By Martin Hutchinson
It’s time to restructure the wheeler-dealers of Wall Street – the U.S. investment banks.
Just over a year ago, there were five major investment banks. Now there are only two – or none, depending on how you define the term.
While the investment banks have disappeared, most of the business they were doing is still around, and some of it is actually essential to the functioning of the U.S. and global economies. The crucial question to answer, then, is this: In five years’ time – when the present unpleasantness has sorted itself out – what form will the purveyors of those services take?
To answer that, some history is necessary.
A Look to the Past
Prior to March 2008 the five investment banks were Goldman Sachs Group Inc. (GS), Morgan Stanley (MS), Merrill Lynch (SQD), Lehman Brothers Holdings Inc. (LEHMQ), and The Bear Stearns Cos. Inc. – roughly in that order of size, prestige and market share.
Then Bear Stearns was rescued by JPMorgan Chase & Co. (JPM), Lehman went bust, Merrill Lynch was taken over in a very expensive deal by Bank of America Corp. (BAC), and Morgan Stanley and Goldman Sachs acquired banking licenses.
Since the Glass-Steagall Act – which maintained a separation between commercial banks and their investment-banking counterparts – was abolished in 1999, two of the previous commercial banks, Citigroup Inc. (C) and JPMorgan, have been able to get into the investment banking business in a pretty big way. And going forward, BofA will now be able to do so through Merrill Lynch.
The upshot: There are now five serious investment banking operations, all with commercial banking licenses – each of which is rated as “too big to fail.”
Goldman Sachs’ first quarter earnings, released Tuesday, provide us with a picture of how successful investment banks will make money: Goldman made $1.66 billion in the first quarter, after payment of preferred stock dividends. By far the largest revenue producer was its fixed-income, currency and commodities division, which at $6.56 billion accounted for 70% of $9.43 billion in total revenue.
Equities trading and commissions accounted for another $2 billion, or 21% of the total. Asset management and securities services accounted for $1.45 billion, 15% of the total.
True investment banking – advisory and underwriting work – accounted for $823 million in revenue, a paltry 9% of the total. That makes 115%; the other 15% represented losses on principal investments that had gone wrong.
Morgan Stanley’s quarterly report, released Wednesday, showed a first quarter loss of $578 million – after payment of preferred stock dividends. Here’s how Morgan’s business breaks down:
* Trading and commissions (debt and equity): 62% of total revenue.
* Wealth management and administration fees: 32%.
* True investment banking activities: 28% ($884 million, or just a tad more than Goldman).
* Other revenue: 14%.
* And principal transactions (including interest received and paid): A loss of 36% of total revenue.
Thus, Morgan and Goldman had pretty much the same business mix.
Goldman Sachs and Morgan Stanley have now acquired banking licenses, but they resemble no other commercial banks. They have no retail-deposit base, no branches, and very little mortgage lending or small-business lending. What’s more, since they have no obvious comparative advantage in those activities, it seems highly unlikely that they can develop these areas of business without a massive destruction of shareholder value.
Can Looks Be Deceiving?
Given these current competitive positions, these two institutions clearly face uncertain – and possibly even unstable – futures. And it’s the shareholders and U.S. taxpayers that ultimately seem to bear the brunt of the business risks Goldman and Morgan are certain to face.
Thus, the question we need to answer is this: What will these two institutions look like a decade from now?
There seems no good reason why many of the operations undertaken by Goldman and Morgan should be housed in institutions deemed “too big to fail,” since that makes them eligible for taxpayer-finance bailouts.
Principal transactions – in normal years, a contributor to profits – are basically the provenance of a hedge fund. If we don’t want to bail out hedge funds, as we did Long-Term Capital Management, we must impose limits on the size hedge funds can achieve: After all, it’s pretty clear that gambling casinos that are large enough to bring down the entire financial system should not be permitted.
If Goldman and Morgan are deemed “too big to fail,” their scope for hedge-fund-type activity must be sharply limited, perhaps to a mere 50% of capital. This would also have the huge benefit of reducing conflicts of interest between the major investment banks and their clients. Currently, the conflicts between their direct investment activities and both their advisory work and their wealth-management activities are much too severe to be eliminated by mere “Chinese walls” that are supposed to keep proprietary information from flowing from the advisory to the investment departments.
Trading and commissions, the major revenue-producers at both Goldman and Morgan, are perfectly acceptable investment banking activities. But there is no reason why brokers and traders should benefit from state bailouts, however necessary we may feel it to protect clients who have accounts with those brokers. Arguments that traders’ derivative books cause a “nexus” with other market participants – requiring traders to be bailed out by the public – can be eliminated by mandating central clearing for derivatives contacts, and imposing harsh capital requirements on contracts, such as credit default swaps, which seem to be especially dangerous to the financial system.
Wealth-management and investment-banking advice are the core activities of an investment bank, and Goldman Sachs and Morgan Stanley are the leaders in those fields. However, gigantic capital bases are not necessary to practice them. The only true investment-banking function that requires large amounts of capital is new issue underwriting (such as initial public offerings, or IPOs), but even that can be carried out with a capital base much smaller than Goldman and Morgan currently employ. After all, isn’t that precisely what syndication is for?
If the principal investment business is removed because of its dangers and conflicts, and the trading businesses are scaled back to a more manageable size, Goldman and Morgan would come to resemble much more closely their 1980s ancestors, and would ideally revert to being privately owned by their partners. Nothing significant would be lost to the U.S. economy by such a change, and a great deal would be gained by the removal of the taxpayer risks and conflicts of interest that we’ve outlined here.
In such an environment, we might expect that the three universal banks – JPMorgan Chase, Bank of America and Citigroup – would have an advantage because of their greater size.
However, Citi has made it abundantly clear with its repeated failures over the past 30 years that there is no significant advantage to be gained in combining the very high-skill activities of asset management and traditional investment banking with the low-paid, low-skill activities of retail banking, most corporate banking and most standardized trading. Thus, given good corporate governance (i.e. shareholders who demand value and rein in management self-aggrandizement), the investment banking and asset-management businesses would in the long term migrate from huge universal bank behemoths to moderately capitalized specialists, if such existed.
Leaving Goldman and Morgan as they are is bad for their shareholders, bad for taxpayers and bad for the U.S. financial system. They must be restructured.