Roy Smith
(Financial Times, January 7, 2003)
The recent
announcement by securities regulators and Eliot Spitzer, New York
attorney-general, of a Dollars 1.4bn (Pounds 870bn) settlement with 10
prominent securities groups for misconduct is a disturbing event for those who
seek clarity and fairness in stock market regulation.
The settlement purports to punish leading
investment banks for engaging in systematic exploitation of investors and to
provide needed reform by tighter regulation of the relationships between
analysts and investment bankers, by changing public underwriting practices and
by requiring Dollars 450m in subsidies for independent research to be provided
to retail customers. But the settlement has been extracted by threats of criminal
prosecution by Mr. Spitzer and by continued public exposure to embarrassing
staff e-mails and other leaked communications. The 10 groups were divided into
different tiers of culpability and put under pressure to pay up (two smaller
companies refused to settle and were deferred). The companies did not admit to
any violation of laws or regulations and the records of the case will
presumably be sealed from further public view. The government has greatly
disproportionate power over Wall Street groups in confrontations such as this
and can impose a solution that may not be fair. Indeed, this global settlement
invites the thought of companies being rounded up in the midst of a public
scandal because of where they rank and then all lumped together under bright
lights for a show trial.
As in a number of cases last year - the
Securities and Exchange Commission against Credit Suisse First Boston and the
state of New York against Merrill Lynch - this settlement does not make clear
what the groups did that might have been in violation of existing laws or
regulations. How do you prove that a research report is fraudulent rather than
wrong? While it is clear that during the years in question the market
experienced the biggest bubble in history, and some analysts were taken in by
their clients and/or were poorly supervised and given excessive inducement to
bring in new banking clients, it is not clear that the effort was systemic or
that the attributable level of harm and injury to retail customers in
particular rises to the level of a Dollars 1.4bn fine.
On
the face of it, a fine of Dollars 1.4bn would suggest an egregious, clear and
deliberate breaking of existing rules simultaneously by 10 leading investment
banks. Could all of these - in fierce competition with each other - have
knowingly issued false research recommendations to gain business? Would not
their more sophisticated corporate and institutional clients have learnt of it
and objected?
If it can be shown that what was done was
against the law, the individuals concerned and their companies - when
appropriate - should be punished accordingly. If that cannot be shown, a forced
group settlement for conduct that is not clearly in violation of law or
regulation is unfair to the banks.
The reform measures of the settlement are
unnecessary and expensive. Mr. Spitzer, the central figure in securing the
settlement, has no business affecting details of federal securities laws. These
are administered and enforced by the SEC and SEC rules already cover most of
the ground that Mr. Spitzer's reforms address. True, the SEC has been headless
and dysfunctional for some time. But that does not give Mr. Spitzer a licence
to insist on new regulations to reform the markets, particularly only a month
or two before the new SEC chairman takes office.
Each
effort to layer more regulation on the market has a cost and that cost is
ultimately born by market users. In addition to huge fines and the likely need
for further settlements with the ever-present plaintiff bar, the added costs of
providing subsidised independent research and other provisions of the
settlement begin to add up. At some point issuers and investors may find that
regulatory costs are much greater in the US than elsewhere.
America’s markets work well because
information flows effectively and relatively inexpensively. Companies value broad distribution of new
issues to include institutions and individuals alike, both of which require
post-offering information about the companies. Their bankers require expert
analysis of private companies before taking them public. Analysts are the
people who supply this information to the market; if they were not needed, they
would not exist.
We do not want reforms to damage the
efficient flow of information or to ignore the cost of additional regulation to
the users of the market. Group settlements for the sake of establishing
scapegoats are not the way to regulate a complex, sophisticated global
securities industry. (Download pdf)
* * * *
(Newsday, December 8, 2002)
Roy C. Smith
Since the
administration of Franklin Roosevelt, America has had 11 presidents and 20
treasury secretaries. George H.W. Bush had one, but Presidents Harry Truman,
Dwight Eisenhower and Jimmy Carter had two each, Presidents John F. Kennedy and
Lyndon Johnson together and Presidents Ronald Reagan and Bill Clinton had
three. Together, Presidents Richard Nixon and Gerald Ford appointed four.
Though the turnover of secretaries of
state and defense is comparable during the last 11 administrations, the
treasury secretary has often been the senior Cabinet member who was least well
known to the new president - someone whose appointment was urged on by
political advisers and with whom the president had not developed a comfortable
relationship. Nixon hardly knew David Kennedy, his first appointment. Likewise,
Carter hardly knew Michael Blumenthal, Reagan hardly knew Donald Regan and
George W. Bush hardly knew Paul O'Neill, who resigned Friday. But these were
not ordinary Cabinet appointments. The treasury secretary is the most visible
member of the administration addressing economic policies - policies which are crucial
to the success of any administration. So, naturally enough, he is the one who
has to take the blame for unsatisfactory economic performance.
O'Neill's departure offers his boss an
important opportunity to bring in new faces and fresh approaches to achieving
better results from unpopular or stalled initiatives. Often the second or third
guy in the Treasury job has been recognized as one of the most effective
members of the
administration
he served - Henry Fowler (Johnson), George Schultz (Nixon), James Baker III
(Reagan) and Robert Rubin (Clinton). But whether or not Bush can turn O'Neill's
resignation into an opportunity depends on who the new appointment is and what
sort of policy shift is likely to follow.
So far, the Bush administration has spent
its economic capital on a tax cut to return much of the expected fiscal surpluses
of a few years ago back to the folks who provided them, as well as some
anti-free trade tariff increases and the restoration of extensive farm
subsidies that were cut out in the Reagan days.
Though since then the economy has
softened and the surpluses have disappeared, unemployment has reached the
6-percent level again, a war on terrorism has been declared and there may soon
be an invasion of Iraq, the economic message from the White House seems to be
that all the economy needs now is to make the earlier, slow-acting tax cuts
permanent to boost consumption and to reduce the tax on corporate dividends to
perk up the stock market.
Today's economic reality, however,
dictates that the new man or woman in the Treasury get a grip quickly on two
policy areas that may already be out of control - the growing danger of huge
federal, state and municipal fiscal deficits in the years ahead and the need to
plan more thoroughly for the cost of wars against terrorists and those
countries that we deem to be harboring them or developing weapons of mass
destruction.
Congress may regard the federal budget as
an unlimited source of spending for pork once again, but the president has the
power to stop it by vetoing bills that are not sufficiently frugal. The direct
costs of warfare and military occupation in the Mideast are likely to be very
large - this time borne mainly by the United States - and they need to be part
of the planning process that leads to spending limits. Even then, the indirect costs
of military operations can be even more serious if these begin to affect
commodity prices and bring about a renewed battle with inflation, as happened
during the 1970s when the economic consequences of the war in Vietnam were felt
around the world, especially in stock and bond markets.
These issues require a tough line from
the White House, one that might offend the ideological base of the Republican
Party and possibly toughen up the resistance shown in the future by Democrats.
But one of the most important jobs that a treasury secretary has is to gain the
president's confidence to force him to face the harsh realities that are out
there now and to resist political motivations to give people what they want.
Bob Rubin was reportedly very effective
at playing this role with former President Clinton after he succeeded Lloyd
Benson as treasury secretary. The Clinton economic policy appeared to change
after Rubin was installed in the Treasury to place the highest emphasis on
deficit reduction, which led to further lowering of interest rates, an
extensive stock market recovery and several years of continued economic growth.
President Bush has a chance now to do
something similar - to focus on the deficits - and Paul O'Neill has given him
that chance by becoming disposable. It has happened to a lot of treasury
secretaries. (Download pdf)
* * * *
Strategic Directions in Investment Banking—A Retrospective Analysis
Roy C Smith
May you live in interesting
times!
—Ancient Chinese curse
Few businesses have ever benefited, as
the U.S. securities industry did, from the almost continuous eighteen-year
economic and financial tailwind that occurred from 1981-1999. At a time when
world and United States GDP increased at a compound (nominal) rate of 7%, U.S.
and world equity market capitalization and trading volume all increased at
about twice that rate. The worldwide volume of new issues of equity securities
increased at 19% and debt securities at 25%. The volume of worldwide mergers
and acquisitions also increased by more than 25% per annum during the period.
During this time also, commercial banks, under pressure from bad loans and
mismanagement and subject to intense competition, gave up vast amounts of
deposits and assets to the securities market in a massive display of
disintermediation.
In such buoyant market conditions, it
would seem to be difficult for any of the handful of American investment banks
that specialized in capital market services to do poorly. In fact, however, the
burden of managing such rapid growth effectively was a great one, and not all
firms fared well. Indeed, for many once-great firms, the opposite was true.
Drexel Burnham went bankrupt and Kidder Peabody was subject to a distress sale.
So was First Boston, a casualty of bridge loans in the late 1980s that had to
be reclaimed by its principal stockholder, Credit Suisse. Lehman Brothers and
Smith Barney, then ailing, were sold, and reshuffled several times (in Lehman’s
case, back to the public in 1994). Salomon Brothers, wounded from its illegal
actions in the Treasury bond auction market in 1990, never fully recovered and
was sold to a division of The Travelers Group. A number of other US firms that
were generally thought unable to keep up with competition, including Dillon
Read, Chase Manhattan, JP Morgan and Paine Webber, found merger with a stronger
partner (although at a decent price) their best strategic alternative. (Download pdf)
* * * *
(Financial Times, April 11, 2002)
Roy C Smith and Ingo Walter
More financial
wealth in America was created in the last two decades of the 20th Century than
at any other time or place in the history of the world. A stupendous stock
market boom boosted the value of financial assets at twice the rate of the
economy’s nominal growth. Many boats rose in this extraordinary tide. As the
new millennium dawned, nearly half of American households were participants in
the stock market. Conspicuous consumption, private philanthropy, and political
activism all followed the market’s boom. It was a great time and American
corporations and financial markets became the wonders of the modern world.
But the early years of the new millennium
have seen an ebbing of the stock market tide. Although the Dow Jones index is
off only about 13% from its all-time high, the NASDAQ index (containing most of
the computer and telecom names) is down by more than 50%. And, the falling tide
not only lowered the boats, but also revealed a lot of rocks and slime that
were overlooked on the way up. The sudden collapse of Enron (and some other
companies) revealed a dark underside to American corporate governance. Though
management could be innovative, aggressive and glib (all useful qualities), it
could also be misleading, dishonest and corrupt. Enron, for example, was able
to contaminate all those who chose to fatten at its corporate trough—its
directors, auditors, bankers, analysts, rating agencies, lawyers and political
friends.
Enron, however, was hardly alone in its
accounting fiddles and dubious management practices. The list is as long as the
trail of shareholder litigation and failed audits by the “big five” accounting
firms. But Enron did much to sharpen sensitivity to financial shenanigans, so
investors today are looking much more skeptically at all companies, including
some of the country’s most respected firms. The growing concern about the
integrity of American corporations dovetails with this year’s publication of
top executives’ compensation awards, with plenty of examples of management self-enrichment
despite declining earnings and eroding stock prices.
How can this be, after so many years of
attention to principles of good “corporate governance” and pontificating to
others about the superiority of the American capital market-dominated system?
In a recent address at New York University Alan Greenspan, Chairman of the
Federal Reserve, said there are “hardly any independent directors left” on
corporate boards, adding that our system has become CEO-dominant and difficult
to restrain, and that mechanisms supposedly binding the interests of managers
and shareholders sometimes do just the opposite.
In the old days, corporate directors like
banker J. Pierpont Morgan (as a representative of bond investors, not
stockholders) imposed restraint on management and owners of large corporations.
Companies feeling the Morgan presence often traded at higher stock prices than
companies without it. But as corporations evolved into public companies
financed in capital markets by fragmented shareholders and equally fragmented
debt-holders, most of the power of restrain reverted to the managers
themselves. In recent years, CEOs have been able to select boards supportive of
their management, and have rewarded them for their loyalty. For CEOs determined
to accomplish their goals, reservations on the part of outside directors (if
any) have had little influence.
Such a system inevitably must pay a price
for lapses in effective governance. Managers may be allowed too easily to
commit their companies to strategic mistakes. The methods used to compensate
management have become absurd. They are paid to sign-up, paid to stay, even
paid to go—often at eye-popping rates that bear no relation to the results
achieved, while stock options are handed out with little accountability or
regard for their dilutive effects—and then sometimes are repriced when they
turn out to be temporarily worthless. Worse, smoke and mirrors appear to make
implausible things seem to work, misreported accounting numbers obscure true performance
and risks, and deals are encouraged just for the sake of showing dynamic
acquisitive behavior (or maybe to increase the size of the CEO’s corporate
platform, fame and personal fortune). Government can and does react to some of
the worst offenses, but standards of proof are high in criminal cases and not
all of them are addressed.
But the pendulum inevitably swings back,
and market forces emerge to cleanse the system. In a rising market, even those
who are victimized fail to see many of the clues that things are seriously
wrong. Reactions are delayed until a serious crack in the system opens. But
when it finally comes, the market can extract a terrible price for unacceptable
conduct. Enron’s stockholders lost all of their investment in a company that a
year before had been worth well over $50 billion. Bank lenders and bondholders
will have to forfeit nearly the same amount. Enron employees and pensioners
with significant voluntary holdings in the company’s stock—some who might have
been middle management whistleblowers but weren’t—lost their hard-earned
retirement assets. Officers and directors have already taken heavy financial
losses and forever have lost their good names—and there will be further losses
as whatever is left of their fortunes is depleted by the many civil lawsuits
they yet must deal with. Enron’s auditor, Arthur Andersen, is already a ruined
hulk, whether it legally survives or not, and its partners will have lost a
lifetime’s earnings retained in the firm. Most recently the shareholders’
lawyers have added nine of Enron’s bankers and two of its law firms to a
growing list of defendants. Finally Enron’s equity and credit analysts have
been embarrassed by their incompetence in finding catastrophic trouble, and
face a future in which their recommendations are likely to be considered
suspect, ignored or scorned. Those involved will not soon wish to repeat their
experiences.
The forces redressing the cumulative
weaknesses in American corporate governance, however, do not stop at Enron. All
of America’s 8,000 publicly traded companies will have to pay more for auditing
services, and much more for officers and directors liability insurance. Stock
prices of companies whose accounts come under suspicion will sag below their
peers, and borrowed money will carry higher interest rates, punishing their
cost of capital and competitive performance in the marketplace. Accounting
rules will tighten and make it more difficult to overstate reality. The
cleansing will take place because the market finally wants it to, and the
market will get what it wants.
For critics of the American system of
CEO-dominated corporate governance, correction by market forces may seem
clumsy, awkward, uneven and unreliable. But it works, as no other system can,
though admittedly its fury is released only after the damage is done. Most
alternatives work against the market.
This one works with the market to
extract retribution, when enough is enough. (Download pdf)
* * * *
Roy C Smith and Ingo Walter
This paper
accepts the premise that an agency conflict does exist when rating agencies perform
credit rating services that are paid for by the recipient of the rating. The
question is to what extent is the conflict injurious or distortive? To examine
the issue we analyze the benefits that ratings provide to investors, regulators
and issuers. Ratings we find have greatest value when published, therefore
becoming a public good to which free riders are inclined to attach. Investors
become disinclined to pay for ratings, yet issuers, who can benefit
considerably from a rating, are willing and able to pay the fees the agencies
charge. The agency business has become quite transparent, especially with
Moody’s becoming a public company required to disclose its business information
to the public. There is relatively limited competition between the major
agencies (Moody’s and S&P between them each rate about 80% of rated issues,
and the ratings tend to be highly correlated with each other) so neither is
inclined to take great risks to increase its market share, and Moody’s we find
to be a very profitable company with approximately $4 billion of market value
depending on its rating “franchise” value. It seems able to make satisfactory
levels of profits without resorting to practices aimed at protecting profits.
We found no evidence of rating distortion caused by shopping for ratings, no
evidence of more favorable (i.e., higher) ratings being granted by the market
leaders, nor evidence of agencies now or ever having offered favorable ratings
for higher fees. Moody’s in particular is highly dependent on maintaining its
reputation for integrity to protect its franchise value, and its ability to
continue in business. Further, we find that the agencies are also much more
exposed than most businesses to potential punishments of regulators and
class-action litigants. In the end, there is reason to believe the rating
agencies manage their built-in conflicts of interest with their customers well
and that agency conflicts, to the extent they exist, are controlled. (Download
pdf)
* * * *
The Integration of World Financial Markets—Past,
Present and Future
Roy C. Smith
Financial people know in their bones that their profession goes back a long way. Its frequent association with "the world’s oldest profession" may simply be because it is almost as old. After all, the essential technology of finance is quite simple, requiring little more than arithmetic and minimal literacy, and the environment in which it applies is universal--that is, any situation that involves money, property or credit, all of which are commodities that have been in demand since humankind's earliest days.[i]
These financial
commodities have been put to use to facilitate trade, commerce and investment
and to accommodate the accumulation, preservation and distribution of wealth by
states, corporations and individuals. Financial transactions can occur in an
almost infinite variety, yet they always require the services of banks, whether
acting as principal or as agent, and financial markets in which they can operate.
Banks have predominately been local institutions throughout their history, but
many have sought international expansion to follow clients abroad or to offer
services not available in other countries.
Banks have a long history:
a history rich in product diversity, international scope and in continuous
change and adaptation. Generally, change has been required to adjust to
shifting economic and regulatory conditions, which have on many occasions been
drastic. On such occasions banks have collapsed, only to be replaced by others
eager to try their hand in this traditionally dangerous but profitable
business. New competitors have continually appeared on the scene, especially
during periods of rapid economic growth, opportunity and comparatively light
governmental interference. Competitive changes have forced adaptations too, and
in general have improved the level and efficiency of services offered to
clients, thereby increasing transactional volume. The one constant in the long
history of banking is, perhaps, the sight of new stars rising and old ones
setting. Some of the older ones have been able to transform themselves into
players capable of competing with the newly powerful houses, but many have not.
Thus the banking industry has much natural similarly to continuous economic
restructuring in general.
[i] This
chapter is based on Chapter 1 of Roy C. Smith and Ingo Walter, Global Banking, (New York: Oxford
University Press, 1997), pp. 1-16.