Summary:
Epicurean Dealmaker elaborates on John Gapper's FT comment about how the investment banking industry got to this stage. The problematic component of i-banking is the capital markets business. Maintaining a credible and effective capital markets operation has always been an expensive proposition, compared to the advisory side of the business. When fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially. Started using a much larger amount of money trading for their own account, on a proprietary basis. As a result of US's ballooning trade deficit, and low interest rates under Greenspan, capital markets operations became the dominant business line of all major investment banks over the past couple of decades. Compensation systems at investment banks could not deal with this development. Imbalances built up, risk and return became misaligned. But capital markets business has always been an integral part of an investment bank's advisory business. No better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client. Pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it. Catch-22. capital markets capabilities cannot pay for themselves without proprietary trading operations. (Published: 16/09/08)
Notes:
- how did the investment banking industry get itself into this pickle, and where does it go from here?
- John Gapper, "May Day": the elimination of fixed commissions for stock trades in 1975
- launched the industry onto the path of relentless growth in capital, people and profits
- capital markets business
- securities sales and trading activities
- has always been a key component of the investment banking model
- but: maintaining a credible and effective capital markets operation has always been an expensive proposition
- requires a lot of people, information technology, dedicated real estate, and other doodads that cost a lot of money to install and a lot of money to maintain
- unlike the advisory side of the business
- your typical M&A banker requires very little in the way of infrastructure
- May Day: when fixed commissions were eliminated, the huge capital markets business of a typical investment bank could no longer support itself financially
- banks needed to find another use for all that investment in infrastructure
- Salomon Brothers:
- first to make the transition from using relatively small amounts of in-house capital to support underwriting and market-making activities to using a much larger amount of money trading for their own account, on a proprietary basis
- because they were "in the flow" and saw the securities markets from the privileged position of market makers, "prop desks" at investment banks started making money hand over fist
- i.e. they started acting like hedge funds
- ballooning federal deficits of the Reagan years
- resulted in huge trading volumes in fixed income securities and related derivatives
- led to an explosion in equity trading
- accompanied the internet boom
- Alan Greenspan
- plying the financial markets with liquidity "like a whorehouse madam plies shore-leave sailors with booze"
- result: capital markets operations became the dominant business line of all major investment banks over the past couple of decades
- trouble in paradise
- problems caused by trying to incorporate a volatile principal-oriented business like proprietary trading into an organization that was otherwise focused on agency business like M&A advisory, capital raising, and underwriting
- when the prop traders made a bundle betting for the firm, they brought home annual bonuses that struck even the highly overcompensated bankers in M&A and corporate finance as nothing short of obscene
- when their trades blew up in their faces everybody else at the firm suffered big cuts in compensation regardless of how good their individual years had been
- compensation systems at investment banks could not deal with this development
- proprietary traders, CDO structurers, and derivatives specialists began taking and holding positions with longer and longer risk tails
- but still got measured and paid based on systems designed to measure the annual production of a banker conducting traditional agency business, like M&A or equity underwriting
- imbalances built up, risk and return became misaligned, "and various pieces of shit began hitting various fans"
- paying traders, corporate financiers, and M&A advisors with long-vesting restricted stock did create some sort of alignment with the firm's and shareholders' interests
- but: it was too blunt an instrument to contain and control the stresses building up in the new hybrid hedge fund-investment banking model
- why didn't the investment banks abandon the securities sales and trading business when it became unprofitable after May 1975? Three reasons:
- commissions did not vanish in one fell swoop after May 1, 1975
- competition was introduced, and commissions shrank gradually over a number of years
- investment banks did not necessarily see the writing on the wall for quite some time
- by the time they realized that pure agency capital markets was now and forever a loss leader business, it was in many respects too late to change
- capital markets businesses were always large
- controlling roughly half the resources of a typical investment bank and sometimes more
- very difficult to kill a business line with so much human, psychological, and political capital committed to it
- plus sharp-elbowed leaders who are committed to fight for it
- most importantly: the capital markets business has always been an integral part of an investment bank's advisory business
- obvious for corporate finance activities like selling bonds to raise capital for a railroad or underwriting an initial public stock offering for a technology company
- raising capital for corporate clients has always been an extremely important business line for investment banks
- was really the only business investment banks conducted for many years after their separation from commercial banks in the 1930s after Glass-Steagall
- until the emergence of a new business in the late 1970s which came to be known as mergers and acquisitions advisory
- "client bankers" to Ford Motor Company, CSX Corporation, and Netscape did and do rely heavily on their buddies on the capital markets desk to gauge investor demand, structure attractive security offerings, and help sell their clients' securities to new investors
- M&A bankers rely heavily and often on their capital markets colleagues, too
- in the case of corporate clients, there is all sorts of useful intelligence an M&A banker can glean from his capital markets partners
- bears directly on the approach, feasibility, and potential price of doing a deal
- publicly traded corporations want to know how the markets will react to the announcement of a transaction
- CEOs want to know who are the top 20 critical investors they should talk to to explain the rationale for selling a division or buying their biggest competitor
- there is no better definition of market-based advice, and no better example of the type of added value an integrated investment bank can bring to its client
- pure advisory boutiques cannot deliver this sort of advice, because they do not have the capital markets arms to deliver it
- capital markets operations of any consequence are too expensive to support solely with the revenues a successful M&A practice brings in
- Catch-22:
- advisory practices cannot compete with fully integrated investment banks in all situations without capital markets capabilities
- but: capital markets capabilities cannot pay for themselves without proprietary trading operations
- we seem to be stuck with the integrated i-bank model, whether we like it or not
