October 28, 2008

Should Banks Be Publicly Traded?

On the 79th anniversary of Black Tuesday and as history repeats itself before our eyes, it's fitting to think a bit harder about how best to regulate banks.

While I haven't heard anyone else make this point, it seems to me that much of the investment banking crisis has stemmed from the increased level of risk created by the sell of bank shares on Wall Street. It's instructive to note that the two investment banks left standing, Goldman Sachs (GS) and Morgan Stanley (MS), were the most fiscally conservative of all.

GS, which is in the strongest position, never wanted to become publicly-traded, fearing the greater risk and thus was the last to cave, resisting an IPO until the late eighties. And even afterwards, both firms made sure to hold conservative debt/equity ratios. Today, GS has $1 of capital for every $22 of assets; MS has $1 for every $30. Amazingly, 22 to 1 and 30 to 1 are considered conservative ratios by recent highly-leveraged investment banking standards. But interestingly, GS continued to hold majority share of its own stock at all times.

Still, both firms chose to convert themselves into holding companies in order to minimize the impact of the global meltdown on their own books, which has already cost both firms' stock to lose roughly half its value over the last year. As such, at least 50% of their stock must now be owned by five or fewer individuals and at least 60% of their adjusted ordinary gross income must come from dividends, interest, rent, and royalties.

I submit that the demise of investment banking--and more generally of all banks foundering under the current mortgage crisis--is in large part the result of their being publicly traded, which promotes gamesmanship by making banks liable to the interests of third-party investors instead of their own clients.

I personally want my bank to make sure it's investing my money prudently. I don't want it beholden to third parties who simply want the bank's stock to rise as fast as possible. And that goes double for my mortgage lender, who should not be re-selling my loan to countless others down the line. That's the kind of money-go-round that betrays the trust I place in the bank as a stakeholder.

As it stands, commercial banks must have greater disclosure, higher capital reserves and less risk-taking. For example, Bank of America has an 11 to 1 debt/equity ratio. But that wasn't enough to keep myriad major commercial banks from collapsing under the weight of bad mortgages.

Numerous democrats such as Barney Frank, Chairman of the House Financial Services Committee, and Henry Waxman, Chairman of the House Oversight and Government Reform Committee, are saying banks should not be allowed to bundle and resell mortgage-backed securities, perform credit-default swaps, or issue subprime mortgages. These might be good measures that would tend to make banks more prudent when issuing loans.

But my point is that the entire problem could be better solved for the long term with a policy hatchet simply requiring that all banks not be publicly-traded. Or at the very least, they should all be regulated as holding companies. Interestingly, as consolidation continues, it would seem the latter may already be occurring.

Such measures would certainly curtail investment and thus inhibit economic growth substantially. But this investment-banking meltdown has shown that the economy simply cannot sustain ever-increasing levels of activity--not to mention that it's also environmentally unsustainable. As a result, we're already seeing widespread contraction of the high finance industry.

Business majors and MBA seekers take note!