Outlook: Shamed investment bankers made to roast on Eliot's spitzer

After the party comes the clean up, and what a clean up it is turning out to be. The way things are going, much of the deregulation of the last half a century and more will get thrown out of the door in addressing the bubble fuelled abuses of the US investment banking industry. Eliot Spitzer is not the first New York State Attorney General to build a political career out of bashing Wall Street, but it's hard to think of any predecessor who has landed more punches. Whether this is an entirely good thing for New York's general prosperity is an open question.

Investment banking in its modern form was made and bred in New York City and the money it generates is the largest single part of the region's economy. The effect is as big as, if not bigger than, the City's impact on London. Without the City, London would be a pale shadow of its prosperous self. If you want to know why the London economy seems so sluggish right now, look no further than the recession-hit City.

Like all regulators, Mr Spitzer believes himself to be on a mission of public duty in exposing, punishing and reforming miscreant financiers. Investment banking has to be cleaned up for it to thrive once more, he would say. The very credibility of New York's capital markets is at stake. This is perhaps not the time for a rumbustuous defence of the investment banking industry. It is too banged to rights for that. But is not Mr Spitzer in danger of throwing the baby out with the bathwater?

Merrill Lynch has already agreed a huge fine alongside root-and-branch reform of the way it operates. Citigroup this week agreed to separate its research and private client business from its investment banking activities and contribute to a $1bn (£640m) pool to fund independent research. Others are still considering their options. If it wasn't for the evidence of our eyes, it would be impossible to believe these zealots of the free-market system had agreed to such interventionism. This is New York, not Paris or Frankfurt, for heaven's sake.

And yet they have, presumably because the alternatives of prosecution and legislative reform are so much worse.

Fast back two or three decades and equity markets both in New York and London were protected from the sort of abuses that ran riot during the bubble through a system of rigidly applied structural divisions. Broking was kept separate from market making. Likewise, investment banking, or merchant banking as it used to be called in the City, was separated from commercial banking. Some of these divisions were enforced not just by tradition and voluntary agreement, but by law.

In the US before deregulation, it wouldn't have been possible for a commercial bank to own an investment bank, this because in the aftermath of the 1929 crash it was discovered that commercial banks in their dash for fees had indulged in an unparalleled frenzy of unsafe lending. Sounds familiar, doesn't it?

The system wasn't perfect, but it did guard against the conflicts of interest that once more came to the fore in the boom of the 1990s - tainted brokers' research, spinning, and once again the practice of soft loans and easy equity in exchange for big fees. A certain amount of water passes under the bridge, it seems, and everyone forgets the lessons of the past, the capital markets push for deregulation, old barriers are dismantled and the party begins afresh.

I'm not saying saying we'd benefit from a return to the system that ruled in the City and Wall Street before deregulation. Far from it. There were plenty of other abuses in those days. The closed shop nature of the City prior to Big Bang, with its neat divisions of responsibility and monopolistic practices, nearly ended up destroying it entirely. Margaret Thatcher's deregulating reforms came in the nick of time. But what goes round come round, and it was perhaps inevitable that investment bankers would end up abusing their hard-won freedoms once they had them back again.

The City managed to avoid Wall Street's worst abuses during the bubble, perhaps oddly because the City is dominated by the same bulge-bracket gang of firms. The Financial Services Authority would put this down to better regulation, and in particular to its system of principle-based rules, obliging practitioners to avoid the conflicts of interest that got Wall Street into such deep water. Because London is mainly a wholesale market, there is also a higher degree of healthy cynicism. House research is assumed to be tainted, but it is still read because rightly or wrongly investors believe it to contain inside information, or special insights. In Britain, the concern is not so much about conflicted research, as the way it is paid for.

As for Wall Street, for the time being it has little option but to bend over and take the punishment. Mr Spitzer's cane, some say, is not nearly as bad as those being prepared on Capitol Hill. Wall Street is hoping that by reforming itself, it can avoid the worst of the regulatory backlash.

Hays warning

There's an old rule of thumb in the City which dictates that you should always sell the shares the moment the founder and driving force in a company decides to hang up his boots. Hays, the business services group, has proved it all over again. Floated at the tale end of the 1980s, Hays was by the turn of the century one of the largest companies in the land.

The man behind it, Ronnie Frost, had transformed a company with roots in frozen chickens and the importation of spices from the Far East into an all embracing logistics, contract labour, recruitment, mail delivery and data processing company. Never mind that Mr Frost was the only one who seemed fully to understand the connection between his many and varied acquisitions, the company appeared tailor made for the demands of a service based economy and the shares soared.

Then Mr Frost left and the profit warnings came thick and fast. After yesterday's shocker that profits for the full and half year will be 10-15 per cent below already depressed City expectations, the shares will struggle to maintain their position in the FTSE 100 share index. Forget Mr Frost, Hays has had no chief executive at all for the past sixteen months. The company insists that this has nothing to do with yesterday's profits warning, which is wholly down to the deteriorating business environment. In the absence of a CEO, the chairman, Bob Lawson has been holding the fort, and rudderless or not, he believes the company has made excellent progress over the last year in setting its house in order.

Controls have been restored and underperforming businesses have been sold. Meanwhile, the progressive dividend policy is safe, he insists. He's also found a new chief executive. Colin Matthews joins from Lattice Group as of today. If Mr Lawson is right, then much of Mr Matthews job is already done, and the new man will be joining at the bottom.

October's rally

There have been better rallies than the present one, but for stock market anoraks, October has none the less proved a notable month. October is traditionally the month of stock market crashes, but this one has been the very reverse. For the Dow Jones Industrial Average, up 11 per cent on the month, October was the best calender month in 16 years and the best October ever. Will the rally hold?

Well perhaps, but few are prepared to stick their necks out and call the end of the bear market quite yet. For that to happen requires a lot more certainty than we've got at the moment. War against Iraq is still odds on, with all the unknowables that such a campaign throws up. There's more optimism about the economy among economists and policy makers, but business leaders remain as down in the dumps as ever, and it is corporate profits that ultimately determine whether stock prices rise or not.

jeremy.warner@independent.co.uk