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How Do We Fix Finance?

The United States needs to put monstrous and mostly self-serving financial institutions in proper check.

April 27, 2017

Credit: Shintaro Koga -

National Economic Council Director Gary Cohn, formerly President of Goldman Sachs, startled markets last week by suggesting that the United States should re-impose the Glass-Steagall division between commercial and investment banking.

That is probably desirable on balance, but it is important to remember that the U.S. and global financial system was already a mess when Glass-Steagall was removed in 1999.

Therefore, we should do more, beyond restoring Glass-Steagall, to restore finance to its proper state.

At the most basic level, therefore, Cohn is right. If we must have deposit insurance, it should not be combined with the massive trading operations and wild risk-taking characteristic of the Wall Street behemoths.

However, Glass-Steagall itself does not do the necessary job. It separates securities underwriting from commercial banking but continues to allow commercial banks to undertake the trading operations in long-term derivatives, credit default swaps and other instruments that form the true nexus of modern banking risk.

The Cadbury mess

There is an additional subtler problem with the modern financial system. Advisory work on mergers, financings and other matters is the most crucial sector of investment banking.

In the mergers area for example, large companies have consistently shown they are incapable of managing acquisition strategy on their own and top management is far too keen on empire building.

This can be seen in the sorry history of Kraft/Mondelez, where Kraft took over the admirable British confectioner Cadbury, then reneged on the promises it had made at the time of the acquisition, then split itself into two, spinning off the confectionary business Mondelez, then merged with Heinz, then made an unsuccessful bid for Unilever, and now there is talk that Kraft and Mondelez may merge again.

At each stage in this saga of futility, the management involved and its investment bankers paid themselves vast fees and bonuses.

Apart from the fees, the motivation for the chain of transactions, all completed in much less than a decade, can only be that management was utterly bored with its portfolio of bog-standard consumer products businesses and had to do something to liven up its day and make a quick buck.

The advisor’s job

There needs to be some discipline on the process, applied by outsiders who can take a rational look at a business’s needs and possibilities with knowledge of the M&A market and of successful strategies pursued by other firms.

The outside advisor needs to be able to apply pressure where necessary, to ensure that management’s more foolish fantasies are stillborn.

In Britain, this advisory role was traditionally played by the larger merchant banks. In the United States, it was traditionally played by J.P. Morgan, but has been absent since 1929 as the post-Glass-Steagall investment banks were mere brokers, shilling for deals.

The best advisors tend to be in medium sized houses, which have fewer conflicts of interest with clients than today’s behemoths, with their bloated trading books. Hence, an ideal financial system would have three parts:

1. Commercial banks

Their deposits would be guaranteed. These would undertake lending business and would be prohibited from the underwriting business, or from large trading positions, beyond simple foreign exchange and commercial paper with less than 1 year maturity.

They would also be forbidden to deal in credit default swaps, except to hedge existing positions (if this killed the CDS market, so be it!)

2. Investment banks

These would be medium sized institutions, probably set up by law as partnerships with no public listing. They would arrange financings (for which they would get underwriting commitments from institutional investors, as used to be done in London) and advise on mergers.

They would have an additional business, descended from 19th Century merchant banks, of advising emerging market countries on their financing – the IMF and World Bank both need to vanish.)

Investment banks would also undertake asset management for conservative and sensible investors, and probably a modicum of private equity business.

3. Hedge funds

They would undertake most of the market’s trading activities and would be guaranteed by nobody. These fly-by-night institutions would wink in and out of existence rapidly but would potentially make some pretty unpleasant people very rich, as they do today.

They would provide most of the liquidity required by the market, but would have little contact with either industrial companies or the public (except the foolish and greedy members of the public who invested with them.)

All we would need then is a Fed that was suitably “Volckerized,” keeping real interest rates substantially positive in almost all circumstances.

With this, you would have the makings of a sound financial system, in which all the bankruptcies would be concentrated in the hedge funds, whose investors and executives would deserve what they got.

If Cohn succeeds in returning us to a world of Glass-Steagall, that is at least a step in the right direction.

However, it will achieve little while commercial banks are able to gamble with our money and the Fed is grossly over-indulgent with monetary policy.

Editor’s Note: This column was published on the True Blue Will Never Stain blog,


Advisory work on mergers, financings and other matters is the most crucial sector of investment banking.

An ideal financial system would have three parts : Commercial banks, Investment banks and Hedge funds.

In a sound financial system, all the bankruptcies would be concentrated in the hedge funds, whose investors would deserve what they got.