This year marks the 20th anniversary of the Financial ServicesModernization Act (FSMA), also known as the Gramm–Leach–Bliley Act,signed into law in President Clinton's second term. The goal ofthis legislation was to improve the efficiency and competitivenessof the financial services industry by removing legal barriersbetween commercial and investment banking. In reality, it laid thegroundwork for an oligopolistic universal banking industry, inwhich a small number of institutions provide a wide variety ofservices across the commercial and investment banking spectrum.

Once implemented, the FSMA led to a massive consolidation offinancial institutions. Today, according to FDIC data, more than 50percent of all deposits in the United States reside with the fourlargest bank holding companies, and these are the same companiesthat sit atop the league tables in merger and acquisition (M&A)advisory, loans, bonds, and equity offerings.

In 1997, Alan Greenspan, then-chairman of the Federal Reserve,explained the rationale for the FSMA this way: “Many companies andindividuals want to deal with a full-service provider that canhandle their entire range of financing needs. This preference for'one-stop shopping' is easy to understand. Starting a new financialrelationship is costly for companies and individuals and, byextension, for the economy as a whole. It takes considerable timeand effort for a customer to convey to an outsider a deepunderstanding of its financial situation. This process, however,can be short-circuited by allowing the customer to rely on a singleorganization for deposit services, loans, strategic advice, theunderwriting of debt and equity securities, and other financialservices.”

Over the past two decades, independent investment banks havegrown significantly, suggesting that the predicted benefits of theone-stop shop were overestimated, at least in investment banking.Ken Moelis, founder of the investment bank Moelis & Company,said in a 2013 interview with Fortune: “The aberrationisn't the boutique. The aberration is the belief that it could allbe conducted more effectively under one roof. The world developedwith advisory and investment banks and commercial banks separatefor a reason. It was only a short time ago that everything was puttogether.”

M&A experts like Moelis have long led the independentbanking movement. In 1995, after two years as deputy secretary ofthe U.S. Treasury Department, Roger Altman founded Evercore, a firmthat is now considered the gold standard for independentM&A-focused investment banks. According to Altman, his guidingprinciple in building the firm was that “clients would be betterserved by advisors not tethered to the demands of a multiproductfinancial institution.”

Independent Advisors Disappear from the LendingProcess

Since the adoption of the FSMA, the term “independent investmentbank” has typically been synonymous with M&A advisory services.Yet one often-overlooked area that has changed even morefundamentally under the new rules is the very straightforwardloan-making function of a bank. FSMA was intended to make financialservices easier for clients to navigate, but it also killed therole of the independent loan intermediary, or “arranger”—which, inthe end, makes it more challenging for corporate borrowers toensure they're getting the best deal and often creates a conflictof interest.

Prior to the enactment of the FSMA, investment banks such asGoldman Sachs or Morgan Stanley often acted as an intermediarybetween a company seeking to borrow and the banks or other capitalproviders looking to lend. Utilizing an independent loan arrangergave the borrower an expert advocate who was working solely on itsbehalf. The loan arranger would identify prospective loans, screenoffers, and negotiate with the lenders on behalf of the corporateborrower.

In the post-FSMA environment, theroles are no longer as straightforward because the investment banksare now also corporate lenders. Goldman Sachs and Morgan Stanleydominate as lenders and syndicators, first and foremost—along withBank of America, JPMorgan, Citigroup, and Wells Fargo. However, allthese institutions also command a sizable share of the globalloan-arrangement business. The financial services industryconsolidates power in these key institutions, and smaller bankshave little incentive to try to compete with them on fees or termsbecause they depend on the universal banks to include them in loangroups.

This dynamic creates inherent conflicts of interest, which areabundantly clear in what used to be the sleepy stock and trade of acommercial bank—loan making. For example, acquisitions are commonlyfinanced using loans. These loans are often arranged by a divisionof the same bank that is providing strategic deal advice throughits M&A advisory group. Subsequently, the loans are either heldby the bank or syndicated to multiple lenders that may includeother banks and institutional investors (hedge funds, mutual funds,private equity funds, etc.). This dual role as both advisor and“arranger” can create a misalignment of incentives.

Such was the case in the 2010 Del Monte Foods merger with aprivate equity group led by KKR. Del Monte was advised by BarclaysCapital, but Barclays also provided the buy-sidefinancing. A shareholder suit was brought, and theDelaware court stated that Barclays had “secretly and selfishlymanipulated the sale process.” However, the court also said thatDel Monte's board failed to provide the oversight that would havechecked Barclays' misconduct. Ultimately, Del Monte andBarclays agreed to settle the suit for $89 million, one of thebiggest recorded in the Delaware Court of Chancery.

As DealBook reporter Michael J. de la Merced wrote at the time: “At the heart of the disputewas Barclays' role as an advisor to the seller and a provider offinancing to potential buyers. Documents disclosed through thelitigation showed that Barclays first began shopping Del MonteFoods as an acquisition target to potential buyers, hoping to reapbig fees by lending money to private equity firms for a deal. Byworking on both sides of the transaction, Barclays stood toessentially double its fees.”

It's hardly surprising that some corporate boards and financeexecutives have become increasingly skeptical about relying on thelargest universal banks for all their advisory services. When acompany is hiring an external advisor for guidance on majorfinancial decisions, shouldn't the advisor's interests alignclearly with the clients'?

Conceptually, it would seem that corporate borrowers couldinclude in their agreements with loan intermediaries a clause thatprevents the arranger from also serving as a lender. In practice,however, this is difficult. It would be a bit like walking into aFord dealership and saying, “I'd like to buy a new car. I'll payyou for your time and advice, but what kind of car—that is not aFord­—do you recommend?”

In addition, the universal banks are all highly attuned to theactions of the others, which effectively stifles competition. Thisis the nature of an oligopolistic industry: When there are fewplayers, each knows what the others are doing. The universal banksare constantly in discussions about rates, covenants, and otherissues related to corporate lending. Finance professionals maythink that by getting bids from two different banks, they'vecreated a competitive dynamic, but in reality, the banks areusually in sync. I like the analogy that universal banks are likeaspen trees. When viewed from above ground, they look likeindividual trees, but when you dig down, you find that their rootsystems are interconnected. A single universal bank will be only asaggressive (competitive) on terms as it needs to be to attain theposition it wants in the syndicate.

Eliminating the role of the dedicated and independent loanarranger puts the borrower and its universal bank advisor at oddson the most basic terms of a loan. Obviously, a decrease in pricefor the borrower means less revenue for the lending bank, andless-stringent terms for the borrower lead to more risk for thelender.

Regardless of the setting, most people would be justifiablyuncomfortable if the agent they hired as an unwavering advocate inany financial transaction also became the principal on the otherside of the table. Consider real estate: Because selling a home issuch a significant transaction, people generally hire aprofessional broker, who can leverage market knowledge, buyernetworks, and transaction experience to ensure that the sellermakes the most lucrative deal possible. If the real estate agenthimself ended up purchasing the home, a seller might reasonably bequite concerned the agent hadn't made every effort to secure thehighest possible price. Likewise, when a corporate borrower allowsa universal bank to combine the arranger and lender roles, it isessentially selling its loan to the intermediary, and it can expectto pay its financial advisors through their investment choices.

The Alternatives: What a Treasurer Can Do

Understanding the dynamics and risks inherent in the universalbanking model is a critical component of risk mitigation fortreasurers as they consider the use of loans in their financingstrategies. Here are some steps finance professionals can take toincrease their odds of achieving the best outcome:

• Begin the process early. The more you need the capital, theless negotiating power you have.
• Be attentive to the motivations and interests of both youradvisors and your counterparties in every transaction.
• Understand and evaluate the tradeoffs embedded in each type ofloan product. Consider how using each type of product might impactyour long-term capital structure strategy and capital allocationdecisions.
• Cultivate new commercial and corporate banking relationshipswith aspirational firms.
• Be willing to refresh your bank group to create truecompetition. Understand that it is a living, breathing ecosystemwhich might be healthier if you dropped some misaligned banks andadded new alternatives.
• When allocating your credit facility, be careful to avoidconcentrating excessive influence on a small number of banks.
• Monitor the bank loan market for comparable transactions tolearn of new additions and enhancements. Look outside your industryfor deals involving companies similar to yours or transactions witha similar credit profile.
• When needed, seek the advice of an independent loanarranger.

The universal banking model has shifted a great deal of power tothe capital providers, especially in the loan capital markets. Itis not surprising that the independent loan-advisor role is onceagain in demand. One could even say the loan arranger ridesagain, protecting the interests of borrowers in the wild, wildcapital markets.

John R. Cryanis a senior advisor at EA Markets LLC, an investment bankproviding comprehensive capital markets advisory services. He is anaccomplished finance executive with more than 16 years of bankingand consulting experience. He has advised boards, seniorexecutives, and investment funds across a broad range of industriesin a variety of transactional and consultative engagements. Cryanis a frequent author and speaker on topics including shareholderactivism, capital allocation, managing for value, and behavioraleconomics.