IN a widely reviewed recent book, Phillip Augur group managing director of Schroeder’s has argued that the integrated investment banking model is inherently flawed since it seeks “an irreconcilable reconciliation between a plethora of inbuilt conflicts of interest”.

These conflicts of interests arise from the role of the investment bank as adviser to both buyer and seller in a single financial transaction.

Augur says that this combination of execution and advice functions creates immense market power enabling investment banks to manipulate the market to serve their own interests.

In the post Sarbene-Oxley world, regulatory measures have not been developed to address these basic flaws of the integrated investment model.

In capital market operations, the same investment bank advises the issuer and arranges distribution of stock through its brokerage subsidiaries. Investment banks thus have the potential to effectively run a new issues cartel. This capability leads to an unjustifiable increase in the cost of new issues—surely a matter which ought to be of serious concern in Pakistan.

Investment banks have also been accused of encouraging take over and merger activity as a means for increasing their own profits. It has been the official policy to encourage concentration of assets in the financial sector but there is no evidence that this has yielded any benefit to the smaller investor or deposit holder.

Analysts of deals in mature financial markets have often complained of rip offs in fund management transactions and of exorbitantly high profits charged by investment banks on structured derivatives.

These criticisms amount to the charge that the allocation of investment funds as mediated through investment banks does not lead to an optimally efficient utilization of society’s total resources— i.e to a maximization of aggregate profit / well being. Which is in the long run interest of the investment banks themselves. It is therefore rational for investment banks to use their considerable regenerative and innovative capabilities for identifying synergies between their strategies for profit maximization and strategies crafted by national policy makers for realizing the full economic potential.

Taking account of national objectives in developing corporate strategies is supposed to have gone out of fashion. Are we not living in the era of global capitalism where the nation state is supposed to be withering away and national policy is becoming a matter of accepting the wishes of the dominant players in world financial and commodities markets and regulatory regimes designed by the international bureaucrats of the WTO, the IMF, the BIS and the EU?

The overwhelming rejection by the French and Dutch electorate of the European constitution has exposed the fictitious character of this myth. The resounding victory of the hard-liners in Iran and America’s inability to create stable client regimes in Iraq and Afghanistan illustrates the continuing saliance of national power. This threatens globalization. It is the American coercive force and it alone, which guarantees the dominance of global market.

However the US power is on decline—its share of global GDP measured in purchasing power parity terms has fallen from over 50 per cent at the end of the Second World War to less than 22 per cent today. During the last decade, America’s trend rate of growth has been half that of China and American factor productivity growth has stagnated. It’s bourgeoning budget and current account deficits and a rapidly aging populations are making global hegemonic projects—increasingly unviable. American client states in Europe and North Asia are facing serious economic stagnation and decline and are in no position to bolster American global hegemony. This creates vulnerabilities for global financial order.

Global financial order is also threatened by intensifying rivalry between America and China. China has shown how protection of domestic markets and industries can be maintained while formal compliance with the global liberal regulatory regime is instituted.

America has failed to dismantle the Chinese foreign exchange regime and its monetary policy. By imposing quotas on textiles, America has initiated a trade war against China which threatens to escalate.

It is therefore unwise for investment bankers to ignore national interests and to accept American hegemony and the dominance of global market players as natural and eternal. In 2005, global financial order faces several serious threats. Growth rates have been scaled down in every major capitalist country. Unemployment has risen. Asset distributional inequity is reaching unprecedented high levels and stagflation is re-emerging as a serious policy concern.

Furthermore, the expectation that self regulation can replace state regulation as a modus vivendi for ensuring financial market stability is being questioned. Alan Greenspan has warned that rapid growth of credit derivatives has created considerate uncertainty about how financial markets may react to economic shocks.

The complexity of derivative transactions and the monopolization of financial markets has made risk assessment more and more difficult for both regulators and participants. This is paradoxical since derivatives are supposed to spread risk among multiple investors and thus increase the resilience of the banking system.

The woeful inadequacy of the existing international regulatory regime to prevent or mitigate crises has been emphasized by Greenspan who has frequently acknowledged that the Federal Reserve simply does not know the size of the global financial market, the degree of leverage of key players within it or the balance of risk sharing between investors.

The regulatory regime cannot address risk management issues raised by the explosive growth of the collateralized debt obligation (CDO) industry. The US regulatory regime measures CDO transactions in terms of their book value and not their risk but a 2005 Morgan Stanley study has shown that during 2003-2004 the book value of CDO transactions represented only about 40 per cent of their risk adjusted value.

Greenspan warns that “understanding the credit risk profile of CDO tranches poses challenges to even the most sophisticated market participant.” CDOs have the potential to act as mechanisms for crisis transmission—investment banks, insurance companies, hedge funds and pension funds have large CDO holdings—and the regulatory regime is not equipped to deal with such a situation. This is becoming an increasingly important concern as interest rates rise in America.

The proliferation of hedge funds is another source of worry. They are highly opaque, highly leveraged and have the potential to rush out of the market at a moment’s notice. Greenspan sees them, “as subject to considerable funding pressure” in 2005 and increasingly risky.

Once again this is paradoxical for hedge funds are supposed to hedge against risk and to correct stock market distortions. The opacity of their operations arises from “their fiduciary obligation to investors.

If a short position became public, this could undermine the reason for making it “says a leading hedge fund CEO. This necessary transactional secretiveness has created market jitters over their potential exposure as returns have fallen from conventional strategies such as convertible arbitrages in 2004 and 2005.

An increase in the risk of hedge funds investment portfolio is a major worry for they regularly account from a quarter to a third of equity traded in the New York Stock Exchange. Since 2002 hedge funds have become one of the biggest and most profitable customers for investment banks.

No effective regulatory mechanisms exists to ensure that hedge funds do not take on “excessive” risk and exposure. American and global regulators expect investment banks to ensure that hedge fund risk exposure is not excessive.

Concern with lapses on hedge funds regulation date from the collapse of ‘Long-Term Capital Management’ (LTCM) in 1998. Huge hedge fund losses have been recorded in the US, Germany, the Netherlands and Singapore in 2005.

In 2005 many hedge funds suffered losses because they were taking huge risks by buying risky CDO tranches and selling short less risky ones and buying corporate debt while selling the equity of the same company short. These trading strategies were seriously hurt earlier this year when Standard and Poor downgraded GM and Ford stock to junk status. This shows that many hedge funds do not adopt strategies for correcting market distortions. Quite the contrary they are momentum traders –“herders” following market trends creating mini bubbles and accentuating market distortions.

Enhanced riskiness of financial markets has been an unintended consequence of the growth of instruments such as CDOs and hedge funds specifically designed to diversify risk. This illustrates that capitalist markets cannot regulate themselves—that belief in the optimality of corporate self-regulation is belief is a not only a false but also a dangerous myth. This realization has induced even countries such as South Korea, which want to become a regional financial hub to tighten up the foreign investment regulatory regime.

In April 2005, seven American private equity funds were being investigated for alleged tax fraud. New policy guidelines have been developed to regulate take over and mergers in South Korea. More stringent requirements for disclosure of source of funds by foreign investors have been enacted and tighter control of portfolio investment is also envisaged.

As global credit markets tighten, global equity markets brace for interest rate shocks, metropolitan country growth rates plummet (as recently forecast by such leading analysts as Merrill Lynch, Jordine Fleming, Goldman Sachs, the IMF and the OECD), conflict between China and the US intensifies and America prepares for abandoning its allies in Asia investment banks need to turn inwards and take national interests seriously.

All banks are by definition public institutions—share holder’s equity is of necessity a small fraction of total capital employed. The banks are custodians of the public’s money and as financial market segmentation is eroded this is as true of investment as it is of commercial banks.

Investment bank strategy should not merely be focused on maximizing share holders value. It should seek to address issues concerning the impact of financial sector profit maximization strategies on the structural transformation of the national economy.

In other words, we must explicitly reject the view that appropriate macro structural transformation is an invertible, unintended consequence of micro level financial sector profit maximization strategies. There is overwhelming empirical evidence which shows that this is not the case.

Perhaps, the most important structural weakness of the national economy is the investment strike which has continued even in the high growth years of FY 2003 to FY 2005. As the Economic Survey shows both total investment and fixed investment declined as a ratio of GDP in 2004-2005.

Public investment as a ratio of GDP has fallen significantly and private sector investment has stagnated paradoxically despite the phenomenal growth of private sector credit. The domestic savings performance is so abysmal that it does not rate a mention in the executive summary of the 2005 survey.

Pakistan is experiencing consumption fuelled growth and the bourgeoning trade deficit indicates increased import dependence of both consumption and investment growth. We are seriously under-investing in capital goods sectors and several UNIDO studies have shown that Pakistan’s technological competitiveness has been declining in global markets.

In terms of technological capability, Pakistan ranked 79th out of 118 countries in 2001—more than 30 ranks below India. The growth that we have been experiencing is detechnologizing growth.

It is also immiserising growth: while per capita income exceeds $730 according to government estimates the majority of labour market participants have a monthly wage of less than Rs4000 and average family size is still six. This means that Pakistan has one of the world’s most unequal patterns of income and asset distribution. The rapid growth of the financial sector means nothing to the bulk of the population. The vast majority of the people have no contact with the formal money and capital markets.

Pakistan is among the few countries in the world where the bank branch to population ratio has declined during the past two decades. During 1985-2005 population has almost doubled but the number of bank branches has fallen by almost twenty percent.

Similarly, while advance accounts in excess of Rs10 million account for less than 0.4 per cent of the total number of advance accounts at scheduled banks in Pakistan, almost 70 per cent of total bank advances are extended to them. Our banks—commercial, investment and other NBFCs are apparently not interested in creating investment products targeting the common man.

If the increased profitability of the investment banks in 2005 is to serve as a vehicle for strengthening the national development effort and stimulating desired structural transformation investment bank strategy must focus on the following issues:

(1)Developing risk management instruments and institutional frameworks for insulating the national financial sector from adverse global market shocks and increasing its resilience. Unless national resilience to global financial shocks is augmented, we may become victims of the type of financial Tsunami that was imposed upon South Korea, Thailand, Malaysia and Indonesia in 1997 and 1998. Investment banks must develop a capacity to assess global political risk of exclusive reliance on America.

(2) Asset management and portfolio management strategies have to be crafted to reduce the volatility of the national capital market. Reducing “short termism” lengthening the time horizon of investment planning periods and promoting structural linkages between physical and financial investment must be major investment banks strategic concerns. The collapse of the DFIs has decimated project financing. All major infrastructure projects in Pakistan are funded by major global players. This exacerbates our global subordination and makes the pursuit of national economic policy objectives more and more difficult.

Investment banks should seek to revitalize investor interest at the long end of the market. Both China and Iran have shown how ambitious project financing can be undertaken without subordination of national development priorities to global capital.

(3) The business strategy of the investment banks must address the issue of exacerbation of asset distributional inequalities. A range of investment products must be developed for the small real sector investor—the shopkeeper, the repair and maintenance business, the small producer of agricultural tools and equipment, the school owner in the peri urban centers.

The micro enterprise financing schemes have all but collapsed because they do not address the question of increasing the productivity of the small manufacturer and businessman. Neither micro banks nor mutual funds can address this issue. Investment banks must develop financial products which promote linkages between large and small enterprises. Such production distributional and technological linkage has played a major role in enhancing the productivity of China’s ‘town and village enterprises’ and in reducing unit costs for the country’s major exporting firms.

Investment banks are social institutions. They are custodians and trustees of the public’s money and promoting national interests—strengthening the sovereignty of our state technological up-gradation and reduction of asset distributional inequities—must be explicit objectives of their business strategy. These objectives will not be unintentionally, automatically achieved by profit maximization. A strategy has to be crafted which deliberately synthesizes financial viability and profitability concerns with the concern for safeguarding national sovereignty and promoting national development.