The end of investment banking?

The big news of the morning is that Goldman Sachs and Morgan Stanley will reorganize themselves as bank holding companies, thus ending a decades-long experiment with stand-alone public investment banking. Before we buy into the hyperbole that this represents the end of of investment banking as we know it, it behooves to us to look both back in time and into the future and examine the implications.

Independent investment banks have been in existence for a long time, but for much of their existence, they were private partnerships that made the bulk of their profits from transactions and as advisors. They seldom put their own capital at risk, largely because they had so little to begin with and it was their own money (partners). Part of the impetus in their going public was the need to raise more capital, which in turn, freed them to indulge in more capital-intensive businesses including proprietary trading. That model worked well for much of the last two decades, but three things (in my view) destroyed it. The first was that it became easier to access low cost, short term debt (especially in the last few years) to fund the capital bets that these firms were making, whether in mortgage backed securities or in other investments. The second was that the compensation structure at investment banks encouraged bad risk-taking, since it rewarded risk-takers for upside gains (extraordinary bonuses tied to trading profits) and punished them inadequately for the downside (at worst, you lost your job but you were not required to disgorge bonuses in prior years... in many cases, finding another trading job on the Street or at a hedge fund was not difficult to do even for the most egregious violators). The third was a patchwork of government regulation that was often exploited by investors to make risky bets and to pass the risk on elsewhere, while pocketing the returns. The combination worked in deadly fashion these last two years to devastate the capital bases at these institutions. Lehman, Bear Stearns and Merrill have fallen...

So, what will change now that Goldman and Morgan Stanley have chosen the bank route? The plus is that it opens more sources of long term capital since they can now attract deposits from investors. Having never done this before, they start off at a disadvantage. The minus is that they will now be covered by banking regulation, where the equity capital they be required to have will be based upon the risk of their investments. This will effectively mean that they will need more equity capital, if they want to keep taking high risk investments, or that they will have to bring down the risk exposure on their investments. My guess is that they would have gone down one of these roads anyway. In pragmatic terms, it will also mean that their returns on equity at investment banks will drop to banking levels - more in the low teens than in the low twenties. I think the stock prices for both investment banks already reflects this expectation.

Ultimately, Goldman and Morgan Stanley have sent a signal to the market that they are willing to accept a more restrictive risk taking system. In today's market, that may be the best signal to send. There will be times in the future, where I am sure that they will regret the restrictions that come with this signal, but they had no choice.