The Remaking of Wall Street

Andrew F. Tuch is Professor of Law at the Washington University in St. Louis School of Law. This post is based on a recent article by Professor Tuch, forthcoming in the Harvard Business Law Review.

At the dawn of the Financial Crisis of 2007-09, major investment banks stood as the elite of Wall Street. They were large-scale, publicly listed corporations providing broad-ranging financial products and services across the globe. But as we know, their reliance on short-term funding and exposure to mortgage-related securities left them financially vulnerable and created system-wide financial risks. As their lending sources dried up, they received massive government assistance designed to avert catastrophic system-wide harms. Those investment banks that survived became bank holding companies (BHCs). These events wiped out major investment banks, prompting The Wall Street Journal to assert that “Wall Street as we’ve known it for decades has ceased to exist.” [1]

Since then, Wall Street has transformed dramatically. Constrained by post crisis regulatory limits, investment banks surviving as BHCs have curtailed their investment banking and other activities. At the same time, private equity firms—among them, Blackstone, KKR, Apollo and Carlyle—have grown massively and ventured into areas previously the domain of investment banks, with important effects.

Scholars have nevertheless paid little attention to this reshaping of the industry and its potential consequences. In The Remaking of Wall Street, I examine the post-Crisis transformation of the financial industry, focusing on the primary economic consequences of the rise of private equity firms and the implications for regulatory reform and scholarship. I argue, first, that private equity firms now mirror the former investment banks in fundamental respects. They engage in a diversified mix of securities and asset management activities. They adopt the ethos of entrepreneurialism, innovation, and aggressive risk taking that was the hallmark of independent investment banking. They act as “shadow banks” because of the bank-like functions they perform, despite falling outside the traditional banking system. Many have gone public. The employer of choice for aspiring financial professionals, these firms have become the new titans of finance.

Although the similarities with the now-defunct investment banks might suggest that private equity firms pose financial risks similar to those of their predecessors, I suggest that private equity firms, as currently structured, are more financially stable and pose less systemic risk to the global economy. I contend specifically that the structure and funding of these firms largely overcomes the basic shortcoming that led to investment banks’ downfall—the use of short-term debt to fund longer-duration assets. Private equity firms lock in funding sources for longer, isolate themselves from the funds they sponsor, limit their financial exposure to their funds, and limit leverage at the firm level. I present data showing that major private equity firms have modest total and short-term debt levels and low leverage and short-term debt ratios. I suggest that, in the face of onerous post-Crisis reforms, Wall Street has so far evolved to displace investment banks with more financially resilient institutions.

My message, however, is largely cautionary. I draw attention to the broker-dealer operations that private equity firms have formed since the Crisis. As many know, today private equity represents a diminishing fraction of the revenues that these firms generate. Firms underwrite securities offerings, advise on M&A, and undertake other securities activities. When Goldman Sachs divested its proprietary trading operations in anticipation of the Volcker rule, for example, it found willing buyers in private equity firms. I argue that ongoing changes in firms’ broker-dealer activities raise systemic risk and financial stability concerns that require active monitoring. Firms’ broker-dealer subsidiaries are currently relatively modest in size and scope and have yet to encompass dealer-bank operations (it seems). But they face strong incentives and opportunities to grow, and they have broad freedom to do so. They would then more closely replicate the mismatch in asset-liability maturity that dogged investment banks, making them institutionally fragile. These conditions could also exacerbate the risk of financial misconduct by these firms.

More controversial are the risks posed by the funds that private equity firms manage. Firms generally structure these funds as private funds, under exemptions to the Investment Company Act. Because of data limitations, analysis of firms’ funds is necessarily more tentative than that of the firms themselves. These funds are incompletely understood, as are their connections with firms and other market actors. There are also limits on our understanding of how systemic risk arises, spreads, and amplifies in such funds, making it hard to identify and assess the systemic risk they currently pose. Nevertheless, I argue that the funds managed by private equity firms—in particular, their hedge and credit funds—may pose systemic and financial stability concerns.

In periods of stress, hedge funds with illiquid assets and permissive redemption rules might experience liquidity crunches if investors withdrew funds en masse. If the funds responded by quickly selling assets, creating downward pressure on prices, they could harm firms holding similar assets, potentially creating redemption pressures for those firms. Multiple hedge funds could thus fail simultaneously, exacerbating the contagion. Their failure could also harm banks with insufficient collateral, creating another avenue for the spread of systemic risk. As I explain in the article, a financially distressed fund might also harm other funds within the same group, even in the absence of cross guarantees or collateralization.

If private equity firms’ credit funds continue growing strongly, they may perform such an integral role in making loans that their collapse adversely affects the credit availability system-wide, because their services are not substitutable. This issue warrants fund-specific analysis and would benefit from public disclosure of relevant data.

I conclude by considering the implications of these developments for the effectiveness of regulatory reform, the concentration of economic and political power financial firms, the incidence of financial misconduct, and the evolution of financial institutions. Among other things, the analysis supports contentious Dodd-Frank act reforms that give the Financial Stability Oversight Council power to designate non-banks—such as private equity firms—as systemically important financial institutions (SIFIs) and then subject them to heightened regulatory requirements. This measure may well constrain the systemic risk-creating activities of private equity firms in a way that the old regulatory environment failed to do for major investment banks. The analysis also draws attention to the control that private equity firms exert over industrial companies, a phenomenon that upsets long-standing US policy of rigidly separating Wall Street from Main Street.

Of course, we cannot be sure what changes lie ahead for private equity firms. For example, they may be midway through an evolutionary arc toward an investment bank model, growing riskier and more fragile in the process. They may have successfully adapted and overcome the shortfalls of their predecessors, representing Wall Street at its most Darwinian. Reforms proposed under the Trump Administration to soften BHC regulation will affect the competitive environment for private equity firms with uncertain effect. What is clear is that as private equity firms continue to evolve, and especially if their broker-deal activities grow further, the parallels with the former investment banks will suggest greater danger and therefore demand a more robust regulatory response.

The complete article, forthcoming in the Harvard Business Law Review, is available here.


1Editorial, “The End of Wall Street,” Wall St. J. (Sept. 23, 2008, 12:01 AM), back)

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