Summary:
According to John Gapper, recent events mark the end of 73 years of full-service investment banking, i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital. In order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them. Two milestones in the history of IBs: 1933 Glass-Steagall Act (enforced the separation of banks and investment banks) and May 1 1975 (fixed commissions for trading securities were abolished) Despite the latter setting off a squeeze on broking revenues, IBs prospered for the next 30 years, mainly through gambling with their own (and later others') capital. But the gambles were potentially life-threatening: IBs did not have sufficient capital to cope with a severe setback in the housing market or markets generally. According to Gapper, there are two options for Goldman and Morgan Stanley: sell out to a large commercial bank with a big capital and deposit base, or scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds. (Published: 15/09/08)
Notes:
- Goldman Sachs and Morgan Stanley last hold-outs among Wall Street's independent investment banks
- full-service investment bank is doomed
- i.e. buying and selling shares and bonds for customers as well as advising companies and trading with its own capital
- in order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them.
- investment banks in future will be smaller, specialist institutions
- like the merchants of old
- history
- enforced the separation of banks and investment banks
- e.g. Morgan Stanley founded in 1935
- fixed commissions for trading securities were abolished
- set off a squeeze on broking revenues
- abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,
- investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.
- following 1975, investment banks went on to enjoy 30 years of prosperity
- grew rapidly, taking on thousands of employees and expanding around the world
- but: under the surface they were ratcheting up their risk-taking
- was increasingly hard to sustain themselves by selling securities
- the traditional core of their business -
- because commissions had shrunk to fractions of a percentage point per trade
- so they were forced to look elsewhere for their profits
- started to gamble more with their own (and later others') capital
- Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets
- at the same time as the bank bought and sold securities on behalf of its customers
- banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong
- but there was no doubt that being "in the flow" gave investment banks' trading desks an edge
- also expanded into the underwriting and selling of complex financial securities
- e.g collateralised debt obligations
- were aided by the Federal Reserve's decision to cut US interest rates sharply after September 11 2001
- set off a boom in housing and in mortgage-related securities
- catch: investment banks were taking what turned out to be life-threatening gambles
- did not have sufficient capital to cope with a severe setback in the housing market or markets generally
- when it occurred, three (so far) of the five biggest banks ended up short of capital and confidence
- a bank can be highly skilled in risk management and trading, as Goldman has proved
- but: a single big mistake may spark a fatal spiral
- two options for Goldman and Morgan Stanley
- sell out to a large commercial bank with a big capital and deposit base
- e.g. Merril
- could provide them with sufficient backing for their capital markets divisions, which can be revenue and profit powerhouses in good times.
- scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds
- would involve a switch from sell side to buy side, where most money is now made
- in exchange for becoming much smaller, they might retain their high margins
