The more that is learnt about the collapse of Enron, the wider the ramifications become. Failures in the audit process and the vulnerability of many employees' pensions have now been joined by concerns over the actions of the banks. The Enron debacle has highlighted fundamental weaknesses in the US system of financial regulation, which has failed to keep pace with changes in the industry.

The latest concern centers on the role of JP Morgan Chase, one of Enron's two main bankers. It was involved in an offshore company used by the energy trader to move risk off its balance sheet. The disclosure of the existence of such off-balance-sheet arrangements accelerated the downward spiral in the company's share price and led to its eventual bankruptcy.

The Securities and Exchange Commission is now investigating whether JP Morgan has also misled its shareholders by making loans to Enron in the form of oil and gas trading contracts. Insurers who face a claim from the bank on surety bonds that guaranteed the contracts allege that they were loans dressed up as trades to keep them off the bank's balance sheet. JP Morgan has already revised its estimate of its Enron exposure from $900m to $2.6bn (£620m to £1.8bn.)The SEC probe is adding to the criticism of risk control procedures at the bank, formed in 2000 by the merger of Chase Manhattan with the venerable House of Morgan.

JP Morgan and Enron's other lead bank, Citigroup, are the largest of a new generation of banking groups formed by combining commercial banks and investment banks to provide a one-stop shop for big corporate clients. The theory is that companies will give the lucrative investment banking mandates for mergers and acquisitions advice, share issues and bond finance to the banks that put loans on the table.

Enron was, until the past few weeks, the sort of case study used to justify the creation of investment banks with big balance sheets. By being prepared to make hefty loans to Enron, Citigroup and JP Morgan beat less well endowed competitors in last year's race to advise it on restructuring and refinancing options. They worked hard - unsuccessfully - to persuade the credit rating agencies not to downgrade Enron.

That they are able to do both investment banking and commercial banking is a consequence of the repeal of the Glass-Steagall Act that had separated the two since the 1930s. It was meant to stop conflicts of interest that had contributed to the Great Crash of 1929 but proved increasingly unworkable as commercial banking, investment banking and the insurance industry converged.

The Gramm-Leach-Bliley Act that repealed the old legislation in 1999 did nothing to rationalise financial regulation, however. The old regulators continued to do their work - the SEC as securities industry watchdog, the Federal Reserve on banking and the Commodity Futures Trading Commission on derivatives. The result is that no single regulator has an overall view of large financial conglomerates, leaving them free to organise their businesses in ways that have consequences for clients as well as investors. The weaknesses of this approach will have to be dealt with when the dust has settled around Enron.

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January 22, 2002.

[Source: Financial Times, January 16, 2002]