The History of Regulation of Investment Banking

By Matt Krantz, Robert R. Johnson

As is the case with most industries, the regulation of the investment banking industry has evolved through time. Unlike most fields, however, major changes in legislation have come in clusters and have been precipitated by seminal crises in the markets.

The goals of investment banking regulation

According to the primary U.S. regulator, the Securities and Exchange Commission (SEC), “The mission of the U.S. Securities and Exchange Commission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” The SEC attempts to accomplish this by requiring full disclosure of all relevant information related to specific securities and financial advisors.

The goal is not to prevent losses by investors, but to allow investors to make informed investment decisions by requiring the disclosure of audited financial and other information.

The concept of a level playing field is central to the regulation of capital markets, thus several aspects of regulation relate to the dissemination of investment information — providing for fair and equal access to investment opportunities across investors.

If investors believe that the markets aren’t a fair game — that, for instance, the markets are skewed to the advantage of large institutions and major investors — investors won’t trust them or participate in them, and an inefficient allocation of resources across the economy and stunted economic growth will result. Regulation should provide investors with a sense of trust in the markets.

Why the rules of today are the result of days past

American historian James A. Field, Jr., a professor at Swarthmore College, was quoted as saying that “It is proverbial that generals always prepare for the last war.” The same can be said of regulators with respect to the investment banking industry. Sweeping regulatory changes generally come out of market crises, and the recent past is certainly no different.

The two biggest crisis periods of the last 100 years — the market crash of 1929 (and subsequent Great Depression) and the financial crisis that began in 2007 — both resulted in major legislation affecting the financial markets. To say that financial regulation is reactive rather than proactive is a gross understatement. Regulators, it seems, have looked to prevent the last crisis instead of trying to avoid the next one.

How regulations have shaped the investment banking industry

To understand today’s securities regulation, you need to know how it developed. Rules passed decades ago are still binding today. The history of regulation of the investment banking industry begins during the Great Depression with the passage of the Glass-Steagall Act of 1933. The main purpose of this act was to separate investment banking activities (primarily securities underwriting and trading) from commercial banking activities (taking deposits and making loans).

This was done because many people felt that commercial bank participation in the stock market was too risky an endeavor and that depositors’ funds shouldn’t be used to speculate in the stock market. It was widely believed that the combination of commercial and investment banking activities within the same firms contributed to the crash of 1929 and the subsequent Great Depression.

The year 1933 also witnessed another seminal regulatory act with the Security Act of 1933, which guides the industry’s behavior to this day. The main purpose of this act was to regulate the primary securities market — that is, the new issue or IPO market. This piece of legislation required that firms issuing securities must fully disclose all material information concerning the new issue.

It also required that investment banking firms provide investors with a prospectus (a formal legal document that contains all relevant information — including audited financial statements and other disclosures) on all new issues.

The very next year witnessed the passage of the Securities Exchange Act of 1934. The primary purpose of this act was to regulate the secondary market (the market where already existing securities are traded). The main points of this act involved setting margin requirements, audit requirements, registration requirements for stocks listed on exchanges, and disclosure requirements. The act also created the SEC as the primary enforcement agency for securities laws.

The final two pieces of major legislation that had its genesis in the stock market crash of 1929 were the Investment Advisors Act of 1940 and the Investment Company Act of 1940. The Investment Advisors Act and subsequent amendments provided that investment advisors with a minimum asset size under management must register with the SEC.

It also provided guidelines regarding the fees and commissions they may collect and detailed the liability of advisors. The Investment Company Act of 1940 detailed requirements for mutual funds (both open- and closed-end) and exchange traded funds (ETFs).

It was near the turn of the century before the next major regulatory change took place. The history of legislation doesn’t simply involve putting more rules on the books — for the investment banking industry, the next big development was the repeal of the Glass-Steagall Act in 1999.

The rationale for allowing institutions to engage in both commercial and investment banking activities was to make the large U.S. institutions more competitive on a global basis. Hindsight is, of course, 20/20, but even the staunchest supporters of this repeal would have to believe that it contributed to the severity of the financial crisis that began in 2007.

It brought into the common vernacular the concept of financial institutions that are “too big to fail.” That is, allowing firms that are so interconnected to fail would prove disastrous to the overall financial markets and, as a result, prove devastating to the economy.