Yves had a very good post yesterday called “Why Big Capital Markets Players Are Unmanageable” on banks: the former i-banks and commercial banks. The biggest takeaway for me came from her statements regarding the level of responsibility that a junior level employee in an investment bank can have. She says:
What makes capital markets businesses different from any other form of enterprise I can think of is the amount of discretion given of necessity to non-managerial employees, meaning traders, salesmen, investment bankers, analysts. In pretty much any other large scale business, decisions that have a meaningful bottom line impact (pricing, new sales campaign, investment decision) are deliberate affairs, ultimately decided at a reasonably senior level. The discretion that customer-facing staff have in pretty much any business in limited. At what level does someone have the authority to negotiate a contract? And even then, how many degrees of freedom do they have?
That is a very significant factor in investment banking that makes it risky. Think about the blow-ups that have occurred in trading enterprises from SocGen to Sumitomo to Barings Bank. In most enterprises, most junior-level employees don’t have the decision-making authority necessary to allow these mistakes to happen.
But, Yves’ post got me to thinking a bit more about investment banking itself and the change in emphasis within firms. John Gapper at the FT had a revealing post yesterday on just this subject. He writes:
There is excited talk of investment bankers reclaiming the power and mystique that veteran rainmakers such as Joe Perella, Robert Greenhill and Roger Altman (all of whom now ply their trade at boutiques) once enjoyed at big banks, rather than being trained as technicians and treated as such.
How seriously should we take this? Not as seriously as the bankers do, it is safe to say. There will always be a place in the boardroom for a few senior advisers with the skills and temperament to give thoughtful and unbiased advice to chief executives facing big, risky decisions.
“Sometimes a chief executive needs a surgeon to operate but sometimes he needs a GP who understands people and politics and governance. The best banker can rise above the short-term deal,” says one.
But, valuable as that job may be to the client, it is a niche activity for large banks. Investment banking – advisory work and underwriting – brought in less than a tenth of Goldman Sachs’ net revenues in the first quarter and was dwarfed by trading and principal investing.
When a bank can earn $30m for making a lending commitment to a company that is acquiring another and only $5m for advising on the merger, it tends to value the former over the latter. Advisory work brings prestige, while financing and lending bring in the big bucks.
Did you see where Gapper says only one-tenth of the earnings comes from traditional advisory work? Today’s investment banks look nothing like their brethren of yesteryear. For all intents and purposes, banks today are giant hedge funds – at least in comparison to what they once were. It is sales & trading that is dominant at today’s firms and that has great significance regarding risk and compensation.
A brief history
Before I get into what things look like today, let me give you a (very) brief history of Wall Street’s structure from the 1920s onward. Back in the roaring 20s, the United States had the Universal banking model. JP Morgan was the king of the hill, with a huge advisory, lending and international operation (The House of Morgan is a good book detailing the history). JPMorgan was so big that the firm and the man literally saved the street during the Panic of 1907 (also chronicled in a book aptly titled The Panic of 1907). It was this event that got us a central bank in America because no one wanted another 1907 and no one wanted the whole system dependent on one private citizen.
Now, the Universal banking model has a few problems that created huge conflicts of interest in the 1920s. Many believe the excess wrought by these conflicts contributed to the Depression. So, we got a fix via Glass-Steagall in 1933, whereby commercial banking and merchant/investment banking activities were separated. In the case of JP Morgan, it was split into three: JP Morgan, a commercial bank, Morgan Stanley, an investment bank, and Morgan Grenfell, a British merchant bank (and also former employer of mine). Other banks had to split too: Bank of Boston – First Boston, for example. Others exited one business or another (Goldman got rid of commercial banking).
As before, money center banks like National City (now Citigroup), Chase, Chemical Bank, Bankers Trust and JP Morgan dominated the wholesale market while other smaller banks concentrated on retail banking, what most of us see on the high street. JP Morgan and Bankers Trust, in fact, had no retail banking whatsoever.
By the 1980s, these banks were chomping at the bit to get into investment banking because retail banking had been disintermediated and was much less profitable. As a result, there was a relaxation of Glass-Steagall whereby commercial banks were permitted to earn up to 25% of their revenue from investment banking activities like trading and advisory work. The money center banks, already having significant business relationships through their huge wholesale businesses, jumped in. At some point, the 25% restriction became onerous for the bankers as they bumped up against the ceiling. JPMorgan was the bank that was most affected by this rule as it developed a very large advisory and trading business.
By the 1990s, the slippery slope made it inevitable that Glass-Steagall was to be repealed. After all, no one blew up due to the 25% rule. Granted Bankers Trust permanently damaged their franchise in the early 1990s with a huge derivatives scandal. But, the bank lobby was still pushing for Glass-Steagall to be repealed.
Of course, it was eventually repealed in order to retroactively allow the Citigroup-Travellers merger to occur. The rest of the history you know.
Moving into trading
What is not evident in this history is that investment banks used to be dominated by dealmakers. The advisory work was considered the main focus. Look at any Wall Street book before “Liar’s Poker.” Almost none of them talks about trading. Sales & trading as considered the bucket shop department where guys whose knuckles were dragging the floor worked. These men – invariably from Brooklyn and sporting ethnic names – were looked down upon by the white shoe investment bankers.
Back when Wall Street was run by partnerships, there was a bulge bracket of firms whose names came fist on any prospectus for bond or equity offerings. This group consisted of Goldman Sachs, Morgan Stanley, Lehman Brothers, Dillon Read, and First Boston. Names not on that list were Salomon Brothers (too much trading), Merrill Lynch (too much retail client focus), and Drexel Burnham (not classy enough). Clearly, the hierarchy was white shoe Investment Bankers first, knuckle dragging traders and middle brow retail shops last.
This all changed, starting in the 1980s. There are a number of factors why, but the change in focus brought Salomon, Merrill and Drexel into the big leagues. As time went on trading became more and more dominant. In my view, a lot of this had to do with economies of scale. Yves says:
So the scale of operation required to be competitive is too large for it to be managed by player-coaches who had deep expertise, and like the Dimon example, were more expert than the people working for them. But the normal corporate/commercial banking management structure, with more managerial layers, and the top brass having broader spans of control, was devised in earlier stages of industrial organization, when you had factories or service business with a great deal of routinization of worker and middle manager tasks. Traditional commercial banks are on the same factory format.
Now, she is focusing on why commercial banks differ from investment banks. I would use this same paragraph to also highlight the difference between an OTC derivatives operation at JPMorgan Chase and the advisory work at a firm like Greenhill or Lazard, the former bread and butter of I-banks. The sales and trading operations benefit from scale in a way advisory work does not. And what that means, given Yves’ quote is that you have a lot of junior people making big decisions.
What’s more is the fact that banks are not acting as passive conduits who ‘make markets,’ their traditional function. They are now taking risks with their own capital. One reason Goldman bounced back from the crisis so well is that it has a large proprietary trading operation that was able to make a lot of money, not through facilitating transactions, but through making trades for Goldman’s own account. In essence, Goldman Sachs is today as much a hedge fund as it is a bank.
The problem with this model, moving from advisory work to trading and from facilitator to principal, is that it is riskier. The reason this past crisis was so devastating has much to do with the move to the bank-trading-as-principal-actor business model. And since scale is a large part of why this works, these firms are not just risky, they are also enormous – which makes them a systemic risk.
Going forward, I hope we see regulators address this problem. Banks of today look nothing like banks of just twenty-five years ago. And investment banking today looks nothing like it did a generation ago either. In both cases, the operations are larger and riskier, a situation which must be addressed if we are to avoid another crisis of this magnitude.
Big banks look to rainmakers again – John Gapper, FT