The Glass-Steagall Act will soon join the dodo bird. But forget the excitement about combining financial and nonfinancial firms. Washington is only lukewarm about the idea and likely to impose stringent limitations. Besides, Sears' purchase and subsequent spinoff of Dean Witter proved that people don't buy their stocks where they buy their socks.
For investors, the much more interesting question is: When banks, brokers, and insurers are completely free to combine, which will win?
Bet on the big banks with their deep pockets. It's like Willy Sutton said when asked why he robbed banks: "That's where the money is."
To prove my point, look at some businesses that have already been deregulated. Newly deregulated industries share some economic characteristics and have undergone similar changes with similar results, as can be seen in the brokerage, airline, and trucking industries. We can usefully apply these parallels to the overall financial services business.
Let's start with the brokerage industry, where I've had personal experience. Historically, commission rates were controlled by the New York Stock Exchange. The meeting under the famous buttonwood tree back in 1792 that led to the formation of the NYSE was called principally to set the minimum rates members would charge nonmembers-in other words, to form a cartel.
The NYSE's cartel, based on fixed commission rates, was effectively blessed by the Securities and Exchange Commission in the 1930s, when that agency was formed. The system caused no serious distortions until the 1950s, when the equities business became institutionalized.
Pension funds and other large institutional pools of capital once held only bonds in their portfolios. In the 1950s, they began to buy equities in huge quantities. The commission schedule, designed to cover the cost of executing and clearing 100-share trades, created unconscionable profits when it was applied to trades of thousands and tens of thousands of shares.
On May Day 1975, however, all restrictions on commissions were removed, and discounts for large trades amounted to only 5% and 10%. The Street yelled, "Non-event!" and breathed a collective sigh of relief.
At that point, however, trading volume on the NYSE was at a peak. By that fall, volume fell by about a third, and commission rate-cutting began with a vengeance.
These developments are instructive, since they proved prophetic for other industries. Competition following deregulation may be relatively benign when the volume of business is high and there's plenty for everyone.
When business started to dry up, however, the winds of competition began blowing the leaves off that buttonwood tree.
By 1978 the cumulative commission rate declines reached almost 40%. Big customers were telling brokers they didn't want to pay for many of those brokers' costs and services.
These sorts of cuts led to the rapid consolidation of the business and the disappearance of many fine old Wall Street names.
With organizations and cost structures geared to the pre-May Day commission rate levels, these firms could simply not survive rate cuts and rationalization.
The trucking industry, which had been regulated for decades by the Interstate Commerce Commission, began to undergo deregulation in 1978. Here, too, there was no immediate effect because business was strong in the late 1970s. Recession hit in 1980, however, and competition and consolidation got merrily under way.
Before 1978 the industry was tightly regulated. Truckers needed specific authority to move goods between specific cities, and sometimes had to do so over circuitous routes. Furthermore, they sometimes had to return those trucks empty if they lacked the authority to ship in the opposite direction.
Despite these inefficiencies, the business was profitable. As in any regulated industry, passing on costs became almost automatic, and there was very little incentive to hold down expenses, particularly labor costs. Huge wage increases for the teamsters were rapidly followed by ICC permission to raise rates enough to cover them and maintain profit margins.
This left the trucking industry ripe for consolidation. Initially, however, few participants saw it that way.
Upon deregulation, everyone invaded everyone else's territory. Most truckers saw themselves not as regional specialists, but as coast-to-coast shippers, despite the finite quantity of business available. Expansion was rampant, in part because trucks could now make return trips loaded. Consolidation and bankruptcies soon followed, as the financially weak - particularly those who were overly aggressive in their expansion activities-were forced off the road.
Airline industry deregulation also commenced in 1978, when business was strong. Indeed, the strength of air travel convinced many that deregulation and the resulting decline in ticket prices were boons to the industry. They saw the increase in traffic as a result of lower ticket prices and concluded the price sensitivity of air travel was so great that lowering prices would greatly increase the total revenues and profitability of the airlines.
Our research at the time painted quite a different picture. We found very little price sensitivity, and instead discovered that the major determinant of air travel was income level. In the late 1970s the strong business expansion lifted many people, particularly postwar babies, to the level at which they could afford airline travel.
This implied big difficulties for the airlines once the next recession struck and the resulting downturn in consumer purchasing power followed. When that happened, we reasoned, not only would many of these people be pushed back below the air travel threshold, but the airlines would also be caught with low ticket prices. We did not foresee two additional detrimental factors-the rapid rises in fuel costs and interest rates in 1979 and 1980.
As in trucking, a number of air carriers reacted to deregulation with coast-to-coast expansion in the expectation of becoming major forces in the industry. And those without strong capital bases soon dissipated their resources. Braniff was a case in point. Almost every airline decided to be a hub carrier, despite the obvious natural limits on the number of hubs the nation could support.
Meanwhile, as many of the older, high-cost carriers were expanding with gay abandon, new airlines with much lower cost structures entered the picture.
Consolidation in the airline industry got under way with a vengeance. Braniff crashed and burned when it tried to invade American's territory. Continental Airlines file for Chapter 11 in order to call the unions' attention to the need for cost control. Financial strength and control of costs, especially labor costs, became the deciding factors for the survivors.
What is the relevance of this analysis for deregulation of the financial services business? I think many of the same characteristics, and therefore consolidation patterns, that we saw in the brokerage, trucking and airline industries apply. Banks and insurers also have high fixed and low marginal costs, along with the leverage of size.
All have the urge to invade each other's territory and have already begun to do so. With the allowed increase to 25%, from 10%, of revenues that banks can get from securities business, BankAmerica is buying Robertson, Stephens & Co.; Bankers Trust is acquiring Alex. Brown & Sons; NationsBank is buying Montgomery; Swiss Bank Corp. is buying Dillon, Read & Co.; and CIBC Wood Gundy is acquiring Oppenheimer.
Meanwhile, Travelers Group is already in the brokerage business with Smith Barney, and many banks sell insurance. Brokers long ago entered cash management.
When Glass-Steagall goes, look for too many financial institutions attempting to be all things to all people. Cutthroat competition will follow, and many will be financially devastated when they overexpand and enter businesses they don't really understand.
In this war, the army with the most guns has the high ground, and the big banks own the arsenal. Citicorp has a market cap of $64 billion, compared with Morgan Stanley Dean Witter's $30 billion; BankAmerica runs $51 billion, versus $25 billion at Merrill Lynch.
But size isn't enough. In addition, the winners will be the low-cost producers and those adding the most value to their services. They will also be willing to sit patiently while others rush to merge and invade their turf. Resisting the temptation to retaliate immediately, they will then counterattack when the opposition's strength is sapped.
Insurance companies also have deep pockets, but many are still mutual institutions that don't fully understand competition or bottom lines. Still, some efficient, well-run firms like Chubb Corp., Travelers, and American International Group are potential final winners. So, too, are Fidelity Investments and American Express Co. GE Capital Services is already a financial powerhouse and could clean up if restrictions on nonfinancial business involvement aren't too severe.
In the coming financial services consolidation, the battle will be won by the strongest-if they are also the smartest.
