Effects of Deregulations on Investment Banks

Submitted to: Mr. Nayyar Nizam Submitted by: Anil Qamar (7205)

Contents
Introduction .................................................................................................................................... 3 Methodology................................................................................................................................... 3 Limitations....................................................................................................................................... 3 Scope ............................................................................................................................................... 3 Financial Deregulation and Investment Banks ........................................................................... 3 1. 2. 3. Repeal of Glass-Steagall Act: ........................................................................................ 4 Capital Requirements and Securities and Exchange Commission: .............................. 4 Credit Default Swaps: ................................................................................................... 4

Aftermath of Deregulation ......................................................................................................... 5 Sub-Prime Lending: ................................................................................................................. 5 Off-Balance sheet financing: ................................................................................................... 5 Shorting the Mortgage market: .............................................................................................. 6 Propriety Trading: ................................................................................................................... 6 As a result of Financial Crisis 2008 .................................................................................................. 7 Volker Rule .................................................................................................................................. 7 Resolution Authority ................................................................................................................... 8 Systematic Risk Regulation ......................................................................................................... 8 Derivative Securities ................................................................................................................... 8 Costumer Protection ................................................................................................................... 8 Bibliography .................................................................................................................................... 9

Introduction
The implementation of the Banking Act of 1933 more commonly known as the Glass-Steagall Act post 1930s great depression made the U.S banking sector arguably the most heavily regulated banking sectors in the developed world. With the repeal of the Glass-Steagall Act the modern era of liberalization witnessed a deregulatory stance on part of the U.S financial markets with the shift in balance from regulated and controlled environments in favor of deregulation and free market economies. Advocates of free markets consider deregulation a boon in the development of the whole financial system and world economies based upon the assumption that a free market is an efficient market. The purpose of this paper is to evaluate the effects of financial deregulation on the investment banking operations and the impact of latter on the US economy and the world.

Methodology
Secondary research was conducted for the purpose of this paper including but not limited to articles from last five years, websites such as investopedia, guardian, and economist along with certain research papers. The objective of the paper is to analyze the effects of deregulation on investment banks and their activities which in turn led to financial crisis 2008.

Limitations
Although an extensive secondary research has been carried out, but some primary work could have been done to make the conclusion stronger and more reliable.

Scope
Years following the great depression of 1930s saw financial regulat ion as the order of the day with implementation of Glass-Steagall act along with several other amendments in order to ensure accountability and efficient performance of the financial sector preventing it from collapsing again. The trend reversed in favor of deregulation during the 1990s only to witness yet another catastrophe in shape of 2007-8 financial crisis.

Financial Deregulation and Investment Banks

Traditionally, investment banks facilitated businesses in their need for raising capital by designing, financing and selling financial products like stocks and bonds. When organization needed money to fund a large capital intensive project, it often hired an investment bank. Another important function of the investment bank was to deal with mergers and acquisitions. Today, investment banks perform a wide array of services including advisory services, derivatives and commodity trading. Many of them also actively participate in the mortgage market assisting lenders or mortgage brokers to package and sell mortgage loans and mortgage backed securities (MBS). Investment banks performed all of the above mentioned services in exchange for fees.

Underwriting was yet another very important service provided by the investment banks and by agreeing in doing so it typically bore the risk of those securities on its books until the securities were sold. In case of the security being publically sold they must be registered with the SEC but if the issuer decides on not going public the securities were issued via private placement with the investment bank acting as the placement agent selling the securities to selected investors. Years following the financial deregulation witnessed following milestones:

1. Repeal of Glass-Steagall Act:

Investopedia defines Glass-Steagall Act as: An act passed by Congress in 1933 that prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities. The act further created Federal Deposit Insurance Corp. whose function was to insure the deposits and supervise the banks that were insured. Furthermore, the Federal Reserve was given an additional authority to prevent the banks from making loans that were speculative in nature and failure in compliance resulted in heavy criminal penalties. The annulment of the Glass-Steagall act blurred the distinction between commercial banking and investment banking activities and banks were no longer supposed to comply with the act.

2. Capital Requirements and Securities and Exchange Commission:

It was not until 1981 that the capital requirements were regulated but afterwards it became an important benchmark. Capital requirements for investment banks were significantly reduced by the Securities and Exchange Commission in 2004. This reduction allowed some firms to hold less capital and enable them to increase their leverage dramatically. Instances were found where the institution was holding 12-to-1 ($1 of capital for every $12 of assets) to 33-to1. Moreover SEC Rule 15c3-1 was amended in 2004 in an attempt to help the five largest investment banks in the United States to meet European regulatory requirements. Some investment banks, referred to as holding companies, owned several broker -dealers, meaning firms that traded securities. Individual broker-dealers were regulated by the SEC, but there was no regulation of the holding companies themselves.

3. Credit Default Swaps:

Investopedia defines CDS as: A swap designed to transfer the credit exposure of
fixed income products between parties. A credit default swap is also referred to as a credit derivative contract, where the purchaser of the swap makes payments up until the maturity date of a contract. Payments are made to the seller of the swap. In return, the seller agrees to pay off a third party debt if this party defaults on the

loan. A CDS is considered insurance against non-payment. A buyer of a CDS might be speculating on the possibility that the third party will indeed default.

The Commodities Future Modernization Act of 2000 established that complicated Financial instruments traded between sophisticated parties would not be regulated as futures, securities or insurance. In particular, credit default swaps, which are contracts that require one party to pay the other in the event that a third party defaults on some obligation, could no longer be regulated by states as insurance or gambling. Previously, the regulations required a buyer of insurance to have an insurable interest i.e. a person is allowed to purchase insurance against his own house, but not a neighbors house. The CDS market attracted speculators who placed bet on the companys ability to pay their debts. It also attracted the bondholders and other investors who owed money by companies and wanted to hedge against the risk of a default.

Aftermath of Deregulation
As a result of financial deregulations, investment banks were reckless in their approach which eventually led to financial crisis of 2008. Following are the list of

Sub-Prime Lending:
The term subprime refers to the credit quality of particular borrowers, who have weakened credit histories and a greater risk of loan default than prime borrowers (FDIC-Guidance for Subprime Lending) Apart from easy lending conditions, government pressures and competitive warfare immensely contributed to an increased amount of subprime lending. The chairman of the Mortgage Bankers Association claimed that mortgage brokers, while profiting from the home loan boom, did not do enough to examine whether borrowers could repay.

Off-Balance sheet financing:

Prior to the crisis, financial Institutions became highly leveraged, increasing their risk appetite and reducing their cushion against losses. Much of this leverage was achieved by means of complex financial instruments such as off-balance sheet securitization and derivatives, which made it difficult for creditors and regulators to monitor and try to reduce financial institution risk levels. Many firms used complex financial tools such as SIVs (Structured Investment Vehicles) which enabled them to move significant amount of their liabilities off their balance sheet allowing them to lend more while maintaining the minimum legal requirements such as SLR and CRR etc. Moreover, off balance sheet financing gives a less levered impression to the firms allowing them to borrow at a cheaper rate.

According to the statistics, several top tier US depository banks moved approximately $5.2 trillion in assets and liabilities off balance sheet into these conduits and SIVs enabling them to meet the minimum capital ratio requirements.

Shorting the Mortgage market:

Prior to the financial crisis, investors commonly purchased Collateralized Debt Obligation securities (CDOs), as long term investments that generated steady income, but during 2005-6 high risk associated with the underlying mortgages began to worry investors. Investors wanted to sell their CDOs but failed to do so due to the lack of an active market which forced them to purchase insurance against a loss on the CDOs they have bought by buying a credit default swap (CDS). Some investors began to purchase single name CDS contracts, not as a hedge to offset losses from CDO securities they owned, but as a way to profit from particular CDO securities they predicted would lose money. CDS contracts that paid off on securities that were not owned by the CDS buyer were known as naked credit default swaps. Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit from mortgage backed securities they believed would fail. Some investment banks took the CDS approach a step further. In 2006, a consortium of investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which created five indices that tracked the aggregate performance of a basket of 20 designated subprime securitizations. Borrowing from longstanding practice in commodities markets, investors could buy and sell contracts linked to the value of one of the ABX indices. Each contract consisted of a credit default swap agreement in which the parties could essentially wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX Index introduced a standardized tool that allowed clients to q uickly gain exposure to the asset class, in this case subprime RMBS securities. An investor or investment bank taking a short position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS securities would lose value.

Propriety Trading:
Banks and other financial institutions held an increasingly large proprietary holding of mortgage related assets. Numerous investment banks bought CDO securities and retained these securities in their investment portfolios. Deutsche Banks RMBS Group in New York, for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio at an affiliated hedge fund, Winchester Capital, exceeded $8 billion. One investment bank, Goldman Sachs, built a large number of proprietary positions to short the mortgage market. Goldman Sachs had helped to build an active mortgage market in the United States and had accumulated a huge portfolio of mortgage related products. In late2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only when some

of its clients lost money on the very securities that Goldman Sachs had sold to them and then shorted. Altogether in 2007, Goldmans mortgage department made $1.2 billion in net revenues from shorting the mortgage market. Despite those gains, Goldman Sachs was given a $10 billion taxpayer bailout under the Troubled Asset Relief Program, tens of billions of dollars in support through accessing the Federal Reserves Primary Dealer Credit Facility, and billions more in indirect government support to ensure its continued existence.

As a result of Financial Crisis 2008

Dodd-Frank Wall Street Reform and Consumer Protection Act or simply known as the DoddFrank Act is a result of 2008 financial crisis. Mark Koba a senior editor for CNBC describes it as: The term Dodd-Frank refers to a comprehensive and complicated piece of financial regulation born out of the Great Recession of 2008. Simply described this act places major regulations on the financial industry to prevent it from disintegrating again along with protection of the consumers investments. Key features of the Dodd-Frank Act include:

Volker Rule
This rule basically prohibits banks to involve in activities like owning or investing in hedge funds and private equity funds or any proprietary trading activities. Proprietary trading:
Bank is basically stocking up stocks and bonds in its vaults. With two assumptions: The prices of the securities which the bank is holding will move up. There will be a market/demand for those securities.

Bank

Prices the banks earn a huge profit. Prices (a)Risk to depositors money. (b)Bank could go bankrupt.

Resolution Authority
Governments can seize and dismantle a large bank in an orderly manner if it is on the verge of failing for e.g. ABC banks Costumer Relation department sold to DEF group while its Investment department sold to XYZ group. This will reduce the bailout costs and the risk associated with it. It will also keep in check the skewed incentives for the banks and financial institutions that are too big to fail.

Systematic Risk Regulation

A financial stability oversight council has been formulated that will monitor the activities and financial conditions of important financial firms. These firms are also required to formulate a living will in which they will describe how they would be liquidated if they fail.

Derivative Securities
In order to increase transparency and reduce counter party risk, derivatives trading in over the counter market will be transferred to electronic exchanges with contracts settled through clearing houses.

Costumer Protection
Dodd-Frank created the Consumer Protection Financial Bureau (CPFB)to protect costumers from unscrupulous lending practices of the banks.

Bibliography
Barker, D. (2012). Is deregulation to blame for the financial crisis?. Westlaw Journal Bank & Lender Liability, 1, 1-3. Retrieved from http://newsandinsight.thomsonreuters.com/Securities/Insight/2012/07__July/Is_deregulation_to_blame_for_the_financial_crisis_/ Credit Default Swap CDS. (n.d.). In Investopedia. Retrieved from http://www.investopedia.com/terms/c/creditdefaultswap.asp#axzz2EHagZxWC Financial crisis of 2007-2008. (n.d.). In Wikipedia. Retrieved from http://en.wikipedia.org/wiki/Financial_crisis_of_2007%E2%80%932008 Glass-Steagall Act. (n.d.). In Investopedia. Retrieved from http://www.investopedia.com/terms/g/glass_steagall_act.asp#axzz2EHagZxWC Levin, C. & Coburn, T. (2011). Wall Street and the financial crisis: Anatomy of a financial collapse. United States: Unites States Senate.