investment termpaper

8/13/2019 Investment Termpaper

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Effects of Deregulations on

Investment Banks

Submitted to: Mr. Nayyar Nizam

Submitted by: Anil Qamar (7205)


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ContentsIntroduction .................................................................................................................................... 3

Methodology ................................................................................................................................... 3

Limitations....................................................................................................................................... 3

Scope ............................................................................................................................................... 3

Financial Deregulation and Investment Banks ........................................................................... 3

1. Repeal of Glass-Steagall Act: ........................................................................................ 4

2. Capital Requirements and Securities and Exchange Commission: .............................. 4

3. 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 ................................................................................................................... 8Bibliography .................................................................................................................................... 9


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IntroductionThe 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.

MethodologySecondary 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.

LimitationsAlthough an extensive secondary research has been carried out, but some primary work could

have been done to make the conclusion stronger and more reliable.

ScopeYears following the great depression of 1930s saw financial regulation 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.


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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 thatwere 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 Securitiesand 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-to-

1.

Moreover SEC Rule 15c3-1 was amended in 2004 in an attempt to help the five largest

investment banks in the United Statestomeet 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: Aswap designed to transfer the credit exposure offixed 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 untilthe maturity date of a contract. Payments are made to the seller of the swap. Inreturn, the seller agrees to pay off a third party debt if this party defaults on the


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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 2000established 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 theother 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 haveweakened 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 warfareimmensely 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 firmsallowing them to borrow at a cheaper rate.


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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 supporttoensure its continued existence.

As a result of Financial Crisis 2008

Dodd-Frank Wall Street Reform and Consumer Protection Act or simply known as the Dodd-

Frank 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 isholding will move up.

There will be a market/demand for thosesecurities.

Bank

Prices the banks earn ahuge profit.

Prices(a)Risk to depositors money(b)Bank could go bankrupt.


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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.


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BibliographyBarker, 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#axzz2EHagZxWCLevin, C. & Coburn, T. (2011). Wall Street and the financial crisis: Anatomy of a financial

collapse. United States: Unites States Senate.

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