Thursday, September 18, 2008

Investment bank fade out

Three of the top five US investment banks have disappeared. Until yesterday, some commentators were insistent that there is still room for investment banks, that the survivors, Goldman Sachs and Morgan Stanley, will actually do better now that competition is less keen.

Well, today's news should cause them to think again. Morgan Stanley is said to be in merger talks with Wachovia Bank and Goldman also exploring possibilities. I argue in my ET column, Wall Street model crumbles that the standalone investment banking model is doomed.

The combination of high leverage and investment on own account in illiquid assets has provd lethal for investment banks. High leverage increases the chance of insolvency; so does dependence on wholesale markets for funding. Alright, say the defenders of investment banks, let's limit leverage through regulation. But, if you take away high leverage, returns in investment bank may cease to be attractive. So, you have to marry leverage with a stable base of funds- and that's where banks come in. That's what the mergers of investment banks with banks are all about.

Not that such mergers don't pose problems. There is clash between the risk-averse culture in banking and the risk-loving approach in investment banking. But, if we accept that the appetite for risk in investment banking will be noticeably lower in the years to come, this gulf can be bridged.

You could argue that investors will not pay a premium for banks diversifiyng into investment banks- corporate finance tells us that what firms can do, investors can do better on their own. So, investment banks will continue to interest investors. But this argument could be applied to diverisification by investment banks too- there should be investment banks specialising in each area: brokerage, advisory services, trading and private equity. Why have full scope investment banks that combine the lot?

Not that every bank will an investment bank will do a great job- JP Morgan Chase may be a success and HSBC too but not Citigroup and UBS. But, at the end of the day, Citigroup and UBS are still standing on their feet while the investment banks have disappeared.

From a regulatory point of view, having investment banks under the roof as commercial banks is looking desirable. After all, banks that are subject to tight capital and other regulatory norms are not the source of the problem today; the problem has arisen in the unregulated part of the financial system featuring investment banks and others.

8 comments:

iRohit said...

been following you blog since the LB crisis. As a layman, I was thinking.. all these investment banks hired top people ..and yet failed so miserably..

How can so many experts go this horribly wrong???

T T Ram Mohan said...

Rohit, it's not merely a matter of expertise. It comes down to incentives for taking risks- top management had all the incentives for taking excessive risks,knowing that if they failed, shareholders would suffer, not so much management.

-TTR

Somil Patni said...

I have a question here ..Does the Top Management of our banks or firms based in India have such incentives for risk too ? Or is our model based on a much solid ground ? Else should we expect a repeat of Wall Street at Dalal Street ?

2jaipm said...

Thanks a lot for writing one of the most laconic post on the Wall Street Scenario.....The ET Editorial takes the cake. Additionally, I also liked the FAQ's on Wallstreet by Anil Kashyap & Doug Diamond on nytimes freakonomics blog http://freakonomics.blogs.nytimes.com/2008/09/18/diamond-and-kashyap-on-the-recent-financial-upheavals/

Anonymous said...

Nouriel Roubini has predicted the end of stand-alone investment bank model a long time ago. In fact his predictions are coming true one by one. Everyone is gripped with fear.

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