The Trouble with Investment Banking: Cluelessness, Not Greed

We assume that the set of marketable financial instruments can be divided into two distinct categories: (1) easy to price and (2) difficult to price, and then isolate two behavioral effects as most important with respect to securities trading in difficult-to-price securities; specifically, the "house money effect" and the "earned money effect." It is shown that these behavioral effects discourage profitable investment in research effort. We then argue that the Private Securities Litigation Reform Act (PSLRA) safe harbor should not apply to investment banks that issue/underwrite difficult-to-price securities. We also advocate for the return of the private investment banking partnership as the most sensible way in which to get the relevant behavioral incentives right vis-à-vis the bank and its investor-clients, and we propose two regulatory measures designed to induce such banks to structure themselves as private partnerships when they are otherwise free to publicly incorporate. Finally, we suggest that fiduciary responsibilities owed to investors by investment advisers and broker-dealers transacting in these kinds of securities must be strengthened and weakened, respectively.

Current reform proposals blur the distinction between these two financial actors. We argue that the line must be drawn as bright as possible in order to make the distinction as salient as possible to investors in whom they can repose their trust and confidence. Moreover, instead of passing legislation designed to eliminate or reduce proprietary transactions, this Article argues for just the opposite--that legislation be passed to make the incentives facing broker-dealers and registered investment advisers--and investment banks as well--look more, not less, like those of the typical hedge fund.