Is it time for a new Glass - Steagall Act?

One of the biggest changes in the banking industry after the Great Depression was the separation of commercial and investment banking. It took the form of the Glass-Steagall Act, which went into effect in 1933. Glass-Steagall led to the separation of JPMorgan Chase (JPM) and Morgan Stanley (MS), but thanks to the effective repeal of Glass- Steagall in 1999, investment and commercial banking are now back together.

It may be worthwhile separating them again. After all, would you trust a bank that's owed money by a corporate borrower to underwrite honestly that companies' common shares? Banks that do this would be in economic conflict with the people buying the shares. That's because the reason a bank would make the secondary offering would be to raise cash to pay off the money that the company owes the bank.

And there's another reason for a buyer of those shares to be suspicious. When a company goes into bankruptcy, the banks are first in line to get the cash from liquidating that company's assets. Last in line are the common shareholders who almost always get wiped out in a bankruptcy.

When a bank underwrites a secondary offering of common shares, it is getting fees for managing the underwriting which could later enter bankruptcy -- leaving the company's liquidation value to the banks and nothing for those who got suckered into buying the common shares.

Banks face conflicts like this all the time. To resolve such conflicts, there are two choices.

* Re-separate commercial from investment banking. As discussed above, this was the law of the land between 1933 and 1999 when Glass-Steagall was effectively repealed. This law had the benefit of keeping the financial system from collapsing due to such conflicts. And re-instituting Glass-Steagall might help repair the trust that seems to have vanished from our financial markets.

* Allow commercial banks to do investment banking and disclose the conflict of interest to stock investors and let them decide whether they are comfortable taking on the risk. Any marginally sophisticated investor knows that common shares are at the bottom of the liquidation hierarchy, so that the bank that owns a company's debt will have an incentive to take actions that are in conflict with the interests of common shareholders in order to maximize how much the debt holders would get if the company liquidated.

If a potential common stock investor is aware of such conflicts and decides to go ahead and invest anyway, then that investor assumes the risk.

The problem for the financial system is that unless a truly independent party -- instead of the bank handling the offering -- is preparing the documents for the secondary offering, then there might be a temptation for the bank to leave out information that would lower the proceeds from that offering.

However, if that secondary offering prospectus discloses clearly all the risks to a potential common stock investor, then I think the ethical burden on the bank would be lifted.

Nevertheless, given the inherent conflict of interest between the bank and the common shareholders -- I would be very reluctant to invest in such a secondary offering.

Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He has no financial interest in the securities mentioned.

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