The greatest financial upheaval since the Great Depression won’t kill investment banking, but will make it smaller, less profitable and probably a heck of a lot less lucrative for its workers.
Bear Stearns and Lehman went out the hard way and Merrill Lynch sold itself to Bank of America, leaving only Morgan Stanley and Goldman Sachs as major independent investment banks. Shares and debt of both remaining banks were under severe pressure last week as investors questioned their business model.
Investment banking is in the midst of a major cyclical recession even without taking into account issues with how those banks fund themselves and problems with assets on their balance sheets.
The dollar value of completed global mergers and acquisitions is down 36 percent year on year, equity issuance is down 18 percent and debt underwriting down 46 percent.
More to the point, the industry is undergoing huge secular changes; the amount of leverage that firms use is on a very bumpy trip lower and regulators will almost certainly impose new costs and attempt to limit risk among the survivors.
More secure, longer-term funding and lower leverage is great and everything, but it does imply lower profits.
Fed Up
It is also very likely that, having picked up the tab for some of the fallout, the taxpayer decides to crack down on risk-taking in invest-ment banks. This is a role investors should have played when times were good—refusing to fund banks that paid employees too much for taking too many risks with their money—but signally they did not.
“Do you need stand-alone investment banks that became hedge funds? No,” said Peter Hahn, a former banker at Citigroup and fellow at Cass Business School in London.
The answer the market seems to be moving towards is housing investment banks within commercial banks. The reasoning is twofold; first, commercial banks have larger balance sheets and have a shot at absorbing the investment banks and secondly, they often enjoy lower costs and more diversified long-term funding.
So an investment bank within a commercial bank, the argument runs, will fund more cheaply and pose less of a systemic threat.
I’m not sure I buy that.
The best home for some of today’s investment banks and their troubled balance sheets may well be in the arms of a big bank, but that is not the same as saying that is a sound business model.
The question that remains to be answered, especially in the United States, is whether this is just another form of regulatory arbitrage. Commercial banks in the U.S. enjoy government insurance on their deposits, and their superior cost of funding is in part a function of that.
The Federal Reserve, acting as Lehman Brothers drew up its bankruptcy filing, actually relaxed limits in the U.S. on how commercial banks can provide funding to their brokerage affiliates.
“In the U.S. you have the issue of moral hazard when you’ve got the Federal Deposit Insurance Corporation subsidising far riskier in-vestment banking activities,” said Roger Ehrenberg, managing partner of IA Capital and the former CEO of DB Advisors.
Boutiques In Vogue
The regulatory fate of investment banking will ultimately be settled politically, so in advance of the November presidential election it is very difficult to predict.
One thing that is likely is lower compensation. This would naturally be the case anyway given that the industry is not making as much money, but I think it might be a trend with strong legs.
