solutions. At the end of the day, it was simply too hard for Dick Fuld to see his company go for a song and he ended up losing it all, something that has been shown over and over to be a common response to losing money.

Posted by Danny_Black | Report as abusive

Danny Black: “csissoko, the point is the consequences were the same whether the brokers were private partnerships or not”

Danny, the point is the consequences were not the same whether the brokers were private partnerships or not.

There’s a big difference between losing $1 billion and losing your house(s) all your assets and $1 billion. That difference matters — and it is why your historical comparisons are faulty.

Posted by csissoko | Report as abusive

Correction: “all your assets and $1 billion” –> “all your assets including $1 billion”

Posted by csissoko | Report as abusive

csissoko, sorry wasn’t clear. By consequences I meant to the economy at large not to the partners.

Posted by Danny_Black | Report as abusive

@Danny Black,

You may disagree, but it seems pretty clear to me that anyone who is at risk of losing everything he owns due to liability for bank obligations, is going to take less risk than somebody who is just going to lose a fraction of what he owns. (In fact, I think this is basic principal-agent theory.) Since risk-taking by banks is the reason we needed the TARP program, it’s very hard for me to understand how the reduction in risk-taking created by telling bank executives that all their personal assets are on the line would fail to reduce the likelihood that we have a financial crisis (though I can easily agree that even this penalty will not entirely eliminate the risk of financial crisis).

Posted by csissoko | Report as abusive

csissoko, well that clearly is not true in this case. Brokers went bankrupt when they were partnerships. GS sailed pretty close to the wind in 1994 when it was a partnership – although to be fair this near-death experience did start the ball rolling to become a public company.

I think the difference here is that I think the managers of these companies did not believe they were taking life-threatening risks. If you put the probability of have those assets taken away at zero – like for instance alot of Lloyds names did – then having those assets at risk will not change your behaviour. As for the wider consequences, again look at the near collapse of banking in Britain in 1825, the panic in the late 19th century after Barings nearly went belly up, the panic of 1907 and of course the Great Depression when plenty of privately owned banks went bankrupt. Again look at LTCM where not only did they lever up with their own money but made a point of giving back the OPM – despite much complaining from those investors.

The only way i can think that a partnership would have changed perspectives is that in a partnership there is motivation to work your way up in one company and become a partner where you make the serious money. Without that motivation people are more mobile and more of a IBGYBG attitude can take over but i think it is a minor factor compared to the simple discounting of the catastrophic downside.

Posted by Danny_Black | Report as abusive

Your answer doesn’t address what I said. We can all agree that brokers will sometimes go bankrupt even if they’re partnerships — the question is one of the frequency and the size of the losses. I don’t think it’s possible to demonstrate that increasing bank CEO losses in the event of bank failure will definitely have no effect on the likelihood of bank failure.

The fact that there were failures even in the presence of full personal liability doesn’t support (or harm) your argument. You’re asserting that personal liability doesn’t matter, I’m asserting that it does. On that issue, I think we’ll just have to agree to disagree.

An additional benefit of personal liability is that it significantly reduces the losses to creditors. I know for sure that Britain’s biggest banking failure of the 19th century (Overend Gurney, similar to Lehman) resulted in 100% recovery for the creditors — after the bankruptcy was processed.

In other words (at least in 19th century Britain) making creditors whole was a private sector obligation, not the public sector obligation it’s become in the modern US. As a taxpayer, I feel strongly that private liability for broker obligations is a better system, even if I can’t prove that it will change their incentives.

Posted by csissoko | Report as abusive

Overend Gurney was a Public Limited Liability Company not a partnership when it went bankrupt which is how a number of the directors didn’t get wiped out.

http://www.telegraph.co.uk/comment/36427 77/Dont-panic-weve-seen-this-before.html

Posted by Danny_Black | Report as abusive

Nice article on Overend Gurney. The private owners took it public less than two years before the bankruptcy — and were required to offer a personal guarantee on the existing liabilities. In an age where shareholders were expected to stump up up to 3x the original purchase price if the firm needed cash, this was a very bad deal for the shareholders — leading as one might expect to criminal prosecution. Your article talks about the ruin of the partners and the losses of the shareholders, but I didn’t see anything about directors not getting wiped out.

I think that financial institution shares that work like they did in late 19th century England and require the purchaser to stand ready to put up an additional $75 per share when the firm needs the money (even if it’s just to pay off creditors in bankruptcy) would be a reasonable alternative to full personal liability for managers.

Posted by csissoko | Report as abusive

No idea, by the way, very interesting thank you for forcing me to learn new stuff and check my assumptions. Will look into it more.

Posted by Danny_Black | Report as abusive

The book the article is based on looks interesting. This was also quite and interesting book I thought – “The Panic of 1907: Lessons Learned from the Market’s Perfect Storm”

Posted by Danny_Black | Report as abusive

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