The New Investment Banking
Content
The New Investment Banking By Ranni Hillyer Chief Operating Officer, Aero Financial Inc. 2008 saw a seismic shift in the banking industry in the U.S. On September 22, 2008, the last two major independent investment banks on Wall Street, Goldman Sachs and Morgan Stanley, elected to become full-function banking institutions (that is, offering both investment banking and commercial banking functions). This was in response to the financial crisis at that time. Around the same time, other Wall Street investment banks were either broken up (Lehman Brothers, for example) or purchased by full-function banks (Merrill Lynch and Bear Stearns, for example). This is the largest shift in the banking scene since the great depression. The absorption or demise of these large Wall Street investment banks, the so-called “bulge bracket” companies, leaves a vacuum in the financial world. The subject of this paper is a new form of investment banking emerging to fill that vacuum. Both on Wall Street and throughout the U.S., a new form of investment banking is emerging. It is led by banking executives who have hopefully learned from the financial crisis of 2008. More accurately, we can say that an old form of investment banking is re-emerging. The new form of investment banking emerging is actually a return to the roots of investment banking and represents a healthy trend. This brief paper describes this new/old form of investment banking and why it is re-appearing. A little background will be helpful. Originally what is known as investment banking in the U.S. was known as “merchant banking” when it began in Europe. Going way back to the beginning of the renaissance in Europe, merchant banks originally provided a range of financial services to farmers and grain dealers. These services included loaning money to farmers collateralized by the grain in the field and insuring the grain crops against bad weather. Bankers would also advance money to farmers and dealers while grain was in shipment to a foreign port. These types of services were gradually made available to other types of businesses. It was all about helping businesses and merchants and making a fair profit in the process. Later on, merchant banks were allowed to sell their clients’ loans (in the form of bonds) and their clients’ stock certificates to the investing public. Thus began the practice of “underwriting” in which the merchant bank first buys an issuing company’s bonds or stock and then resells it to the investing public. Throughout all this time, the primary function of the merchant bank remained the same – to assist businesses with their financing needs. The merchant bank would profit to the degree that their business clients survived and grew. Skipping hundreds of years of gradual evolution, this brings us to the present day. There are three main missions of an investment bank. First, the primary mission remains to assist businesses in obtaining financing. Second, there are other related services for businesses such as assisting with mergers, acquisitions and divestitures. All these services involve in some way the providing of financing and financing-related advice to businesses. Third, investment banks also have to attract investors who have money to invest (i.e., who want to buy stocks and bonds). So the third primary mission of an investment bank is to assist investors in investing their spare assets profitably and safely. In summary, investment banks have both a sell side (helping businesses find investors) and a buy side (helping investors to find business opportunities in which to invest).
So how did these kinds of supposedly useful and helpful investment banks become selfdestructive? In a competitive market, investment banks have to work very hard and creatively to attract both types of clients. The evolution of investment banking into a self-destructive machine was a natural tendency in this competitive market. Here’s why: it’s a natural tendency for a competitive investment bank to create new unique financial products for investors, in order to be more competitive, that is, in order to gain an advantage attracting investors. That’s why derivatives such as mortgage backed securities and options trading were created. They were created to attract investment clients by offering investment tools that the clients could not get anywhere else. As time went on, ever more exotic securities were customized for larger investment clients – in the never-ending battle to attract clientele seeking higher returns. These are all apparently reasonable things for a competitive investment bank to do. Or so it seems. It’s also a natural tendency to believe that one’s own investment products work better than the competition, and therefore to bet the company’s own money on them. So the investment banks began investing their own internal funds using the same exotic investment vehicles which were created for clients. In the end, investment banks “bet the bank” on their own exotic financial products. In the most recent financial crisis of 2008, after the real estate bubble burst, the investment banks themselves were injured fatally. This occurred because they had invested their own funds in exotic investment vehicles which they themselves had invented. This is an apparently reasonable thing to do. Or so it seemed. So if all of this evolution is a natural and reasonable tendency, what’s the problem? How did this evolution within investment banks become self-destructive? The problem, I believe, was that investment banks have increasingly strayed from their original function of assisting businesses and investors. They gradually turned inward and became largely concerned with investing their own assets, for themselves. So, when the market bubble eventually burst, the investment banks themselves were fatally injured. This could have been corrected in several ways: Had the investment banks been more concerned with their external clients as a guiding principle, they would have been more conservative and diversified with their internal investments. Had the investment banks been more concerned with customer service than the science of inventing novel investment vehicles, they could have avoided self-destructive investments. And had the investment banks been more concerned with customer service than leveraging their own profits, they would have avoided the over-leveraging of their own investments which killed them when the bubble burst. These are admittedly complex problems, but they all involve straying from the original mission of assisting businesses and investors with service and integrity. And they all involve a change in focus – rather than focusing outward on the client needs, they increasingly focused inward on their own financial needs and their own need for the development of exotic financial products. How can this problem be explained in common parlance? This situation was like a doctor who has practiced successfully for many years, using the medicines developed by scientists. Everyone loved this doctor because he cared for his clients. Then one day the doctor decides he knows enough to invent his own medicine. But he continues to practice as a physician also. As time goes on, he prescribes his own medicine to the exclusion of others. He loses his objectivity. He becomes obsesses with his own invention. Eventually, the doctor himself gets sick. He takes his own medicine rather than consulting with another doctor. When the medicine turns out to be faulty, the doctor himself dies and his patients die. What can we conclude? The doctor turned his attention inward – toward his need to be an inventor rather than outward, toward the needs of his patients.
Now there is nothing wrong with inventing new medicines. In fact, it is essential if progress is to be had. The point here is that doctoring and inventing medicine are two different businesses with different focuses. The doctor focuses on patients. The medicine inventor focuses on inventing. The business of doctoring and the business of inventing medicine should be kept apart. Likewise, the business of serving business clients and the business of inventing novel investment vehicles like derivatives should be kept apart. The natural tendency to turn inward, to focus on the bank’s own internal needs and inventions is now being resisted by a new generation of investment bankers. They have found a new, or rather old, way to do business. They focus primarily on their clients’ needs. To attract investor clients, they focus on customer service, careful attention to client financial needs, integrity, and independent analysis of investment opportunities, rather than on the invention of novel investment widgets. The invention of novel investment widgets is treated as a separate business. To attract business clients, they focus on really understanding the needs of growing business and providing the kind of financing vehicles work best for the client, not for the bank. In short, their focus is on serving the clients financial needs. The bank’s own financial needs will be met in the old fashioned way --- by succeeding in their primary business of serving the clientele. So, what’s happening now is that investment banking is returning to its roots. Specifically, new investment banks are concentrating on three essential functions: 1) Managing the investments of well-healed individuals and institutional clients, 2) raising capital in the debt and equity markets for businesses and governments, and 3) advising companies on major financial transactions such as mergers, acquisitions and divestitures. These functions work very well together. With attention to basic operating principles and regulations, the potential for conflicts of interest are minimized. The focus is always outward, on the clients. The potential for self-destructive behavior is minimized. The result is an investment bank resembling the original merchant banks where successful people brought their financial needs – to raise capital, to invest their assets wisely, and to carry out financial restructuring. With that kind of investment bank, clients need never worry about the doctor killing himself, and his clients, with his own medicine. # # #
So how did these kinds of supposedly useful and helpful investment banks become selfdestructive? In a competitive market, investment banks have to work very hard and creatively to attract both types of clients. The evolution of investment banking into a self-destructive machine was a natural tendency in this competitive market. Here’s why: it’s a natural tendency for a competitive investment bank to create new unique financial products for investors, in order to be more competitive, that is, in order to gain an advantage attracting investors. That’s why derivatives such as mortgage backed securities and options trading were created. They were created to attract investment clients by offering investment tools that the clients could not get anywhere else. As time went on, ever more exotic securities were customized for larger investment clients – in the never-ending battle to attract clientele seeking higher returns. These are all apparently reasonable things for a competitive investment bank to do. Or so it seems. It’s also a natural tendency to believe that one’s own investment products work better than the competition, and therefore to bet the company’s own money on them. So the investment banks began investing their own internal funds using the same exotic investment vehicles which were created for clients. In the end, investment banks “bet the bank” on their own exotic financial products. In the most recent financial crisis of 2008, after the real estate bubble burst, the investment banks themselves were injured fatally. This occurred because they had invested their own funds in exotic investment vehicles which they themselves had invented. This is an apparently reasonable thing to do. Or so it seemed. So if all of this evolution is a natural and reasonable tendency, what’s the problem? How did this evolution within investment banks become self-destructive? The problem, I believe, was that investment banks have increasingly strayed from their original function of assisting businesses and investors. They gradually turned inward and became largely concerned with investing their own assets, for themselves. So, when the market bubble eventually burst, the investment banks themselves were fatally injured. This could have been corrected in several ways: Had the investment banks been more concerned with their external clients as a guiding principle, they would have been more conservative and diversified with their internal investments. Had the investment banks been more concerned with customer service than the science of inventing novel investment vehicles, they could have avoided self-destructive investments. And had the investment banks been more concerned with customer service than leveraging their own profits, they would have avoided the over-leveraging of their own investments which killed them when the bubble burst. These are admittedly complex problems, but they all involve straying from the original mission of assisting businesses and investors with service and integrity. And they all involve a change in focus – rather than focusing outward on the client needs, they increasingly focused inward on their own financial needs and their own need for the development of exotic financial products. How can this problem be explained in common parlance? This situation was like a doctor who has practiced successfully for many years, using the medicines developed by scientists. Everyone loved this doctor because he cared for his clients. Then one day the doctor decides he knows enough to invent his own medicine. But he continues to practice as a physician also. As time goes on, he prescribes his own medicine to the exclusion of others. He loses his objectivity. He becomes obsesses with his own invention. Eventually, the doctor himself gets sick. He takes his own medicine rather than consulting with another doctor. When the medicine turns out to be faulty, the doctor himself dies and his patients die. What can we conclude? The doctor turned his attention inward – toward his need to be an inventor rather than outward, toward the needs of his patients.
Now there is nothing wrong with inventing new medicines. In fact, it is essential if progress is to be had. The point here is that doctoring and inventing medicine are two different businesses with different focuses. The doctor focuses on patients. The medicine inventor focuses on inventing. The business of doctoring and the business of inventing medicine should be kept apart. Likewise, the business of serving business clients and the business of inventing novel investment vehicles like derivatives should be kept apart. The natural tendency to turn inward, to focus on the bank’s own internal needs and inventions is now being resisted by a new generation of investment bankers. They have found a new, or rather old, way to do business. They focus primarily on their clients’ needs. To attract investor clients, they focus on customer service, careful attention to client financial needs, integrity, and independent analysis of investment opportunities, rather than on the invention of novel investment widgets. The invention of novel investment widgets is treated as a separate business. To attract business clients, they focus on really understanding the needs of growing business and providing the kind of financing vehicles work best for the client, not for the bank. In short, their focus is on serving the clients financial needs. The bank’s own financial needs will be met in the old fashioned way --- by succeeding in their primary business of serving the clientele. So, what’s happening now is that investment banking is returning to its roots. Specifically, new investment banks are concentrating on three essential functions: 1) Managing the investments of well-healed individuals and institutional clients, 2) raising capital in the debt and equity markets for businesses and governments, and 3) advising companies on major financial transactions such as mergers, acquisitions and divestitures. These functions work very well together. With attention to basic operating principles and regulations, the potential for conflicts of interest are minimized. The focus is always outward, on the clients. The potential for self-destructive behavior is minimized. The result is an investment bank resembling the original merchant banks where successful people brought their financial needs – to raise capital, to invest their assets wisely, and to carry out financial restructuring. With that kind of investment bank, clients need never worry about the doctor killing himself, and his clients, with his own medicine. # # #
