The investment banking and securities dealing industry underwent massive disruptions over the past two years. The year 2008 saw a complete makeover of the industry as Bear Stearns fell into the hands of JP Morgan, Lehman Brothers filed for bankruptcy protection, Merrill Lynch staved off collapse with a Bank of America takeover and the two remaining giants, Goldman Sachs Group and Morgan Stanley, converted into bank holding companies to qualify for government assistance. We have seen an incredible destruction of the industry that was years in the making. Many of the causes came from perverse regulatory incentives as the industry transitioned from a natural oligopoly into freer competition. Structure
The investment banking industry directly correlates to economic growth given that its ability to profit derives from the securitization of businesses. Generally, mergers, acquisitions and other underwriting services depend on the overall level of corporate activity. Corporate activity directly follows from earnings increases of individual companies and the general economic outlook and confidence in business prospects. So the fate of investment banking revenues relies heavily on the fate of the overall economy. Given some of the key structural characteristics of the investment banking industry, investment banks must seek to form long-term relationships with individual firms while respecting others banks’ relationships in a naturally oligopolistic industry.
First, investment banks must perform significantly deep and pointed research into the companies that they offer securitization services to. The initial enticement into private placements is largely dependent on the solid reputation of the lead investment banks promoting the security. In order to find buyers for a particular stock issue that the investment bank wishes to sell to the public, the bank puts its own reputation on the line claiming its high-standards and due diligence of financial statement review give the investor security. An investor needs to be able to trust the investment bank’s opinion on the future prospects of the company and the investment. No investment bank will survive long should it promote the securities of soon-failing institutions. Any individual bank promoting worthless companies will soon go bankrupt as investors realize the ill-advised investments they are taking. This is clearly why so-called “chop shops” and penny-stock promoters typically never gain respected status and fail in short order or are shutdown by the SEC for fraud. The major players in the industry have had collective breakdowns in underwriting standards in times of the past but generally banks must be trustworthy and provide accurate assessments of future business prospects. (2001 Anand & Galetovic)
Initially, then, a bank must study the company and its prospects and assign an appropriate valuation. This initial due diligence is costly and results in sunk costs in order to begin a relationship with outside firms. The costs are necessary but are undertaken because the bank clearly believes it can garner greater profits in the future by having a relationship. (2001 Anand & Galetovic) These unrecoverable costs are worthwhile if the bank can create a lasting relationship where it reuses the same information for future deals and is able to recoup the costs associated to that particular company as well as the sunk costs lost on firms where potential deals were rejected due to lower credit quality.
These sunk costs relate to another trait in the investment banking industry, the misaligned connection between costs and fee revenue. (2001 Anand & Galetovic) Investment banks only generate revenue when they create and execute a particular security deal. While banks may spend months and months studying a company, gauging market buying interest, promoting a deal, offering advice, they are only paid fee income once the deal is finally consecrated. Ultimately a bank may provide a great deal of services and never collect fee revenues.
A third characteristic of the industry is a bank’s inability to claim any rights over the information it generates about a particular firm it is investigating for a potential deal. (2001 Anand & Galetovic) The firm may spend hundreds of man hours dedicated to deal but it has difficulty maintaining that information as proprietary. The risk of a lead person on the deal team to be hired away by another bank is high. Banks can attempt to reduce this risk through non-compete agreements but given the global nature of today’s financial system, non-competes can fail rather easily given their geographical limitations. Then, this employee who is hired away would bring with them all the information they had gathered in hours of research at the bank. Also, once the bank has researched the potential company for underwriting, it must use its reports to generate outside interest among investors. In seeking these outsider investors, the research is pushed into the public forum and its privacy is lost.
These three traits of the industry point to why investment banking is naturally oligopolistic. In perfect competition, investment banks would allow other firms to incur the initial sunk costs for a deal and then free ride off the information obtained. A bank could easily achieve this by stepping in late in the deal just before the security is actually created and sold and undercut the initial firm. A simple way to create the relationship would be to hire away the lead employee on the deal who has the most intricate knowledge of the company and the deal at hand. “For example, Deutsche Bank built a global investment bank in a year (Deutsche Morgan Grenfell) by hiring away staff en masse from other major banks” (2001 Anand & Galetovic). The information and advice exchanged prior to a deal’s completion give strong incentive for another investment bank to free ride and offer the deal at a much lower price having not incurred the setup costs. Therefore, the investment banking industry cannot be perfectly competitive and must result in a voluntary cooperation among banks not to undercut each other in ruinous competition that will ultimately destroy the incentives to create long-lasting relationships with firms. Evidence of this dynamic has been studied in various literatures. In Struggle and Survival on Wall Street written in 1994, Matthews found that firms have charged 7/8 percent for underwriting top quality bonds for decades. Matthews concluded that there must be some type of unspoken collusion among banks for this to occur so systematically for so long. Chen and Ritter reported that “gross spreads received by underwriters on initial public offerings in the United States are much higher than in other countries. Furthermore, in recent years more than 90 percent of deals raising $20-80 million have spreads of exactly seven percent, three times the proportion of a decade earlier.” The spreads were not near or around seven percent, they broke down to exactly seven percent. In a more competitive industry, one would expect to find spreads in a range where banks would compete with each other at least to some degree. Chen and Ritter go on to claim that investment bankers will openly admit that “they don’t want to turn it into a commodity business” so banks do not compete on the prices charged for initial public offerings. The ability to perform high-yielding securities deals is the lifeblood of the investment banking industry and executives have made sure not to cause a breakdown in the fee schedule. These implicit agreements show the oligopolistic structure of the investment banking industry.
In such a structure, there is a relatively fixed size of each individual dominant firm in the industry. If firms are all too small, they will free ride off each other’s information and ruin each other. While if a particular firm is too large relative to the others, the smaller firms will have increased incentive to free ride to the detriment of the large firm. Therefore, no firm can become too large without other, smaller firms attacking it and driving up its costs and reducing its fee revenues through undercutting. The large firms operate on mutual high reputations and an implicit agreement not to fall into ruinous competition. This creates the “boys club” that Wall Street is sometimes seen as.
The high barriers to entry in the industry also help support the Wall Street club. The Securities and Exchange Commission has set a high standard of capital and regulatory requirements that must be passed in order to setup as an investment bank (2009 IBIS). The capital standards require large initial investments for conducting business. More recently, increased regulation of the industry is likely thus further increasing the barriers to entry for companies not able to produce significant economies of scale to spread the high costs of compliance with legal regulations. Yet, once a bank is established, their fixed capital costs are relatively low in comparison to variable labor costs. The services provided by investment banks require a large amount of administrative work and are highly labor intensive in general (2009 IBIS). These employees are typically highly educated and very specialized in their field resulting in outsized wage expenses to maintain the workforce. This relatively large portion of variable costs helps banks deal with downturns in economic activity and massive layoffs are an understood part of the business in times of economic contraction. But, as a barrier to entry into the industry, it can be difficult to attract the well-qualified candidates in order to setup an enterprise especially in investment banking because of its reliance on a bonus as a significant portion of an employee’s compensation. This bonus is very large relative to the employee’s salary and is only guaranteed if the firm can guarantee its ability to perform high profile securities deals. In this way, the top firms of the industry are naturally supported by their employees who stay with the reputation and success guaranteeing their income at the end of the year.
Also, one of the greatest components for success for an investment bank is its reputation. Reputations are not made in short order but rather take years of quality servicing and then decades to establish the firm commitment to maintaining integrity in its dealings. Gaining acceptance from firms as a desired promoter and underwriter of securities is a long, hard-won battle that substantially hinders new entrants from the market. Reputation and brand can be measured by goodwill accounting within the financial statements. Goldman Sachs, for example, records an asset value of over $5 billion for its goodwill and intangible assets on its financial statements (2009 GS). UBS valued its goodwill at over $4 billion for the year ended December 31, 2008 (2008 UBS). These goodwill measurements indicate the value of the business segments that exceed the discounted expected future cash flows and point to a valuation of a company’s reputation, brand image and customer loyalty.
The Panic of 2008
According to U.S. Census Bureau statistics, the investment banking industry had 5,583 firms in 2007 generating a total of $207.4 billion in sales and employing over 140,000. The industry experienced rapid growth over the previous five-year period with a 109.7 percent growth in revenues fueled by a relatively minor 19.7 percent growth in the number of firms coupled with a miniscule 6.4 percent increase in the number of employees. Compensation increased 57 percent over the same period from 2002 to 2007, a 9.5 percent compound annual growth rate. (2009 Census)
The state of New York is, by far, the dominant player in the investment banking industry in terms of revenue, but not hardly so in terms of the number of institutions. While accounting for only 20.8 percent of the total firms in 2002, New York firms produced 77.9 percent of the total revenues generated in the industry. California takes up second in the total revenues with a measly 4.1 percent of total sales. This divergence clearly points to the dominance of Wall Street and the large market shares of a limited number of firms. (2009 Census)
The year 2008 saw an extraordinary 93.0 percent drop in industry revenue as the sector imploded in the wake of the subprime mortgage meltdown. As recently as the year 2007, the top six investment banking firms accounted for 86 percent of the total market. By the end of 2008, major consolidation had occurred and the top three firms now had market share of 65 percent. The top six investment banks in 2007, in order of market share, were Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns and JP Morgan. By the end of the 2008, Goldman Sachs and Morgan Stanley had survived only by converting to bank holding companies to qualify for government capital infusions. Merrill Lynch was forced into an acquisition by Bank of America after Lehman Brothers dramatically collapsed in a short time. Bear Stearns was the first to fall in early 2008 forcing a takeover by JP Morgan. The composure of the investment banking industry has dramatically changed and will continue to change in the future. There are no independent investment banks remaining of any sizable importance. (2009 IBIS)
The current industry now has four key players accounting for 80 percent of the market. JP Morgan, after acquiring Bear Stearns in May of 2008, now holds a 26 percent share operating with assets of $1.6 trillion and 180,000 employees. JP Morgan bartered an exceptional deal with the Federal Reserve Bank bearing only the first $1 billion in potential losses from the acquisition while the Fed bears the next $29 billion offering JP a great chance to snap up huge market share gains without excessive risk of losing capital. JP participated in the same leveraged loans and mortgage investments that other banks did but on a much more conservative scale so that still maintained profitability in 2008 with incomes declining 64%. (2009 IBIS)
Goldman Sachs, one of the two remaining firms from the group of the five independent investment banks, comes in second in market share with 23 percent. Goldman also weathered the subprime meltdown relatively well as it hedged its positions wisely and experienced an 80 percent decline in net income in the year 2008. Morgan Stanley ranks third in share with 16 percent and Bank of America rounds out the top four with 15 percent market share. These four companies dominate the investment banking industry in the United States now. Citigroup is the fifth largest and holds a measly one percent share. (2009 IBIS)
Causes of the Collapse
The 54 percent drop in the equity market from the October 2007 high to the March 2009 low has left many market participants asking why the crisis occurred. Given that the crisis was first felt within the walls of Wall Street firms, it makes one ask how investment banks could have incurred such massive losses. The top five firms as well as other commercial banking institutions threatened the collapse of the entire global financial system with their extraordinarily excessive leverage and concentration in subprime mortgage backed securities. Much of the changes in banking habits can be traced back the Gramm-Leach-Bliley Act (GLBA) of 1999.
The GLBA most notably repealed Section 20 of the Glass-Steagall Act of 1933 (2009 Geyfman & Yeager). After the stock market crash in 1929 the Federal government passed many new wide-ranging sweeping measures to curtail excessive risk-taking in the financial markets by large banking institutions. The SEC was formed to regulate entities and Federal Deposit Insurance Corporation was founded to insure the deposits of individual customers. Along with these two entities which have proved to be major successes in creating stability in financial markets, the Glass-Steagall Act had the specific provision of Section 20. Section 20 prohibited commercial banking institutions from engaging in securities activities. Banks that held customer deposits were now prohibited from engaging in or having affiliations with firms that “engaged principally in the issue, flotation, underwriting, public sale, or distribution at wholesale or retail or through syndicate participation of stock, bonds, debentures, notes or other securities” (Title 12, U.S Code, Section 20).
Section 20 intended to separate the riskiness of activities that dealt with securities and the necessity of safety for consumer depositors. Glass-Steagall looked to curtail the negative effects losses in securities dealing would have on the security of banking deposits in a firm participating in both aspects of the financial system. As with many other industries, the move to deregulation seen in the United States throughout the 1980s had its effects on the financial services industry as well. The slow erosion of Section 20 finally culminated in the passing of GLBA, otherwise known as the Financial Services Modernization Act in 1999. This Act allowed bank holding companies to convert into financial holding companies and perform dealings in securities through subsidiaries without regulatory limits. (2009 Geyfman & Yeager)
The repeal of Section 20 was strenuously lobbied for in Congress by banking institutions on the premise that major synergies could be achieved without it creating significant economies of scale. Investment banks must undergo costly creditworthiness evaluations in order to underwrite securities. These activities are linked to a firm’s day-to-day financial activities. A bank holding company holding the deposits and providing credit lines to an institution will have already conducted evaluations of the firm that can then be transferred into underwriting activities without repeat of the initial sunk costs independent investment banks must endure. Recent studies have shown a “modest risk diversification benefits in the post-GLBA era” (2009 Geyfman & Yeager) and “significant revenue synergies between IB and commercial banking” (2005 Yasuda). On the other hand, now banks are participating in a significantly riskier world of securities dealing with the downside of the risks to be felt by those seeking safety in simple depository transactions with the bank. Geyfman and Yeager found that “universal banks had similar systemic risk but sharply higher total and unsystematic risk than more traditional banks” (2009). This finding points to the inherent risks in securities dealing and the possible spillover disruptions these activities could have on traditional commercial banking activities.
The GLBA led to significant changes in the investment banking industry. The five largest independent investment banks that had operated under implicit cooperation were forced to produce earnings elsewhere as many new competitors entered the market. Previously an unhindered oligopoly, the top five independent investment banks found themselves competing for securities deals with the new so-called universal banks, major players like JP Morgan, Citigroup and Bank of America. Every banking institution was now allowed in on the deal-making turf and held significant sway over firms making securitization decisions because of the existing relationship with banks holding depository funds. A study in 2005 showed that companies having existing banking relationships will more often choose that particular bank as their underwriter in securities deals (2005 Yasuda). This poses a great challenge to investment banks that do not hold deposits because customers that were previously forced to seek out an independent investment bank were now choosing the bank holding companies they already had established relationships with for securities deals.
After five years of competing with all other firms in the banking world for securities deals, investment banks needed a new way to make money. The new solution included employing a great deal of leverage. One of the most crucial elements of the financial industry collapse was the major change the SEC passed in legislation in 2004. Since 1975, the SEC had limited broker dealers a debt-to-net capital ratio of 12-to-1. Most banks exhibit leverage ratios between 9 and 12 percent depending on the management’s appetite for risk. Investment banks though, have always found ways to exceed those ratios but the 2004 SEC rules gave them free reign. The SEC now allowed the top five investment banks to leverage up 30, even 40 to 1. (2008 ParaPundit)
One of the most striking elements of the leverage equation is that it does not include many off-balance sheets obligations and does not account for the implicit leverage in derivatives contracts. Unhedged positions in credit default swaps and options can produce catastrophic losses in an extremely short amount of time. American International Group is a prime example of the riskiness of CDS contracts with the asset values of their books plummeting as fear of counterparty bankruptcy skyrocketed after Lehman Brothers’ collapse. Yet, even without the inclusions of these pieces of the equation, the leverage seen on investment banking balance sheets struck market participants as showing astounding arrogance and extreme recklessness.
At first, leverage was a great boon to the industry as evidenced by the 109.7 percent growth in revenues from 2002 to 2007. Investment banks increased their principal trading throughout this period rising from 16% of revenue generation in 2002 to 23% by 2007 (2009 IBIS). Average leverage ratios skyrocketed in a short time after the 2004 enactment at the major five investment banks. On average from 1999 to 2003 the top banks had leverage ratios of: Bear Stearns, 27.6 percent; Goldman Sachs, 19.2 percent; Lehman Brothers, 25.8 percent; Merrill Lynch, 18.5 percent; and Morgan Stanley, 21.7 percent. By 2007 every bank had large increases in their debt to capital ratios: Bear Stearns, 21.5 percent increase to 33.5 percent; Goldman Sachs, 16.6 percent increase to 22.4 percent; Lehman Brothers, 19.2 percent increase to 30.7 percent; Merrill Lynch, 73.2 percent increase to 32.0 percent; and Morgan Stanley, 53.8 percent increase to 33.4 percent (2008 Epicurean). These banks took advantage of the SEC rule change to the fullest extent pushing their balance sheets to the limit, and then over the limit. While the top four investment banks had market share totaling 39.1 percent in 2002, the leverage fueled large gains and by 2007, the top four firms had combined market share of 69.0 percent (2009 IBIS).
Leverage is a great bonus in boom times as seen in the housing market throughout the early 2000s as real estate prices soared. But, leverage is much more of a zero-sum game than most would like to admit and the fall in housing demand towards the end of 2007 caused losses in banking portfolios and ultimately resulted in billions of dollars in writedowns.
In the end, none of the top five investment banks existed in its independent investment banking form by the end of 2008. Bear Stearns collapsed and was sold off to JP Morgan at a pittance of its former stock price. Lehman Brothers found the government unwilling providers of bailout monies and claimed bankruptcy in September 2008. Merrill Lynch, seen as the next domino in a falling cascade, was forced into an acquisition by Bank of America to salvage the company. Goldman Sachs and Morgan Stanley soon converted into bank holding companies to receive access to the Federal Reserve discount window. This conversion dictates a major reduction in leverage for the two banks to comply with regulation.
Conclusion
The underlying regulatory structure created economic incentives that fueled the boom and bust in the investment banking industry. A naturally oligopolistic industry that would fall victim to ruinous competition under a perfectly competitive market found itself in a state of implicit cooperation. Investment banks chose not to compete on price for securities deals as evidenced by clustering of spreads on corporate bonds offerings and initial public offerings in equities sold by banks. The repeal of Section 20 from the Glass-Steagall Act of 1933 allowed a new field of entrants into the investment banking arena. The rise of the universal bank allowed institutions that held depository accounts to now be the one-stop shop for all a firm’s financial needs. As studies have shown, firms are more likely to use the bank they already have a relationship with in going forward on securities deals. So, the independent investment bank found itself in a tough spot. Its oligopoly was invaded by a swath of new competitors and it had to find a new competitive advantage. The solution was disastrous in the long-run even while providing five years of record-setting growth rates.
Investment banks leveraged up their mortgage dealings and engaged in a variety of high-risk derivative bets. It is interesting to note that the two banks with persistently highest leverage ratio prior to the 2004 SEC rule change were the first to collapse in the 2008 panic. Goldman Sachs, the best-surviving member of the top five, exhibited the lowest leverage ratio directly resulting in lessening the blow from the mortgage fallout.
It is unclear whether the investment banking industry will ever be the same again. What is clear is that an underlying regulatory framework that encourages perverse economic incentives can easily cause collapse.
Works Cited
“Banks’ Interactions with Highly Leveraged Institutions”, Basle Committee on Banking Supervision, January 1999.
Chen, H. and J. Ritter, “The Seven Percent Solution,” Journal of Finance, 2000.
Economist, The, “The Living Dead: Restructuring Banks”, November 7, 2009.
Goldman Sachs Group Inc., Stock Report, Matthew Albrecht, Standard & Poor’s, The McGraw-Hill Companies, October 20, 2009.
GS Quarterly Earnings Release, Goldman Sachs Group Inc., September 2009.
Investment Banking & Securities Dealing in the US: 52311. IBISWorld Industry Report, July 29, 2009.
Investment Banking and Security Market Development: Does Finance Follow Industry?, Bharat N. Anand, Harvard University; Alexander Galetovic, Universidad de Chile; February 2001, http://www.people.hbs.edu/banand/investmentbanking.pdf.
Matthews, J. Struggle and Survival on Wall Street. New York: Oxford University Press, 1994.
“On the Riskiness of Universal Banking: Evidence from Banks in the Investment Banking Business Pre- and Post-GLBA”, Victoria Geyfman and Timothy J. Yeager, Journal of Money, Credit and Banking, Volume 41, Number 8, December 2009.
ParaPundit, “SEC Leverage Rule Change Contributed to Investment Bank Failure”, http://www.parapundit.com/archives/005558.html, September 21, 2008.
Epicurean Dealmaker, “Supermassive Black Hole”, http://epicureandealmaker.blogspot.com/2009/09/supermassive-black-hole.html, September 22, 2008.
UBS Quarterly Financial Statement. UBS Financial Services. http://www.ubs.com/1/e/investors/accounting_standardsandpolicies/criticalaccountingpolicies/goodwill.html, December 31, 2008.
U.S. Census Bureau, http://factfinder.census.gov, November 2009.
Yasuda, Ayako. “Do Banking Relationships Affect the Firm’s Undewriter Choice in the Corporate-Bond Underwriting Market?” Journal of Finance, 2005.