Wall Street Journal - September 18, 2002
Banks Were Victims in Fraud Cases, Not Accomplices
By WILLIAM B. HARRISON, JR.
In the aftermath of Enron, we are now hearing a drumbeat of "return to the good old days," when banks were banks and investment banks were separate. Many are asking whether bankers of either stripe played a role in helping Enron and other companies defraud their investors. The reasoning behind this inquiry ignores what actually happened to the companies and the history of commercial banks and investment firms. To wit:
It appears likely that the main reason for the failures of Enron, WorldCom and Adelphia was outright fraud. In WorldCom's case, it is charged that executives fraudulently capitalized normal operating expenses; in Adelphia's that they fraudulently diverted corporate assets for personal use; at Enron, that they created a series of transactions with private partnerships that enriched certain individuals and concealed losses. It does not appear that American commercial banks were involved in any of these transactions, except as lenders and passive investors who lost money along with other investors.
Banks are alleged to have been tempted into billions of dollars of loans in order to win investment banking assignments, which supposedly could not have happened in the days before the repeal of Glass-Steagall. To the contrary, the problem that the banking system had before the repeal of Glass-Steagall was that lending was its primary product. How quickly we forget the emerging markets, real-estate and leveraged-buyout debacles of the 1980s and early '90s, when banks had no such "temptations" as are now alleged. One reason Glass-Steagall was repealed was to enable banks to diversify their earnings streams and avoid excessive dependence on loans. That the banking system has survived the bursting of the Internet and telecom bubble in relatively good health is testimony to the success of the new law.
Sometimes it is alleged that "structured finance" is itself the culprit -- that financial engineering has become too complex to explain. At its heart, structured finance involves the pooling, segregation or reallocation of expected cash flows in ways that reduce uncertainty or diversify or reallocate risk. By matching up the needs of issuers and investors with greater precision than "plain vanilla" finance, the resulting structures reduce borrowing costs or extend the variety of funding sources. Structured finance, which now makes up a large segment of the U.S. debt market, can be complex, but it has contributed greatly to the expansion of the U.S. economy. The use of structured finance vehicles did not cause the demise of any of the companies in the news; again the cause appears to have been old-fashioned fraud.
What about the "prepay" transactions through which it has been charged that a dozen banks, including Citigroup and JP Morgan Chase, helped Enron "disguise billions of dollars in debt as energy trading income." The transactions certainly helped Enron finance itself by monetizing value in its trading book, but we believe that they created no income on Enron's books and that the resulting liability was reflected on Enron's balance sheet in accordance with GAAP. Would greater disclosure by Enron have been helpful to investors? Maybe, but the notion that bankers were conspiring with Enron executives to hide transactions which date back to 1992 and which were accounted for correctly does not make a lot of sense -- especially when the bankers were left with large losses.
One way to think about these "prepay" transactions is to compare them to leases. Both are like loans in the sense that money is advanced and has to be repaid in some form with an appropriate return to the lender. But leases, like prepays, are not loans; they have different economic characteristics and are treated differently for tax, legal and accounting purposes. Operating leases do not appear on the balance sheet, but they are usually in footnotes to financial statements. Sometimes companies (or even individuals who lease automobiles) prefer leases because under the relevant rules they are not classified as "debt." Should we think that all the lessors and lessees in lease financings are dishonest?
Various other conflicts are alleged -- primarily revolving around the subjugation of research to the investment banking function and the possibly improper allocation of hot IPOs to investment banking clients. Virtually all of these conflicts or potential conflicts have existed within investment banking firms for a long time and are unrelated to the merging of commercial banks and investment banks. That clients want the integrated model is clearly established by the market place. The ability to manage the conflicts that are inherent in delivering large-scale integrated service to clients will ultimately distinguish the long-term winners in this business.
At JP Morgan Chase, we do believe that change is necessary. Among the reforms we have adopted are (1) the creation of a senior level Policy Review Office to examine all complex transactions and to help JP Morgan Chase avoid participating in transactions that are not properly disclosed by our clients; (2) the adoption of the Spitzer "Investment Protection Principles" relating to investment research; (3) the decision to expense options on our own financial statements; (4) the creation of stock ownership guidelines, which require that each Executive Committee member retain 75% of the net shares of stock received from stock grants and options; and (5) the prohibition on our giving consulting assignments to our outside auditors. These changes are positive responses to real problems that will lead to greater transparency for all investors.
After every bubble, there is a search for scapegoats. History teaches that sometimes the cure is worse than the disease, often because of a misdiagnosis of the root cause of the problem. Banks, as lenders and investors, have more at stake in the accuracy and transparency of financial reporting than anyone else. To say that they contributed to or even condoned fraud, when the evidence indicates that they have been among the parties most damaged, only adds insult to injury.
Mr. Harrison is chairman & CEO of JP Morgan Chase.