When Goldman Sachs and Morgan Stanley became bank holding companies in September, it seemed to mark an historic shift; the end of an era in investment banking. Following the collapse of Lehman Brothers and Bear Stearns, it was certainly the culmination of a year that had turned the financial world upside down. If Americans were not so incensed by how much the financial crisis was costing the public purse, they would probably have mourned the passing of such potent names in Wall Street mythology.
Firms, which early last year were on top, are this year down, if not out. When the Royal Bank of Scotland, Fortis and Santander won the battle for ABN AMRO last year, they were hailed victorious and Barclays vanquished; many suggested losing the deal could even make Barclays a takeover target. Fast forward and Fortis has been acquired and chopped up, RBS management sacked and the bank partially nationalised. Merrill Lynch, the sole advisor to the trio, has been forced to sell itself to Bank of America to avoid bankruptcy. Barclays, meanwhile, has emerged from the crisis relatively unscathed, to bag the US business of bankrupt Lehman Brothers at a bargain basement price.
Products that promised to mitigate risk have instead spread and amplified risk. Nobody could have foreseen that credit derivatives, created at the end of the 1990s to help mitigate loan book risk would grow into a $6200bn market at its height, and would bring down the US’s biggest insurer, AIG, when it defaulted on $14bn of collateralised debt obligations (CDOs). When the US government realised that AIG had, in fact, insured $414bn-worth of CDOs, including $55bn tainted by subprime loans, it had to step in.
Reshaping the industry
With the wholesale reshaping of the US investment banking industry, as well as the broader banking sector, has come much wailing and gnashing of teeth. Not just because of the furore it has unleashed into the world’s economy, but because many wonder whether the scale of this financial crisis has fatally undermined the idea of laissez faire capitalism.
If the US and Europe have had to intervene in such a momentous fashion to get credit flowing again, what does that say about the notion of free markets? If the nightmare on Wall Street can only be ended with greater oversight from the Federal Reserve, what does that say about the ideal of deregulation that the West has championed?
We do not know in what form, but we know that a huge regulatory clampdown is on its way – for all banks, not just new bank holding companies; and for other entities within the financial world, including the roundly criticised ratings agencies. At its annual meeting in Washington in October, the International Institute of Finance called for a global regulator. “Out of a every crisis comes opportunity,” said managing director Charles Dallara in a press conference. “From the Asian crisis we got the Financial Stability Forum; from this crisis there should come a global regulatory body.”
Realising the vision
Whether or not this vision is realised, banks will be forced to increase capital, deleverage, and focus their efforts on business more closely related to the real economy. Esoteric and arcane instruments will be few and far between. But if a newly chastened Wall Street emerges that is smaller, deleveraged and highly regulated, will it radically alter the business mix of investment banking? Is it the end of the independent, full service investment bank?
Much is made of the change to supervision by the Federal Reserve, which sits permanent teams of bank examiners in regulated entities’ offices; the implication is that it is only greedy investment banks, supervised by the Securities and Exchange Commission, who have made this mess. Yet Fed oversight did not prevent Citigroup’s horrendous losses, just as the Financial Services Authority did not save Northern Rock from disaster, nor did German regulator BaFin prevent the need for four German banks to be bailed out.
It is clear that commercial banks have hardly been poster children for financial prudence. “Nobody can address this problem until they admit that this has not been simply an ‘investment banking’ problem,” says one US commercial banker. “The Federal Reserve’s leverage limits or capital requirements did little to rein in Citigroup; as a consequence, it has been one of the biggest losers in terms of writedowns. And didn’t any of the Fed team sitting in Citi’s office notice that Citi was using vast off-balance sheet structured investment vehicles to generate returns yet avoid regulatory capital requirements?
“Regulation by the Fed of a handful of investment banks would have done little to curb the growth of structured products or credit derivatives. Who is the biggest credit derivatives player on Wall Street? Fed-regulated JPMorgan; one of the creators of credit derivatives and central to their industrialisation.”
Spot the difference
In terms of its business mix, it is arguable whether it makes any difference if Goldman Sachs or Morgan Stanley is now a bank holding company. Can we really tell the difference between the structure of Morgan Stanley’s business and, say, Deutsche Bank’s?
Acknowledging differences in culture, style and scale, both have capital markets platforms and both do corporate advisory; they both have prime brokerages, derivatives platforms, structured products, asset management and principal investment arms. Yet one is a European commercial bank and the other was, until September, a blue-blooded, white shoe US investment bank.
A key change is the steep reduction in leverage promised now that the Fed is in charge. Many believe that the roots of the current crisis lie in an exemption from the limits on the amount of debt that investment banks could take on, granted to the big five US investment banks by the Securities and Exchange Commission in April 2004. It unshackled billions of dollars previously held as a cushion against losses on their assets, and unleashed the five to radically change their business models.
It is argued that the forced deveraging will now force drastic changes to the types of businesses that are economic. But is this the case? Goldman Sachs – which says it was already within the Fed’s leverage limits and capital requirements by the time it gained bank holding company status – argues that it will not be making substantive changes to its business mix. It will still advise and co-invest with clients; it will still have a capital markets and a trading business; and it will continue to operate its commodities business.
Not just about leverage
Leverage limits are not an alien concept, says Goldman Sachs’ spokesman Lucas van Praag. “At some point we may not be able to use as much leverage as we might want to but since we adopted Basel II, we’ve effectively been using the Fed leverage guidelines for some years anyway,” he says.
And considering its current levels are already within the Fed’s threshold, he argues that it is unlikely that Fed restrictions will be a constraint on Goldman’s business. “Our natural concern about risk management is more likely to be a restraining element than a [leverage] ceiling imposed by regulators,” he says.
Further, Mr van Praag says that too much emphasis is placed on leverage, rather than risk. He argues that it matters less what the ratio of leverage is than what the assets are. For example, a bank could offload $10bn-worth of subprime from its books and it would reduce risk quite dramatically, but would barely move the needle on the leverage scale. On the other hand, it could sell $100bn-worth of treasury bills and reduce its leverage dramatically, but hardly move the needle on risk.
“We are much more focused on risk, and risk-adjusted leverage, than we are on leverage alone because it just doesn’t tell you enough about the business,” says Mr van Praag.
Exemptions not regulation
Since the crisis began, the banking industry has been promised more, and tougher, regulation. Thus far, however, more of the existing rules and restrictions have been bypassed than new ones added.
For example, as major players in the commodities markets, Goldman Sachs and Morgan Stanley were both granted exemptions from the rule that prevents commercial banks from operating in much of the commodities markets, and specifically from owning non-financial assets, such as Goldman’s power stations and Morgan Stanley’s fleet of oil tankers, among other assets.
Regulators feared that should such key players withdraw from the market, there would be chaos. For similar reasons, and to expedite the rescue package, JPMorgan previously won an exemption from the same restriction when it acquired Bear Stearns.
Rather than being forced to change in order to comply with commercial banking regulations, Goldman and Morgan Stanley could end up changing the commercial banking landscape to fit their businesses. While the banks have been given a two-year exemption, with a further three in the offing, Morgan Stanley, certainly, has applied for the exemptions to extend beyond the five-year window. Some believe that the restriction will be permanently removed, opening the commodities markets to further incursion by other commercial banks.
“Goldman, Morgan Stanley and JPMorgan are major players in the commodities markets; at the moment it is unclear what regulators will do when their exemptions expire. However, unless every regulator around the globe prohibits commercial banks from this kind of business, we will end up with another kind of regulatory arbitrage; I think the Fed will cave in,” says one regulatory consultant.
In another regulatory bypass, competition rules seem to have been suspended for the duration of the crisis. The acquisition of the major UK mortgage bank HBOS by Lloyds TSB, for example, would never have been approved by the competition authorities were it not to prevent bankruptcy.
JPMorgan’s acquisition of Washington Mutual may not push JPMorgan through the US’s regulatory ceiling of 10% of retail deposits – because WaMu is a thrift and so its volumes do not count towards concentration. But the fact remains, just four banks – Bank of America, JPMorgan Chase, Wells Fargo and Citigroup – the US super banks – will largely determine how much Main Street pays for its loans, credit cards and checking accounts.
In the wholesale markets, what the emergence of a handful of global super-bulge bracket firms – including JPMorgan/Bear Stearns, Bank of America/Merrill and Barclays/Lehman – means for the industry is another question waiting to be answered as the post-crisis picture unfolds.
Fatal injury to markets
Globally, many wonder if the crisis has fatally wounded the deregulated approach to financial markets; or if it may even halt migration to a markets-based funding model, which had barely begun in most developing economies before the financial collapse revealed its vulnerabilities. The West, and particularly America, has vigorously promulgated its vision of deregulated capitalism, but some posit that this crisis may be the beginning of the end for free markets.
This debate has already been raging in other sectors, where the free market approach has failed to deliver on its promises. In the US energy sector, for example, the failure of deregulation to increase consumer choice, increase capacity or cut consumer costs, has led several US states to ‘re-regulate’ their energy sectors (see The Banker, October 2008).
Even one of the titans of the private equity sector believes that this financial crisis has done damage to the free market system. In his keynote address to a private equity conference in Dubai in October, Henry Kravis, founding partner of Kohlberg Kravis Roberts, also admitted that private equity firms needed to accept some responsibility for the meltdown.
Time to rebuild trust
A loss of trust has undermined the markets, said Mr Kravis, but there is a silver lining. “If we take the right lessons from this crisis, we can build a more durable financial system driven by ownership principles – responsibility and stewardship,” he said.
Jerry del Missier, president of Barclays Capital, is certain that even if the deregulated, market approach has been discredited by the crisis, it is not beyond repair.
“In the long run, it is the only sustainable model. The challenge now is to solve the issues in the banking system as soon as possible. You can’t go into an economic downturn with a banking system incapable of providing intermediation. One reason the 2001 to 2002 downturn was so shallow was because the banking system was relatively unaffected and could step in when big technology and telecoms companies needed big debt restructurings; you had good old-fashioned intermediation. We will see that again.”
In an article in Newsweek magazine, Fareed Zakaria, author of The Post-American World, stresses that history has proven the free market to be the most stable financial system available – albeit less than perfect. First, he argues, government intervention is not unprecedented, it has happened in countless crises in the past 30 years.
Second, no modern economy could accept the kind of downswings common in the 19th century – the era of real laissez faire capitalism – when the average recession lasted for 22 months and a US recession came around every 49 months. Now they average eight months and it can be 100 months between downturns.
Keeping sight of strengths
Mr del Missier says the world must not lose sight of the market’s strengths as it tries to repair its weaknesses: “You have to differentiate between deregulation, and effective but loose regulation. Less is generally better, but what is there has to be effective. Hopefully, [regulators will respond] in a measured way that doesn’t neglect the fact that, generally speaking, our economic cycles are now more robust and last longer. [We must not lose] the ability for corporates to hedge risk, [and for] institutions to access new markets and provide capital to emerging companies. Having risk transfer markets is, long term, very good for the global economy.”
Investment banking businesses of all persuasions may just emerge from the crisis healthier, more sustainable, and more in tune with the real economy.
| “Things will not go back to the way they were,” says Eugene Ludwig, CEO of Promontory Financial Group, a Washington-based consulting firm. “The same forces that created the crisis also spell a historic sea-change for the financial sector and the [global] economy. Whether that change is adaptive or maladaptive depends on whether we draw the right lessons from what happened.” |
Mr Ludwig, the former US comptroller of the currency (the federal agency that supervises all national banks, and the federal branches and agencies of foreign banks in the US), has suggested that new and untried instruments should attract a much greater capital charge – maybe even as high as 1:1 – greater reserving, or be subject to concentration or growth limits. “A good regulatory regime is sufficiently careful that it allows for innovation within a proper framework of capital and controls,” he says.
“That would certainly stop investment banks from inventing new products,” says one investment banker.
It is not a question of stifling innovation or creativity, counters Mr Ludwig, but about making sure that hot products are kept in the fireplace “and not in the centre of the living room”.
Enter the advisors
As the financial sector reshapes itself, boutique advisory firms are certainly taking advantage of the chaos upstream, saying that their businesses are less exposed to a downturn in private equity volumes, and that the need for advice has not disappeared. “In this tougher environment, clients value us for our relationship strengths and our ability to provide conflict-free advice,” says David Landman, partner at boutique house Perella Weinberg Partners, previously a managing director at Morgan Stanley who served as COO for the European investment banking business.
Market opportunity
Firms such as PWP, and mid-market investment banks, are using the downturn as an opportunity to grow: trouble at big banks means there are some premium bankers up for grabs. Mid-market firm Jefferies has accelerated its expansion, hiring 20 staff from Bear Stearns. Moelis & Co, founded by former UBS investment banking head Ken Moelis, has hired more than 160 staff so far this year, including several senior staff from Bear Stearns.
But large banks, too, say that if you can look past the crisis, and are able to see beyond the downturn, there is more than a glimmer of hope. In a conference call discussing the acquisition of Lehman’s North American business, Barclays president Bob Diamond said that the pools of investment banking and investment management revenues are just less than $1000bn. “They are growing at double the rate of gross domestic product, notwithstanding the fact that 2008 will be a slow year,” said Mr Diamond.
BarCap’s Mr del Missier perceives both challenges and opportunities. “Nobody is underestimating the scale of what we are facing, but there are some very positive trends. The markets are more sensible: the risk premium is back in pricing so asset valuations are much more realistic.”
Gaping holes in revenues
There are gaping holes left by the loss of revenues in areas such as credit, structured finance and prime brokerage, not to mention the barren equity and mergers and acquisitions markets, but there are also areas with better prospects.
For one thing, with the public sector aiming to raise a huge amount of funding, primary dealers will be well positioned. Equally, corporate finance businesses are readying their public sector advisory services for the restructuring and, ultimately, divestment of recently nationalised assets.
If it is clear that emerging markets will not escape from this crisis unscathed, then many have much deeper reserves than in previous downturns, and nascent local currency markets, hard hit by a flight to safety, will return and thrive. “Our long-term fundamental view is that these economies are growing in a sustainable way,” says Mr del Missier.
Once the markets unfreeze, more realistic asset prices will entice strategic buyers back into the game, but some believe it may also not be long before private equity volumes pick up. “If you look at the reduction of asset values and then at the number of private equity funds with a lot of equity to put to work, they won’t be able to resist such cheap assets for long. They may not post big returns next year, but come 2012 and 2013 when they’re harvesting the next round of asset purchases they will be putting up very good figures,” says one banker.
The competitive landscape
More importantly for banks such as Barclays Capital, which is emerging bigger and broader from the meltdown, the competitive landscape looks a lot less cluttered. “There are clearly fewer global players out there with the kind of franchise that we have,” says Mr del Missier.
Another senior banker points out that for banks whose core business is traditional intermediation, the post-crisis environment looks much brighter. “It is good to see the leverage leaving the system and pricing returning to economic levels. Bid-offer spreads now reflect the volatility in the market which means that our market-making business is performing well. And, in our loans business, the crazy competition that led to pressure to do business at sub-economic [levels] has disappeared.”
Whatever the global economy’s immediate prospects, most believe that we are entering into an era of lower return on equity. While Goldman maintains that it will be able to maintain an average of 20% over a five-year period, shareholders may have to settle for the more moderate, but perfectly respectable, 13% that JPMorgan achieved in the first nine months of this year. And, with many believing there is a combustible relationship between return on equity, excessive risk taking and annual bonuses, maybe managers should be encouraged to focus on increasing return on assets.
A great deal still has to be played out. The regulatory response will take some time to be framed. But when it is, it must respond to the role played by every part of the value chain in creating this firestorm. If it doesn’t, it may skew the priorities of banks and the shape of markets just as badly as the current framework has done.
“Governments will insist going forward on a more robust and comprehensive regulatory regime that encompasses virtually all manner of financial services entity,” says Mr Ludwig. “The challenge both for governments and the private sector is to improve the regulatory mechanism so that it is both more effective and less burdensome at the same time. This is possible.”
Clearly, banks have been culpable in this crisis. But so, too, have investors who outsourced their due diligence to ratings agencies, on instruments they happily soaked up in their thirst for yield. Shareholders, with their eyes on the short term, pushed for higher returns on equity, which encouraged banks in their migration to riskier businesses. The transformation was aided by boards who failed to understand the business they were safeguarding, and regulators whose rules made it easy for banks to hold less capital and move money off-balance sheet, and who allowed short-term pressures to rule financial institutions.
Disconnected from reality
Accounting mechanisms became disconnected from business and economic reality to the point that some run contrary to the principle that accounting should reflect, not drive economic reality. The hardened mantra of industry bodies that markets will self-regulate and that problems can always be solved by voluntary action has worn very thin.
Much will change. There will be more consolidation. Maybe new businesses will emerge from the ashes of the crisis. With the rating agencies’ business model in tatters, that particular playing field has definitely been levelled.
If many are to be believed, in the new world order the investment banking business will be dominated by commercial banks, and the centre of power will be found not on Wall Street, but Charlotte, North Carolina – the home of Bank of America – or in Canary Wharf, London – the home of Barclays. If Mr Zakaria’s book is right – which contends that this crisis does not mark the end of free markets but the end of American economic dominance – the home of investment banking may soon be moving to Shanghai.
In the end, though, Wall Street – always an amorphous concept – may prove more resilient than expected. On October 15, Goldman Sachs and Morgan Stanley received their first ‘buy’ recommendations since the September demise of Lehman Brothers. Analysts contended that if the global economy goes into a prolonged recession, the former broker-dealers may perform better than their larger commercial banking brethren, because they are less exposed to the real economy.
