Quote of the day: Investment Bank Leverage

With Goldman Sachs and Morgan Stanley becoming bank holding companies, the traditional U.S. investment banking model has come to an end.

But it bears remembering that investment banks are highly leveraged institutions. Both Goldman Sachs and Morgan Stanley will have to either deleverage significantly or merge with an existing depositary institution with less leverage in order to meet the stricter regulatory requirements bans face.

That brings me to the quote of the day, which comes from Niels Jensen and Jan Wilhelmsen of Absolute Return Partners via John Mauldin.

For the past couple of decades investment banks have been operating like mega hedge funds. An ever larger part of profits has been derived from proprietary activities. I remember once, not that many years ago, when I worked for one of the largest investment banks, it was explained to me that the bank’s gearing was around 40-45 times during the month. Then, every month, as we approached month-end, the gearing would be brought down to below 30 in order to satisfy the regulator. I would be surprised if this practice was not widespread, but I would be even more startled if this sort of activity has not been seriously curtailed in the current environment. As markets have frozen, investment banks have had to reconsider their business model.
–Observations on a Crisis, Investors Insights

That this went on in the shadows of the U.S. financial system is further evidence of why we are where we are today.