Research Desk: Should investment banks be private?

at 03:02 PM ET, 11/02/2011

Commenter fredbrack asks:

Investment banks used to be partnerships. Partners took risks with their own money, not with stockholders’ and taxpayers’ money. That partnership model effectively prevented investment banking from turning Wall Street into a no-lose casino for pinstripers.

Could investment banks be legally forced to again operate under that partnership model? (When it comes to financial-services reform, it’s a question that’s not being asked, but it should be.)

In fairness, a few people have suggested that financial reform should involve forcing investment banks, which are now commonly organized as public corporations, to become partnerships again. Jonathan Berk, a Stanford finance professor, suggested it in late 2008, and both the Financial Times’ Lex column and e21, a conservative think tank, endorsed the idea this past summer.

As fredbrack says, the rationale is that by forcing bankers to put their own money on the line, partnership models discourage risk-taking of the kind that caused the financial crisis. It’s hard to say if reverting to partnerships would actually reduce risk-taking, but it’s worth noting that Goldman Sachs, the most partnership-like of the big investment banks, also weathered the crisis better than its competitors.

As a historical note, it’s also worth noting that federal policy isn’t behind the transition away from partnerships. As Oxford and UVA (respectively) business professors Alan Morrison and William Wilhelm explain in their paper, “The Demise of Investment-Banking Partnerships: Theory and Evidence,” the transition from partnerships to public investment banks began as a result of deregulation in 1970. But the deregulation wasn’t initiated by Congress, but by the New York Stock Exchange, which that year started allowing its members (that is, investment banks) to be public corporations.

Of course, the NYSE has no reason to reverse course now, and even if it did so investment banks could just start a new exchange that allows public companies to be members. But there’s no earlier federal legal regime requiring partnerships for us to revive, the way many want to revive the old Glass-Steagall bank regulations.

 
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