The re-entry of commercial banks into the securities business transformed U.S. financial markets during the 1990s. The Gramm-Leach-Bliley Act of 1999 (GLBA) removed most of the legal barriers that had separated commercial and investment banking since 1933. GLBA allows commercial banks to become universal banks by affiliating with securities firms and insurance companies. In large part, GLBA ratified the securities underwriting powers that commercial banks gained during the 1990s, based on a series of orders issued by federal regulators and federal courts.
By 2000, the top ten global underwriters of securities included three U.S. banks, three foreign banks, and four U.S. securities firms. Competition between commercial banks and securities firms spurred a spectacular growth in the issuance of corporate securities during the late 1990s. The growth in new securities contributed to the stock market boom of 1994-2000, which was comparable to the great bull market of 1923-2029. Unfortunately, as in the 1920s, the stock market boom of the 1990s was followed by a steep decline in stock prices during 2000-2002. The fall in stock prices was especially severe between December 2001 and October 2002, as investors reacted to reports of accounting fraud and self-dealing at new economy firms that had been viewed as stars during the boom. The sudden collapses of Enron and WorldCom - the two largest bankruptcies in U.S. history - were especially shocking to investors. Subsequent investigations and lawsuits revealed that universal banks had played key roles in financing the rapid expansion of Enron and WorldCom and in promoting the sale of their securities.
This chapter is part of a larger project that will examine the role of universal banks during the U.S. economy's boom-and-bust cycle of 1994-2002. The evidence presented in this chapter supports several conclusions. First, universal banks arranged dozens of structured-finance transactions for Enron, even though bank officials recognized that the transactions were deceptive and exposed their banks to reputational risk and legal liability. Second, universal banks competed for investment banking mandates by providing extraordinary financial favors to senior executives of Enron and WorldCom, notwithstanding the obvious corruption inherent in those favors. Third, universal banks distributed offering prospectuses and research reports that encouraged investors to buy Enron's and WorldCom's securities, even though bank officials knew or should have known that the banks' promotional documents were materially misleading and failed to disclose significant investment risks. Fourth, universal banks repeatedly extended credit to Enron and WorldCom in order to attract investment banking business, despite serious concerns among bank officials about the financial viability of both companies.
During the Enron and WorldCom episodes, universal banks exhibited promotional pressures, conflicts of interest, speculative financing and exploitation of investors that were similar to the perceived abuses that led Congress to separate commercial and investment banking in 1933. Both episodes indicate that GLBA's regulatory framework is not adequate to control the risks posed by universal banking powers. A comprehensive reform of the supervisory system for universal banks should therefore become a top priority for Congress and financial regulators.
GW Paper Series
GWU Law School Public Law Research Paper No. 234; GWU Legal Studies Research Paper No. 234
Arthur E. Wilmarth Jr., Conflicts of Interest and Corporate Governance Failures at Universal Banks During the Stock Market Boom of the 1990s: The Cases of Enron and Worldcom in CORPORATE GOVERNANCE IN BANKING: A GLOBAL PERSPECTIVE (Benton E. Gup, ed., Edward Elgar Publishing Ltd., 2007).