How did the investment banks get so deep in this mess?
Many people are asking this right now. Not a bad question. Considering that investment bankers are supposed to be smart, highly paid technocrats, how can they have committed the consecutive mess that have befallen the financial markets in the last decade alone? The Long Term Capital mess, the Enron, Worldcom, and Global Crossing mess, the Internet Bubble mess, the Sub-prime Housing Bubble?
Why is it that everything they get their hands on lately has been subject to maniacal excess, by an obsessive over-shooting of growth followed by spectacular fall? Many experts have tried to put forth their own explanations and opinions. Allow me to put forth some of my own contributions. Warning: this may tend to be one-sided in favour of investment bankers.
Let me list four main factors, and summarize some recent broad trends in these factors, that affected investment banker behaviour, which then led to these consecutive excesses of stupidity and greed.
ORGANIZATIONAL. Starting in the late 1980’s and culminating in the 1990’s, commercial banks have tried to poach into the field of investment banking. Because of ‘80s financial innovations such as securitization, and the increasing ability of commercial bank’s best clients to access the capital markets directly, many commercial banks began to experience margin pressure, and potentially, loss of market share. Thus, they began to look to make inroads in the higher-margin investment banking. Many began to build investment banking subsidiaries. I would say that the culmination of all this poaching was the outright takeover by many large commercial banks of the most successful investment banks by the turn of the century.
This resulted in sudden over-capacity in investment banking. Everyone suddenly was involved in it. Everyone had a unit doing it. Everyone was throwing money towards doing it.
Complicating this was the fact that the top bosses were now commercial bankers, who were used to managing credit for straightforward loans. They were supposed to oversee investment banking transactions, at just about the time when they were starting to get more esoteric and innovative.
The i-banking organizational framework, which used to favour relatively smaller firms ruled by partnerships composed of long-time investment bankers, now was replaced by the large bureaucratic organization. Often, the parent organization was a large publicly-listed entity that was supposed to maintain an increasing stock price by continually delivering above-average returns, regardless of market prospects.
You know what this meant? Whereas before, investment bankers were supposed to chase only after upstanding clients, and structure transaction terms that made sense, for deserving projects and firms - now, they simply had to close transactions. That’s the only way they can pay the public shareholders the returns they expected, to compensate them for the huge premiums paid to the i-banks by their commercial bank acquirers.
I-banking is a cyclical activity. When the economy has overshot expansion, it is supposed to contract a little, before expanding again. Now that i-banks were owned by publicly listed firms, and managed by commercial bankers used to steady interest income, they were now expected to achieve ever-increasing growth targets year after year. The new set of shareholders was not supposed to understand that i-banking can achieve spectacular returns for a couple of years, but then have sluggish returns the next two.
If you’re an i-banker, used to earning up-front fees for closed transactions, how are you supposed to steady income growth? You close more transactions, even after you’ve exhausted the good clients list. You also keep more of your underwritten assets on the books, so you get both recurring interest income from the asset, and possibly, trading gains if you decide to sell the asset later on. You invent more and more esoteric products and transaction structures, to sell more transactions to more clients, and more products to more classes of investors. In other words, you take on more risk.
Who cared if you’re lowering your underwriting standards? As long as your parent bank shareholders are happy, and your corporate banker bosses are too satisfied to understand what you are really doing, then by all means you continued doing anything that achieved your targets, made money for your firm, and kept your job.
MARKET. If you’re an i-banking client, and you knew that you were among an i-bank’s best clients, meaning, you had the best credit credentials, then you constantly demanded better terms than the i-bank’s last transaction. It didn’t matter whether the i-bank’s margin was already pressured to the bone. If a couple dozen other i-banks were chasing after you, you awarded your business to the one willing to bend backwards the most for you.
All clients thought like this. This led to transactions closing with better and better yield for the clients, at the cost of i-banking firms, and increasingly - regardless of client quality.
COMPETITION. As I mentioned, with the influx of more players, there was a sudden over-capacity in investment banking. To keep afloat, many firms started lowering their underwriting standards. Those who could not get the best clients simply took the next tier.
Those who found a profitable niche milked it to the bone by closing more transactions than the amount of deserving clients warranted. And once their competitors realized that they were onto something, it wasn’t long before everybody else was knocking over each other trying to close as many deals as possible, before the door closed on profiting from that particular niche. Often, deals got closed long after the door of opportunity was supposed to have closed. There was just too much capacity chasing after deals.
Often one of the unwritten rules of competition is that, if your closest competitor started lowering his standard, you also lowered yours. Otherwise, the next tier of clients will go to him rather than you. That is not going to bode well with your commercial bank bosses and shareholders, who expect steady, and even, growing income. If the competitor lowers again, you lower yours again. In the end it is a battle of who has the deepest pocket. Again, in an environment of historically high excess liquidity, the potential to lower standards was also historically high.
PEOPLE . If you were a producer in your i-bank, the takeover by the banks put you in the following environment:
- You reported to people who generally did not understand, or did not put as much focus on, what you did as to other units of the bank
- You were appraised much like the other officers of the commercial bank. That meant you had to produce an ever-increasing revenue stream, regardless of the status of the economy.
- You may have started feeling you weren’t paid enough, when compared with other people in the over-all bank, given that you put in longer hours, prospected with more clients, put up with more shit, and sacrificed more to get the job done.
- You may also have realized that you had more specialized skills that nobody else in the bank can replicate, but you were being overlooked in the over-all banking environment.
- You may have found yourself stifled by this new environment. Your best ideas were denied or left by the way-side, and found company resources dedicated to less lofty projects. You also found that the company did not understand i-banking risk, and the bank either avoided initiatives with absolutely-mitigable risks, but put on other risks that you thought were just plain dumb.
If you found yourself feeling any of the above, or perhaps a host of other related grumblings, you left the banking conglomerate and started your own private firm.
Thus, along with the rise of the financial supermarkets, where everybody thought the future belonged to the biggest banks able to offer everything and anything under the financial sun, we also saw the rise of many boutique advisory firms, private equity shops, and private hedge funds. These were peopled by the best traders, analysts, and corporate finance advisors who have decided to leave their now befuddling banking environments.
Thus, the big banks were left with people willing to put up with the unreasonably increasing targets, willing to put up with commercial bank policies that were, more often than not, incompatible with effective investment banking, willing to put up with bosses who treat investment banking as just another item on their menu of financial products.
Yes, many of these people stayed because commercial banks, having the deepest pockets, could finance the most, and biggest, transactions. Staying with a commercial bank meant they could get involved in more transactions, while those colleagues who opted to transfer to the niche, specialty knowledge firms had to content with a much smaller deal flow, and since these speciality firms did not have the resources of the big banks, had to dedicate more time to fewer deals.
The corollary to the choice of staying in the large commercial bank was the mindless mass-manufacture of the latest fad in financing. The faster these were closed, and the more clients were called on, the bigger was the volume of deals, and therefore, the better the bank was able to compensate for any pressure on its margin.
Never mind if the last deal was no longer closed with as much attention to detail as the previous ones. After all, once you’ve done one, you’ve done them all, right? Having the template from previous transactions gave you the license to just cut-and-paste everything, and to minimize any special case considerations, for this particular transaction or that particular deal.
After all, if everybody – the shareholders, the clients, the senior managers, the market, and the general public – thinks that all investment banking activity can and should be commoditized, why not just go about it as if it were, right? If everybody treated investment banking activities as if they were no different than documented and codified bank activities, such as clearing and settlement, then doing more in the exact same way is the right way to go, isn’t it?
Let me end by saying that I believe the right business model for i-banks is – providing clients with intellectual capital as opposed to financial muscle. Less risk, more value added, and more tangible benefit to the client. The commercial banks, along with their commercial banking shareholders, are destroying the investment banking culture and business.
Update: Exposure to a different business model from that that destroyed the US financial system got me looking at it differently. It's actually the other way around - the commercial banks, wanting to act like investment banks, got themselves into the same mess as the investment banks. But the reckless investment bank model is what got them into this mess.