The Chinese Wall is a moral concept of separation between groups, departments or individuals within the same organization-a virtual barrier that prohibits the exchange of information or exchanges that may lead to conflicts of interest. Although the concept of a wall exists in various industries and professions—including journalism, law, insurance, computer science, reverse engineering, and computer security—it is most often associated with the financial services sector. Offensive and racist terms are commonly used in investment banks, retail banks, and brokerage firms. The historical milestones in the United States explain why the moral wall was needed in the first place and why legislation was enacted to keep it in place.
- The Chinese Wall refers to a moral concept that acts as a virtual barrier to prohibit groups or individuals within the same organization from sharing information that may cause conflicts of interest.
- This offensive term became popular after the stock market crash in 1929 prompted Congress to enact legislation to separate the activities of commercial banks and investment banks.
- For decades, Congress has enacted legislation regulating insider trading, increasing disclosure requirements, and reforming broker compensation practices.
- Despite these regulations, many investment companies continued to engage in fraud, which was evident during the burst of the Internet bubble in 2001 and the subprime mortgage crisis in 2007.
The Chinese Wall and the stock market crash of 1929
Originating from the Great Wall of China, this ancient impervious building was built to protect the Chinese from invaders, and the term “Chinese Wall” became popular in the early 1930s-and in the financial world. Stimulated by the 1929 stock market crash (at the time due in part to price manipulation and insider information trading), Congress passed the Glass-Steagall Act (GSA) of 1933, requiring the separation of commercial banking and investment banking— -Namely investment banks, brokerage companies and retail banks.
Although the bill did lead to the dissolution of some securities and financial giants, such as JPMorgan Chase (which had to spin off the brokerage business into a new company Morgan Stanley), its main purpose was to prevent conflicts of interest.For example, a broker recommends that a client buy stock in a new company whose investment banking colleagues happen to be dealing with the company’s initial public offering (IPO). Glass-Steagall did not force the company to participate in the business of providing research or providing investment banking services. Instead, it tried to create an environment in which one company could do both at the same time. It just mandates a division between departments: the Chinese Wall.
This wall is not a physical boundary, but an ethical boundary that financial institutions should abide by. Internal or non-public information may not be passed or shared between departments. If the investment banking team were working on a transaction to list a company, their brokerage partners downstairs would not know about it—until the rest of the world knew about it.
As linguistic discrimination and racism
This term is usually regarded as culturally insensitive and an offensive reflection of Chinese culture. Unfortunately, it is now in the global market. Some people even argued in court.
It appeared in a consensual opinion in Peat, Marwick, Mitchell & Co. v. High Court (1988), in which Judge Hanning wrote: “The’Chinese Wall’ is a piece of law that should be resolutely abandoned. Many people would think that this term is a subtle form of racial focus of linguistic discrimination. Of course, the continued use of the term will be insensitive to the racial identity of many Chinese people. Modern courts shouldn’t change from outdated, more primitive thinking. Way.”
The alternative suggested by the judge is the “moral wall.” The American Bar Association’s rules of conduct recommend “screening” or “screening” as a way of describing this concept because it is related to resolving conflicts of interest in law firms.
The Chinese Wall and deregulation in the 1970s
For decades, this arrangement has been beyond doubt. Then, about 40 years later, the deregulation of brokerage commissions in 1975 became a catalyst for increasing concerns about conflicts of interest.
This change abolished the fixed interest rate minimum commission for securities trading, resulting in a sharp drop in the profits of the brokerage business. This becomes a major issue for sell-side analysts, who conduct securities research and provide information to the public. On the other hand, buy-side analysts work for mutual fund companies and other organizations. Their research is used to guide investment decisions made by the companies that hire them.
Once the pricing of brokerage commissions changes, sell-side analysts are encouraged to write reports that help sell stocks and receive financial rewards when their reports facilitate the initial public offerings of their companies. The generous year-end bonus is based on such success.
All this helped create the roaring bull market and evolving era of Wall Street in the 1980s, as well as some high-profile insider trading cases and the annoying market adjustment in 1987. The market supervision department of the Exchange Commission (SEC) has conducted multiple reviews of the Chinese Wall procedures of six major broker-dealers. Partly as a result of its investigation, Congress enacted the Insider Trading and Securities Fraud Enforcement Act of 1988, which increased penalties for insider trading and granted the SEC wider rule-making powers regarding the Chinese Wall.
The Chinese Wall and the Internet boom
The Chinese Wall, or Moral Wall, became the focus of attention again in the heyday of the Internet era in the late 1990s. At that time, superstar analysts such as Mary Meeker of Morgan Stanley and Jack Grubman of Salomon Smith Barney were keen on specific The publicity of securities is well-known.
During this period, as investors buy and sell based on analyst recommendations, a few words from top analysts may cause stock prices to soar or plummet. In addition, the Gramm-Leach-Bliley Act (GLBA) of 1999 repealed most of the Glass-Steagall Act, which prohibits banks, insurance companies, and financial services companies from acting as consolidated companies.
The bursting of the Internet bubble in 2001 revealed the flaws of this system. When it was discovered that well-known analysts were privately selling the stocks they promoted and were forced to provide good ratings, regulators took note (although personal opinions and research indicate that these stocks are not worth buying). The regulator also found that many of these analysts own pre-IPO shares of the security. If they succeed, they will make huge personal profits, provide “hot” tips to institutional clients, and favor certain clients so that they can make money from it. Take huge profits. Unsuspecting members of the public.
Interestingly, there is no law prohibiting this practice. Weak disclosure requirements have allowed this practice to flourish. Similarly, people find that few analysts give a “sell” rating to any company they cover. Encouraging investors to sell certain securities is not suitable for investment bankers because such ratings would prevent underrated companies from doing business with banks-even though analysts and their cronies often sell the exact same securities. Investors who buy securities based on the recommendations of their favorite analysts believe that their recommendations are fair and lose a lot of money.
The consequences of the internet
After the dot-com bubble burst, Congress, the National Association of Securities Dealers (NASD), and the New York Stock Exchange (NYSE) all participated in the development of new regulations for the industry. Ten big-name companies including Bear Stearns; Credit Suisse First Boston (CS); Goldman Sachs (GS); Lehman Brothers; JPMorgan Chase Securities (JPM); Merrill Lynch, Pierce, Fenner and Smith; Morgan Stanley (MS); and Citi Global Markets were forced to separate its research and investment banking divisions.
This legislation leads to the establishment or strengthening of the separation between analysts and underwriters. It also includes reforms to remuneration practices, because the previous practices provide analysts with financial incentives to evaluate favorably for underwriting clients.
Is the moral wall effective?
Today, there are additional safeguards, such as prohibiting the link between analyst compensation and the success of a particular IPO, restricting the provision of information to certain customers but not others, prohibiting analysts from conducting personal transactions in securities they cover, and additional Disclosure is intended to protect the requirements of investors.
But lawmakers are still grappling with the role conflicts of interest played in the 2007 subprime mortgage crisis that led to the Great Recession, and want to know to what extent the moral wall helped or hindered practices before the collapse. There seem to be signs that ensuring the separation between the product rating service and its client company is being scorned.
Another problem: One department of an investment company recommends mortgage bonds (or other products) to investors, while another department of the same company sells them short. In other words, they opposed their proposals at the expense of investors.
In addition to legality, all these dark events and scandal-ridden eras have revealed some ugly truths about ethics, greed, and the ability of professionals to self-regulate. There have always been people who doubt the effectiveness of the ethical wall; of course, they have tested self-regulation to the limit. Regrettably, the morality of the last century seems to be that the concept of an ethical wall helps define ethical boundaries-but it has little effect on preventing fraud.