Financial institutions won deregulation in the 1990s by convincing lawmakers and regulators that they could manage the complex new conflicts of interest that would arise when, for instance, investment banks and commercial banks were merged under one roof. They argued that all investors would benefit from the resulting synergies. But their assurances are beginning to ring hollow. In case after case, financial supermarkets such as Citigroup (C) and J.P. Morgan Chase & Co. (JPM) stand accused of enriching themselves and favored clients at the expense of less informed investors.
It gets worse. Evidence is accumulating that financial institutions have done a poor job of managing even the kind of conflicts that existed before liberalization. Merrill Lynch & Co.'s convoluted dealings with Enron Chief Financial Officer Andrew S. Fastow are the latest example. Investment banks such as Merrill have always had to balance their desire to win underwriting fees with their obligation to fully inform investors of all possible problems with the securities they sell. But investigators are building a case that in working with Fastow, Merrill failed that basic standard.
The firm had multiple relationships with Enron Corp. and Fastow--as investor, lender, underwriter, and counterparty in energy-derivatives deals. With a few pointed questions, Merrill might have uncovered the full scope of what Fastow was up to and brought that information to investors. But that, of course, would have enraged Enron and Fastow and cut off the lucrative flow of deals. Merrill says its employees did nothing improper and that it knew nothing more than the public did. But, adds Merrill, it wouldn't have done business with Enron if it knew then what it knows now.
Boiled down, Merrill's defense is, "we didn't know." But it's a defense that regulators and law enforcers are increasingly unwilling to accept. Wall Street made billions of dollars on underwriting in recent years with a see-no-evil approach to conflicts in which it used perfunctory sign-offs by auditors and lawyers to justify deals that were obviously flawed. If financial institutions don't start taking seriously the need to manage conflicts of interest, they risk the possibility of draconian re-regulation--and a rollback of the market liberalization that was a hallmark of the 1990s.