Just as markets reached lunatic levels of exuberance on the way up, there is no reason to expect sanity on the way back down. The baying mob is now convinced that standalone investment banks are history. Equity markets, it seems, will accept nothing less. Bear Stearns, Lehman Brothers and Merrill Lynch are already gone. Now, incredibly, two of the bluest-chip names on Wall Street, Morgan Stanley and Goldman Sachs, are fighting for survival. Shares in the former have more than halved this week alone, forcing it into talks with Wachovia about a merger and with China Investment Corp about increasing its 9.9 per cent stake.

Lex chart
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All financials are taking a beating, but is the disappearance of arguably the highest quality investment banks inevitable? Forget the hysterical arguments about the viability of broker-dealers. If only a modicum of calm returned to markets, Morgan Stanley and Goldman Sachs should be able to survive. But the perception of what were perfectly adequate funding and capital positions last week can change within an hour. That in itself can become fatally self-fulfilling.

But even if markets stop pummelling Morgan Stanley and Goldman Sachs this week, the investment banks may then have to face a very different world.

Sure, funding costs will be higher, returns therefore lower and economic activity subdued. But those are secondary issues next to the quid pro quo politicians may demand for bailing out the industry. For example, Goldman’s Tier 1 ratio of 11.5 per cent (of which, unlike other banks, nearly all the equity is “common”) would have once been deemed perfectly healthy. But it is still more than 20 times geared on a tangible asset basis. Wachovia’s leverage ratio, by contrast, is less than half that.

And what if regulators decide 10 times is the required number – or 5 times? Leverage levels are arbitrary anyway (as they are for Tier 1 regulatory capital requirements). If that happens, investment banks are finished in their current form. Or they need a deposit-daddy. Perhaps markets are not as mad as they look.

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