When Hank Paulson took joint charge of Goldman Sachs in 1994, the investment bank was enduring one of the worst years in its recent history.
Sudden swings in the financial markets had left the private partnership nursing heavy losses on its proprietary trading portfolio. The deficit wiped out income from Goldman’s corporate finance operations and the firm narrowly avoided slipping into the red.
Twelve years later, as Mr Paulson prepares to pass the baton to Lloyd Blankfein (pictured), the bank’s president, the picture could hardly be more different. Now a public company, Goldman on Tuesday reported post-tax earnings of $2.29bn (?1.24bn, ?1.81bn) for the three months to May, its second-highest quarterly profit.
As striking as the turnround itself was the reason behind it. The big money had been made from trading in bonds, currencies, commodities and equities. Despite near-perfect market conditions, Goldman’s traditional investment banking business ? which includes underwriting debt and equity issues as well as advising on mergers and acquisitions generated just 15 per cent of net revenues.
The shift helps explain why Mr Blankfein, a former gold salesman who has spent almost his entire career running parts of Goldman’s trading operations, has been elevated to the most powerful executive position on Wall Street.
The departure of Mr Paulson, who made his name advising corporate clients in Chicago, and the decision to appoint Mr Blankfein as both chairman and chief executive, has been portrayed as a watershed: the moment the bank’s traders asserted their supremacy over the investment bankers with whom they had long shared power. But a glance at the bank’s earnings statement shows that, in revenue terms at least, the contest has been over for some time.
Across Wall Street, executives who came up through the securities business have risen to the top of almost every large institution. Zoe Cruz, recently appointed co-president of Morgan Stanley, used to run the bank’s currency and fixed-income businesses. Steve Black and Bill Winters, co-heads of the investment banking division at JPMorgan Chase, previously worked in the equities and fixed-income divisions respectively. UBS has promoted Huw Jenkins, who ran its equities business, to be chairman and chief executive of its investment bank. Oswald Gr?bel, the chief executive of Credit Suisse, started out as a bond trader.
The elevation of these executives reflects the growing profits that investment banks generate from selling and trading shares, bonds and derivatives. In the past decade, there has been an explosion in the number of assets that have been converted into tradeable securities. Contracts based on future electricity prices, complex baskets of currencies, or the likelihood that a company will default on its debt are now easily bought and sold on financial markets.
“The industry has become much more capital-intensive,” says Mr Jenkins. “A board has to have some degree of confidence that the person put in charge will be a good steward of the balance sheet and understand the risks involved in running a securities company.”
Booming demand from investors, particularly hedge funds, has boosted trading volumes. This growth has propelled a rising generation of forty-something executives from the securities side of the business into investment banks? inner circle. In an industry where money is often the sole measure of success, those who run the most profitable businesses exercise the most influence.
The generational shift also reflects the changing risks facing banks. As recently as the mid-1980s, most securities houses acted principally as intermediaries, buying and selling on behalf of clients but putting up relatively little of their own capital. Today, they have large balance sheets that they use to help execute trades for clients or ? as is increasingly the case ? to make proprietary bets. The risks involved have become much larger and more complicated.
What effect will the rise of executives who have spent most of their careers on a trading floor have on the evolution of the industry? Some observers wonder whether the change in management will be reflected in a still greater willingness to take on proprietary risks. But others play down the significance of the shift, pointing out that Goldman?s transformation has taken place on Mr Paulson?s watch.
Nevertheless, the rise of the traders risks irking investment banker colleagues. Some complain that their advisory skills are no longer valued, or that clients? interests are sacrificed for short-term profits.
The growing clout of hedge funds and private-equity firms, which account for a large chunk of most investment banks? revenues has underlined the shift, as has the stream of high-profile bankers moving from large firms to independent boutiques, such as the new partnership being set up by Joe Perella, the veteran dealmaker who left Morgan Stanley last year.
However, even if some bankers have felt sidelined in the big institutions, it would be wrong to suggest that investment banks no longer value their ability to nurture corporate clients.
The expansion of the financial markets and the growing range of tradeable securities have in turn allowed banks to create new products. In the past, most companies turned to investment banks when they needed to raise debt or equity or wanted advice on an M&A deal. Today, they are as likely to be seeking to hedge exposures to fluctuations in the exchange rate or the oil price, or trying to find ways to fix a pension fund deficit.
Working out how significant these revenues are is difficult, largely because many transactions are not captured in league tables and it is often unclear where and how the business is booked. What is clear, however, is that large corporate clients account for a greater share of investment banks? profits than suggested by the level of underwriting and advisory revenues. Moreover, senior executives insist, selling this broader range of products requires good relationships at the highest level ? their area of expertise.
?The chief executive or chief financial officer is now responsible for managing these risks and that means the role of a trusted adviser has become incredibly important,? says a high-ranking executive at a Wall Street investment bank.
Many large investment banks have been reorganising their operations in an effort to encourage corporate clients to buy a broader range of products. As a result, while the M&A business is relatively small in terms of revenues, it is seen as opening the door to other, more lucrative, products and services.
?If you are going to be a bulge-bracket advisory firm, one of the things you should be systematic about is creating linkages into the secondary market,? says Davide Taliente, a managing director at Mercer Oliver Wyman, the financial services consultancy.
This is not always straightforward. Banks such as Goldman, at or near the top of the M&A league tables, do not necessarily dominate the financing business. Meanwhile, integrated banks such as Barclays and Royal Bank of Scotland have built up large financing and risk management operations even though neither offers pure M&A advice.
There are also cultural barriers. Banks are grappling with how to share revenues among divisions in order to give bankers incentives to co-operate. Some investment bankers also remain suspicious of their counterparts on the trading floor, or find it difficult to talk to clients about products and services they do not fully understand. ?When we learn to accept that investment bankers are basically just salesmen, everyone will be a lot happier,? says a senior executive at a leading European bank.
However, there is another powerful reason why Mr Blankfein and his counterparts are unlikely to neglect their corporate clients: the traditional investment banking business is seen as good for the share price. The advisory business is a tiny proportion of most banks? overall business ? about 6 per cent of Goldman?s revenues in the second quarter. Nor is it especially profitable, because M&A bankers tend to demand large bonus payments based on the deals they bring in.
But investors appear to attach a higher value to advisory revenues that are seen as paving the way to other products and services. Long-term client relationships are expected to prove more lasting than trading revenues, which are seen as harder to predict. Mr Taliente says: ?There is still an underlying belief that the advisory businesses create a multiplier effect into the secondary businesses.? It may, he says, ?be a rational economic decision for big players to cross-subsidise their advisory business because they get an uplift in their share price off the back of it.?
At Goldman Sachs, internal divisions about the relative importance of trading and corporate finance have been further complicated by an intense debate about the bank?s decision to pursue large private-equity investments. Other banks make similar investments but Goldman has pushed this strategy much further than its rivals. It recently raised an $8.5bn fund ? one of the world?s largest ? and has been aggressive in pursuit of deals. Yesterday a consortium led by Goldman agreed to buy Associated British Ports of the UK for ?2.5bn ($4.62bn, ?3.66bn).
However, the bank?s unsuccessful attempts to lead buy-outs of British companies such as ITV, the commercial broadcaster, BAA, the UK airports operator, and Mitchells & Butlers, the pub chain, have proved controversial. Shortly before he announced his departure, Mr Paulson warned colleagues that Goldman should not invest its own capital in bids that were perceived as hostile.
Some Goldman insiders argue that the debate about private equity is largely about execution: by publicly failing to buy several companies, Goldman has damaged its reputation.
But other executives question the wisdom of the strategy, believing the bank?s determination to invest on its own account risks alienating its corporate client base in the long term.
This argument has flared up again in the context of who should replace Mr Blankfein as president. Goldman executives are debating whether to split the job between two bankers, as has happened in the past. Investment bankers are lobbying hard to make sure that at least one of the two would have a background on the advisory side.
But whoever is selected, Goldman?s securities businesses will dominate the investment banking business, as they do at almost every Wall Street bank.
It remains to be seen how well all banks will be able to manage the tensions raised by the growth of their trading businesses and their moves into private equity.
But by the time Mr Blankfein hands over to his own successor at Goldman, the distinction between traders, salesmen and investment bankers may have blurred to the point where nobody can tell the difference.
ONE BANK, TWO CULTURES
It is not hard to spot investment bankers who cut their teeth on the trading floor. Most keep dealing screens in their offices ? even if they no longer have day-to-day responsibility for trading businesses ? and regularly checkthe markets.
Some executives who have risen through the ranks of the securities businesses made their reputations as salesmen, developing strong relationships with investors and other clients but not actually risking the bank?s capital. Yet the cultural differences between the trading and advisory sides of the business are impossible to miss.
Investment bankers tend to be suave and persuasive, capable of developing long-term relationships with clients. Those with a trading background have an appetite for risk-taking and an unnerving ability to remain calm.
The two sides often view each other with suspicion and, at times, outright disdain. Traders scoff at what they see as bankers? lack of commercial nous. Bankers tend to think that traders have no feel for trusted relationships.