The big investment banks are dead. Investment banking has a bright future. This is not contradictory. When Goldman Sachs and Morgan Stanley fled into the protection of commercial bank charters last month, large U.S. stand-alone investment banks became history.
The global financial meltdown and debate over the rescue package have pushed the changes in investment banking to the background, but they are still worth noting.
Investment banks perform vital functions for society. That need won’t go away. The demise of mega-firms opens space for smaller, prudently managed companies to grow and prosper.
The term “investment bank” covered a multitude of sins. Large investment banks did some things that, while requiring resources and expertise, were relatively low-risk. Other activities involved great risk.
Underwriting new issues of bonds or corporate stocks was a bread-and-butter business that required financial analysis and knowledge of the legal requirements of such issues. It usually involved little risk.
Packaging mortgages and other debt from car, boat or student loans or credit cards into “mortgage-backed bonds” or “collateralized debt operations” was part of underwriting. This was not, in itself, highly risky as long as the underwriter did not retain any aspect of ownership or liability in the securities.
Investment banks also acted as brokers and dealers. Brokers buy and sell stocks and bonds for others on commission. There is very little risk.
Dealers own a quantity of certain bonds or stocks and “make a market.” That is, they stand ready to sell these securities to anyone seeking to buy and to buy from anyone seeking to sell. A spread between buying and selling prices affords their income. In normal times, such broker-dealer functions also involve low risk.
Investment banks also provide legal and financial advice and arrange funding to carry out corporate mergers and acquisitions. This is on a fee-for-service basis and not risky.
Finally, these banks also acted as traders, buying and selling stocks, bonds, futures contracts, options, swaps and other financial instruments for their own account in the hope of making a profit. They often borrowed large amounts of money elsewhere to leverage their own capital.
Such trading can be extremely risky. It is what just blew up in their faces, putting the last five big banks out of business or into fundamental restructurings.
Despite the fact that famous institutions bankrupted themselves creating and trading complex securities they themselves didn’t understand, someone still has to issue new securities, trade stocks and bonds and advise businesses on mergers.
The need for these vital economic services did not go away. Nor are all investment banks dead, just the big ones in which managers allowed the trading tail to wag the entire company dog.
Smaller firms on Wall Street, in Chicago or San Francisco or in regional centers like Atlanta, Minneapolis or Seattle have decades of experience and skilled staffs. Some have survived and even prospered because they shunned the hubris that destroyed the big boys. The next few years will be difficult for the economy but offer opportunities for prudent investment banks.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.