Criteria for an Ideal Future Management Model for Chinese Securities Firms

Financial Holding Companies: The Best Model for Large Investment Banks in the Tendency toward Integration

The Inevitability of Integration: An Analysis that Builds upon the Driving Forces of the Development of Investment Banking and the Logic of Institutional Change We can learn from the change of the financial system and the historical evolution of investment banking in developed countries around the world that the financial industry in most of these countries has undergone changes from crossover through separation to re-crossover. Either the crossover or the separation model is an outcome of the evolution that helps the industry adapt to the inherent requirements of economic development. The change of investment banking business model results from market orientation and institutional reasons.

The endogenous forces that drive investment banking to integration come from the following four areas:

1. Increasing public consumption of financial services: As the primary cause, this pushes commercial and investment banking to integration. Companies and families want convenient financial services and request financial institutions to be one-stop shops. As a result, "financial supermarkets" and like institutions that offer integrated financial services come into being. If a provider can offer complete financial services, companies save trouble in finding financial counterparties.

2. Market competition: As the capital market develops, the portion of conventional commercial banking shrinks in commercial banks whose growth is also limited due to separation of activities. Therefore, for commercial banks, the realistic way out is to explore new business and break through the limitations of separation of activities. Driven by competition, investment banks also desire to become stronger. In other words, there is a strong demand for crossover between commercial and investment banking and between money and capital markets.

3. Rapid development of information technology: This allows for convenient and efficient connection and interaction between capital and money markets and also results in inevitable interpénétration between commercial and investment banking.

4. Financial liberalization and internationalization: This accelerates the integration of commercial and investment banking.

If the change of business model in investment banking is endogenously driven by the development of financial markets, such change surely cannot happen without the change of a regulatory model that allows for, or adapts to, a new business model. Within less than a century, the law of the negation worked on the American financial system. The institutional evolution seems to be a simple cycle, but in fact it has its own laws. As economy develops, the system may not maintain equilibrium and players who desire to maximize expected revenue have motives to cause the system to be changed. When it comes to integration, if revenue is expected to exceed costs, there is a possible systematic change, bringing about a tendency to equilibrium.[1] The current global trend of crossover into the financial industry is an inevitable result of market development, as the comparative cost advantage of competition works its way into the reconstruction of the financial market. Although it is government that pushes the change of the financial system, the government would have to cave in to the demands of the market if the relations of production did not facilitate the development of productive forces. The market, competition, external environment, and other factors jointly result in an irresistible trend from separation to integration of activities.

In the United States, the Financial Services Modernization Act of 1999 came into existence to remove constraints imposed on the financial industry by the former financial system and regulation. In the United Kingdom, the Big Bang reform in 1986 allowed commercial banks to merge with investment banks into financial conglomerates, offering a variety of financial services. In 1998, Japan implemented a financial system reform package that deregulated the banking, securities, and insurance businesses; repealed the ban on banks in securities and insurance businesses; and allowed the crossover of financial institutions. Globally, the financial industry in the United States, the United Kingdom, and some other countries has gone from crossover through separation to integration. Germany, France, Italy, The Netherlands, Switzerland, and others disagree that banking crossover is the cause of the Great Depression of the 1930s. They have no legislation similar to the American one on separation of financial activities, and they have been following the "universal banking system," which is a crossover model that integrates banking and securities.

In China, the integration in investment banking is also an inherent requirement for the development of the capital market and commercial banks. As integral parts of the modern financial system, the capital market and commercial banks have some natural connections. The capital market needs the banking system as a necessary financing channel and also promotes the asset and liability growth in commercial banking. Due to some inherent defects such as the mismatch of assets and liabilities regarding returns and risks, commercial banks have to rely on the capital market for asset, liability, and liquidity management. As China keeps moving toward a market economy and increasing its economic aggregate, rapid accumulation of social wealth leads to an increasing demand for diversified financial services. This is resulting in declining conventional commercial banking in terms of business functionality. And as the capital market is becoming increasingly important in the macro economy, commercial banking has to use the platform for business innovation. For both the capital market and commercial banking, cooperation and integration are necessary at certain stages as the only path to further development.

The transition to integration in investment banking is also an inevitable choice for the Chinese financial system to improve its international competitiveness. Chinese securities firms will face double competitive pressures from foreign investment banks as well as other Chinese financial institutions, which penetrate into investment banking and move toward integration. Overly strict regulation and separation of activities continue to exist. A sound capital flow mechanism continues to be absent. Tools and activities continue to be inflexibly confined. If these conditions continue against a backdrop of financial globalization where competition is fierce, the Chinese commercial banking and securities markets will be severely limited in competitive strength and will be much less motivated to develop.

After the year 2000, in the global trend of financial liberalization and deregulation, China became the last "fortress" of all market economies for the separation of activities in the financial industry. From the regulatory perspective, the separation policy has become flexible in recent years. As the Chinese financial system reform goes further, the walls that keep commercial banks, insurance companies, and trust and investment companies from the securities business are crumbling and integration would be the ultimate choice.

Therefore, integration is an inevitable result of historical development. This is because of the global trend and an inherent requirement of the Chinese financial industry. In the financial market, large investment banks are driven by profit and under the pressure of intense competition. They diversify activities and change their business model from the one that serves one particular kind of activity and independence to the one that serves integration. Such change in business models would certainly cause change to organizational models.

Financial Holding Companies Are the Best Model for Large Investment Banks to Achieve Integration For investment banks, the change of business model would certainly lead to the change of organizational model. In the development trend of financial globalization and conglomeration, crossover would clearly be the future of the Chinese financial industry. But considering the realities of the Chinese financial sector, it would be a gradual process of development from separation to integration of activities.[2] During the transition, financial holding companies would be the choice that has the lowest cost and the highest return, and also the choice that best meets real-world conditions and needs.

After the outbreak of the financial crisis, following the acquisition of Merrill Lynch and Bear Stearns and the bankruptcy of Lehman Brothers, Goldman Sachs and Morgan Stanley chose to convert into bank holding companies and submitted themselves to more stringent regulation by the U.S. federal government. The conversion of the big three U.S. investment banks into bank holding companies is a historic incident of the global financial industry. It means to some extent that the mainstream independent investment banking model started to change, and the financial holding company model started to take over.

The Financial Services Modernization Act of 1999 was mainly intended "for the affiliation of banks, securities firms, insurance companies and other financial service providers." Considering the fact that investment banks generally do not engage in the business of savings banks, financial holding companies and national banks are the main financial institutions that cross over activities at large. The Act allows qualified bank subsidiaries to engage in securities and insurance business. It also allows banking, securities, and insurance companies to penetrate into each other's territories for the purpose of affiliation via financial holding companies—a typical model of such a crossover system.

Along with the increasing popularity of crossover in financial services around the world in recent years, many countries have started to encourage the affiliation of financial institutions, and some financial mega-conglomerates have emerged. Financial holding companies became the first choice for large financial institutions. In 1998, Citigroup started to take control of Citibank (commercial banking), Solomon (securities business), and Travelers Group (insurance business). Although the three wholly owned subsidiaries are engaged in different activities respectively, Citigroup has established the structure of a financial holding company. HSBC Holdings (incorporated in 1991) has wholly owned subsidiaries in different regions. They run independently and engage in commercial banking, investment banking, asset management, insurance, and trust business, among others. Mizuho Holdings (incorporated in 2002) owns Mizuho Bank, Mizuho Corporate Bank, Mizuho Securities, Mizuho Trust, and other subsidiaries in financial services. After three major mergers and reorganizations in 1995, 1998, and 1999 respectively, UBS now owns UBS Warburg (investment banking), UBS Global Asset Management, and UBS Swiss Bank.

In China, despite an investment banking history of only more than 20 years, independent investment banks have been dominant due to the legal restrictions of separation of activities. However, the growth model and competitive landscape are not stable. After the overall improvement initiative for securities firms, the organizational model in Chinese investment banking is quietly experiencing some change along with the Chinese financial system reform and under the influence of the trend in the international financial market. Some large financial holding companies have started to give strong support to investment banking by making use of the business and network advantages of the commercial banks under their control. The number of independent investment banks will likely decrease, and more large investment banks will likely embrace the financial holding company model.

  • [1] From the perspective of functionality, both financial intermediaries and market-based instruments are the carriers that help deliver basic financial functions. As for the delivery of financial functions, players compete against each other and the change of competitive cost is the key to decide competitive advantage. In the scenario of optimal arrangement, financial functions are delivered by players who can do it at the lowest cost. This process, known as competitive arrangement of financial functions, has a bearing on the change of structure and the development of the financial system. We can learn from the current trend in the financial industry that the boundaries between conventional activities are blurring, and it is hard to categorize some new financial products into a specific category of conventional activities. Therefore, the separation of activities is a relative concept, and crossover is a more efficient separation of duties that replaces the previous one. The change in financial functional arrangement results in a change of separation of duties in the financial sector, helping improve the efficiency of the financial system. This is how the separation of duties goes further in the financial sector.
  • [2] In general, the evolution of the Chinese financial system is a progressive reform. Since it is the government that pushes the reform forward, the evolution has the characteristics of mandatory change. Regulators make some arrangement for a new financial system out of the old one, instead of destroying the core of the latter. Such an arrangement paves the way for reform, so regulators push the reform further. While such a shift maintains stability and continuity and also reduces friction costs, it costs time in the reform. According to the logic of a progressive reform, it would take some time, even a very long period of time, for the Chinese investment banking system to shift from operations and oversight based on a separation of activities to operations and oversight based on an integration of activities. But crossover in financial services and related legislation will be necessary elements in the future reform of the financial sector.
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