Epitaph for an Industry: Investment Banking

Investment banks have long been separated from commercial and savings banks by federal law. When we speak of a "bank," we usually think of a business that takes money from depositors (savings accounts, savings accounts, money market accounts) and lends to other entities. The bank's income comes from the spread between the interest rate it pays on deposits, and the [higher] rate it charges on loans. This is not what investment banks do.

Deserted interior, Lehman Europe HQ, Sep 2008 Click for larger image

An investment bank's customers are corporations issuing stock, bonds, or paper.¹ When a company wants to issue stock, it approaches an investment bank to raise the money. The investment reviews the prospectus for the issuing firm, carries out its own research, and determines how much money can be raised on the capital (stock) or money (bonds, paper) markets. It draws up the actual securities and buys them from the client, then sells the securities on the capital markets. The difference between the face value of the stocks and their sale price is the IB's main source of revenue.

If the share issue is quite large, then the IB usually spreads the risk through syndication. The primary IB in contact with the issuing firm contacts other IB's and invites them to buy a share of the security issue; in the case of paper, the issue is routinely absorbed by a money market fund.² Members of the syndicate usually make a firm commitment to distribute a certain percentage of the entire offering and are held financially responsible for any unsold portions. Selling groups of chosen brokerages assist the syndicate members meet their obligations to distribute the new securities. Members of the selling group usually act on a "best efforts" basis and are not financially responsible for any unsold portions.

IB's are not a very large sector of the Usonian economy: about $200 billion in total revenues for 2006,³ or probably 31% the size of the commercial banking sector.⁴ Fannie Mae and Freddie Mac belong to neither sector. However, the smallish revenues belie the great importance of this business to the world economy. The US IB sector is immensely important to the coordination of capital markets; it mediates the best available data on sector growth in other industries, soundness of management at individual firms, etc., into capital allocation (bond and stock issues). Commercial banks traditionally address more routine needs for loans; they are usually more interested in the firm's balance sheet, rather than its long-run outlook for expansion or diversification. In a way, IB represents a disembodied and convicted guide to world industry, a not-so-invisible hand with its own peculiar ideological proclivities.

One of the most important New Deal measures was the Glass-Steagall Act (1933), which created firewalls between the different functions of banks. The most important of this was between investment banking and commercial/savings banking; another isolated financial firms generally from non-banking activities. After 1960, the Glass-Steagall Act was eroded by loopholes, until the last barriers were dissolved (1999); the financial services industry was opened up to homologization. There was an immense spike in the number of mergers, and in the value of the deals.⁵ Nearly all recent literature reviewed (i.e., published pre-2008) is emphatically in favor of even more consolidation, with the claim that further homologization in the financial services industry has created intense competition. Judging by the Japanese experience of the late '90's, it seems plausible that the banking regulators will see consolidation as a low-cost way of resolving bad balance sheets.

As of this writing, the IB industry has been almost completely annexed to other financial services, and we can safely assume the age of the universal bank/financial supermarket has arrived. On Wall Street, only two independent investment banks remain: Morgan-Stanley and Goldman-Sachs; the latter is extremely well-connected politically.⁶

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NOTES:

1 "Paper" (commercial or government) is short term debt; it is usually acquired by money market funds, because it affords extremely low risk.

2 Money markets deposit accounts were an early breach in the wall between investment and commercial banking; they were accounts offered by banks whose value was tied by an index to the money market funds (1982; "Money Market Deposit Account," Financial & Investment Dictionary). They are required by law to invest in federally listed low-risk securities, of which paper is a major part. See "Money Market Funds," US Securities Exchange Commission, specifically the "Investment Company Act of 1940" (PDF). Commercial paper is not a very important market; it only accounts for $150-200 billion dollars of debt at any time (Federal Reserve). Money market fund balances are around $3.2 trillion (retail + institutional); see "Economic Indicators," GPO (July '08); they've become a rather important component of M3.

3 US Bureau of the Census, Economic Survey 2006, NAICS 52 (PDF).

4 US Bureau of the Census, Economic Survey 2002, NAICS 522110; unfortunately, the latest available commercial banking revenue data is for 2002. IBISWorld estimates 2005 revenues at 635.9 billion for '05.

5 Data on M&A activity specific to banking is proprietary; however, one source is Steven J. Pilloff, "Bank Merger Activity in the United States, 1994–2003" (PDF), Board of Governors of the Federal Reserve System (May 2004). The largest spike was in 1998, the year before the much-anticipated dissolution of Glass-Steagall. However, this was mainly due to the merger of CitiCorp with Travellers.

6 Well connected politically: e.g.,

• Treasury Secretary Henry Paulson is a former CEO;
• White House Chief of Staff Josh Bolton is a former executive director;
• Asst Secretary of Treasury Neel Kashkari (Financial Stability) is a former VP at Goldman Sachs. He was appointed to this job by his once-and-present boss, Henry Paulson, 8 October (yes, this is an update);
• PFIAB Chair Stephen Friedman, previously Chair of the National Economic Council (NEC), has worked most of his live in executive positions at Goldman Sachs. The PFIAB stands for "President's foreign intelligence advisory board"
• World Bank President and US Trade Representative Robert Zoellick is a former managing director;
• New Jersey Gov. Jon Corzine is a former senior partner.
• Former partner Robert Rubin was President Clinton's Treasury Secretary.

Conversely, E. Gerald Corrigan, once President of the Federal Reserve Bank of NY, is now a Goldman-Sachs Partner.

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ADDITIONAL READING:

Steven Druckera & Manju Purib, "The Tying of Lending and Equity Underwriting" (PDF), Federal Reserve Bank of Chicago (2004)

Peter Thal Larsen & Francesco Guerrera , "Investment banks’ future questioned," Financial Times (18 Sept 2008)