The future of investment banking

After all the mauling they received, what is the future of banking? Plain vanilla commercial banks can be expected to operate as before. They provide basic functions like mobilizing savings, providing fixed deposits, etc. In many cases, they also provide letters of credit and other forms of trade financing. These functions are well understood. Indeed, these “non glamorous functions,” may regain their importance.
But what about investment banks? A few like Goldman Sachs already seem to have recovered. But many others are still struggling. With the collapse of Bear Stearns and Lehmann and the acquisition of Merrill by Bank of America, the air of invincibility about large financial institutions no longer exists.

Till recently, investment banks remained the dream employers for graduates of most leading Business Schools. The cowboy approach of the investment bankers received admiration and respect from society, even though of a grudging type. They came to be known as “Masters of the Universe.” Under the guise of financial innovation and various quantitative models, the investment bankers succeeded in convincing regulators that they had found ingenious ways to package and disperse risk. But it is now clear that many of these strategies were undesirable from the systemic risk point of view.

Thanks to the sub prime melt down, investment banking will undoubtedly undergo some structural changes in the coming years. Many banks are examining their product lines to determine whether the returns generated justify the risks taken. We saw this in great detail in the case of the investment banking division of the global Swiss bank, UBS in Chapter 13. Banks are also reducing leverage dramatically.

Leverage has traditionally been an integral part of the business model of most investment banks. Indeed, investment banks thrived on leverage to generate adequate returns for shareholders. The leverage ratio (Total assets to equity) for Wall Street banks was in the range 25-30 before the bubble burst. The great thing about leverage is that even a small rise in the value of investments results in a phenomenal return on capital. But the downside is that a small drop in the value of investments can wipe out the equity and raise fundamental concerns about a bank’s viability causing the stock price to plunge. That is why investment banks are reducing leverage. But as leverage reduces and capital goes up, the returns to shareholders are bound to reduce. So investment banks will have to get used to much lower returns on equity than they have been used to delivering in the past. In the early part of 2009, some banks such as Goldman have shown record profits. But that seems to be more due to government support. It is unlikely that these profits can be sustained in the long run.

Investment banks will also have to diversify their fund base. They will have to reduce their dependence on wholesale short term funding. During the sub prime crisis, when this funding dried up, it became difficult to roll over positions. That is how the Structured Investment Vehicles (SIVs) got into trouble. Liquidity dried up and many of the sub prime assets came back to the balance sheets of banks. In future, investment banks are likely to depend on “stickier,” retail deposits for their funding needs.

What kind of shakeout can we expect in the investment banking industry? It is too early to make predictions but already there are some doubts about the future of bulge bracket investment banks. Advisory boutiques with a “partnership,” culture that also give clients good, independent advice, seem to be doing well after the meltdown. These boutiques also have less conflict of interest. For example, they are generally not involved in proprietary trading or market making.