Investment bankers are not generally lost for words. But as they surveyed the battered landscape of their industry this week, many were struggling to sum up the damage the latest financial storm has inflicted. In less than a fortnight, a business that emerged from the wreckage of the Great Depression to become the dominant force in financial markets has changed beyond recognition.
Two weekends ago, huddled inside the New York Federal Reserve headquarters in lower Manhattan, top bankers witnessed the disappearance of two of Wall Street’s most famous names. Lehman Brothers, whose history stretched back 158 years, slid into bankruptcy after the US government refused to support a rescue, while the once mighty Merrill Lynch rushed into the arms of Bank of America.
The upending of the established order left many aghast. At Morgan Stanley, as its share price plummeted and the cost to insure its debt shot up, staff in the bank’s US offices sneaked out of their cubicles to catch a glimpse of the news about their employer on television or newswires. Others stayed at their desks clicking the “refresh” button on news websites to find out what was happening. “We were staring into the abyss last week and it was tough not to know our fate,” says one.
Morgan Stanley along with Goldman Sachs, the other pillar of Wall Street’s global financial primacy, promptly converted themselves into commercial banks, submitting to the tighter controls of the Fed in return for permanent access to the central bank’s supplies of liquidity. The two then scrambled to raise billions of dollars, turning respectively to Japan’s Mitsubishi UFJ Financial Group and Warren Buffett (pictured below), the “sage of Omaha”, to shore up their balance sheets.
“The market has changed more in the past 10 days than it had in the previous 70 years,” says one senior executive at a European investment bank. The events have confirmed beyond doubt what bankers around the world have gradually come to recognise: investment banking’s long boom is over and several lean years lie ahead. Even when it recovers, the business is likely to be narrower in scope, subject to greater regulation, smaller than in its heyday and – above all – less profitable.
When the credit crunch started in the summer of 2007, many bankers believed it was little more than one of the periodic downward swings that have punctuated the industry’s rise. Some drew comfort in drawing a comparison with 1998, when market turmoil triggered by Russia’s debt default and the collapse of Long-Term Capital Management, a hedge fund, was followed by a quick recovery. Others saw parallels with 2001, when the bursting of the dotcom bubble brought a brief retreat before low interest rates heralded a new boom.
Neither of these downturns prompted bankers to question the fundamental shape of the business. The devastating events of the past 13 months have. In the words of an executive at one Wall Street bank: “This is an existential crisis.”
Few dispute that investment banks will in future have to operate within stricter regulatory constraints. The experience of the debt bubble has convinced regulators and investors that banks should hold greater capital reserves. The scope for using balance sheets to make large proprietary bets will also be reduced.
Without the cheap debt of recent years, some activities – such as creating complex credit products and financing private equity buy-outs – will shrink to a fraction of their previous size. The scope for banks to scoop up and repackage loans – as they did with subprime mortgages – will also be constrained.
“I believe we are entering an era in which the industry’s recent propensity for high leverage, together with the extreme complexity of some investment vehicles, will no longer be acceptable,” Stephen Green, chairman of the UK’s HSBC, said in a recent speech.
That in turn, will squeeze returns. “For the next few years, investment banks will have to realise that the only way to stay in business is to shrink both the scope and volume of their activities,” says a Wall Street veteran.
Indeed, it can be easy to forget that the industry was not always this large. As recently as the mid-1980s, most Wall Street firms were private partnerships, with limited capital, that specialised mainly in underwriting equity and bond offerings and providing advice to companies.
Since then, fuelled by deregulation, consolidation and the globalisation of capital flows, they have transformed themselves into publicly traded behemoths, intermediating in a bewildering array of financial risks and placing huge bets with their own capital. At the end of 1998, its last full year as a private partnership, Goldman had assets of just over $50bn (£27bn, €34bn), equity of $6.3bn and about 15,000 employees. By November 2007, its workforce had doubled, its equity had swelled to $42.8bn and its balance sheet had expanded 20-fold to $1,100bn.
The central question now facing investment banks is the extent to which they will be able to borrow. In the heady years leading up to the current crisis, leverage – described by one private equity executive as the “cocaine” of the financial world – turbocharged profits by enabling banks to reap high returns from relatively small amounts of capital. Few paid much attention to the absolute level of assets that banks were accumulating. The dominant trend in banking regulation favoured measuring assets on a risk-weighted basis – and that relied heavily on banks’ own risk models.
But given the comprehensive failure of most banks to measure or manage their risk, regulators are keen to cap banks’ ability to accumulate assets, regardless of their apparent solidity. Switzerland’s banking watchdog is considering imposing a leverage ratio – which limits the assets a bank can own as a proportion of its equity – on UBS and Credit Suisse. In the US, the Fed is likely to use its new-found authority to press Goldman and Morgan Stanley to shrink.
The shift will be at the expense of profitability. Citigroup analysts estimate that for investment banks with “normalised” leverage, return on equity – a measure of profitability that was well above 20 per cent for most banks during the boom – could fall to less than 13 per cent. At the same time, banks face new restraints on their ability to make proprietary bets. Regulators have already forced banks to hold more capital against so-called trading assets.
Peter Hahn, a former Citigroup managing director and a fellow at Cass Business School in London, sees increased regulation as the inevitable by-product of past excesses: “This is the result of investment banks deciding they wanted to be private equity and hedge fund investors. The concept of having large, illiquid assets on the balance sheet of a trading institution is nuts.”
Banks will instead have to concentrate on generating revenues from traditional activities such as underwriting, advising and financing, as well as trading equities, bonds, interest rate products and foreign exchange.
These businesses are less profitable than the more complex activities that have been responsible for much of the recent growth. In equities, only those banks with the scale to capture a large enough share of trading flows are likely to be consistently profitable. Other banks will come under pressure to team up with rivals or pull out of the market.
This shrinkage has already produced two benefits for the survivors. First, institutions such as Bear Stearns and Lehman have disappeared, removing capital and competition from the industry. Second, the scarcity of capital means margins have improved. “There comes a tipping point when better pricing offsets lower volumes and enables us to remain profitable even in a down market,” says one Wall Street executive.
Goldman, for one, has so far refused to change its pre-crisis pledge to deliver an average 20 per cent return on equity over the business cycle.
But Goldman and Morgan Stanley are the last examples of a species that is close to extinction. Most investment banks have been subsumed into larger universal banks, which have a more diverse funding base, including retail deposits. In theory, universal banks should be safer.
Recent experience, however, suggests otherwise. Citigroup – arguably the ultimate diversified financial group – has suffered billions of dollars in writedowns, while UBS has offered a case study in how not to run an integrated financial institution. Regulators will want to make sure that poor investment banking decisions are never again allowed to put an entire group at risk.
As the industry becomes more regulated and less lucrative, the most talented bankers and traders may defect to the more entrepreneurial and financially rewarding world of boutique investment banks, private equity firms and hedge funds. Were that to happen, private equity groups including Blackstone and Kohlberg Kravis Roberts, independent investment banks such as Lazard and Rothschild and hedge funds like Citadel could gain.
Seasoned investment bankers dismiss this view, arguing that their industry has a chameleon-like ability to adapt to changing circumstances. But even the most ardent proponents of this theory acknowledge that, given the severity of the current plight, such a transformation will take time. “Other generations of bankers will be allowed to make the same mistakes I did; of that I am sure,” says a veteran banker at a European bank. “The only question is how long it will take.”