Tommy says…

I don’t blog about the economy and markets as a rule, mainly because I’m scared of getting it wrong. The events of this week, however, are just too bizarre not to write about.

Three of the big five independent investment banks on Wall Street have fallen (Bear Stearns bought at heavy discount by JP Morgan; Lehman Brothers filed for bankruptcy; Merrill Lynch to be bought by Bank of America), and now the fourth has confirmed that it is in talks to be acquired, possibly by CIC, the sovereign wealth fund of China.

Some say the credit crisis is causing a much-needed weeding out of badly managed entities, with unsustainable business models. If that be true, then we are getting perilously close to a conclusion that the market judges investment banks per se to be an unsustainable business model. “What will the world be like without the big American investment banks?” It’s a scary yet tantalising thought, the idea that we may be on the brink of a new kind of market.

Perhaps a better way to characterise it is a rejection of the American investment banking model – the so-called “bulge bracket“ investment banks which have no retail base. The biggest of these independent investment banks include the three that are gone, Lehman Brothers, Merrill Lynch, and Bear Stearns (though Bear Stearns is sometimes seen as not big enough to be “bulge bracket), as well as Morgan Stanely (looking to sell), and Goldman Sachs (apparently not yet in trouble). 

By contrast, the other major investment banks, the Europeans like Credit Suisse, Deutsche Bank or UBS, as well as Americans such as Citi and JP Morgan, are called “universal banks” in American terminology, because they engage in both retail banking (e.g. Swiss bank accounts) and investment banking (e.g. buying and selling businesses). The advantage of the universal bank model, as shown in sharp relief in the current crisis, is that they have a soft cushion formed by the retail deposit base. When one of these banks writes down a couple of billion in subprime losses, it’s a big deal but not so big as to threaten the firm as a whole in any way. In fact, the big universal banks have each chalked up more losses than what brought down some of the independent investment banks. One may have to ride out a depressed share price for a couple of years and sack a few thousand people, but one lives to fight another day. By contrast, independent investment banks suffer in a downturn like the present – and it looks like we may be waving them goodbye.

I believe this is a good thing. Independent investment banks in the US were created in 1933 by the Glass-Steagall Act, a reaction to the 1933 bank collapses. This piece of regulatory reform is remarkable for its lack of sophistication. A stock-market crash in 1929, followed by bank runs, exacerbated by an ineffective Federal Reserve and a lame-duck President Hoover, meant that the in-coming administration had to do something, anything, to stop the rot. One of the provisions was the separation of investment banking and commercial banking. This sought to address the issue of conflicts of interest (see Comments below) and fraud by the diversified “universal” banks, and ultimately tried to end speculation, which was perceived to be the cause of the earlier crisis.

This reform was convenient from a regulatory perspective. Separate out commercial and investment banking, and there is no possibility of conflict of interest. But it’s about as smart as using a chain saw to crack an egg: and it sowed the seeds for turmoil in the financial markets. Investment banks are highly cyclical. In a bouyant market, they perform an important role as the lubricant in the great wheels of commerce. In a downturn, they suffer. 

In a downturn, for the economy as a whole, it is much better that the losses in the investment bank be insulated by the larger organisation. The alternative, which is what has happened to the indpendent investment banks, is a fire sale or collapse, which has unpredictable and wide-ranging effects. Witness, for example, the panic that set in around the world after the collapse of Lehman Brothers, as companies and governments raced to count how much of Lehman Brothers’ debts they owned, and how much of their own shares were owned by Lehman Brothers funds.

In other words, the economy will always have ups and downs. Someone has to do the investment banking in an upturn. When a downturn comes, it is better for a large organisation to internalise the damage – fire a few people, write down a couple of billion, unwind losses in an orderly fashion - than for the risk to be externalised and jeopardise the system in unpredictable ways.

In today’s market, the regulatory concerns that triggered the Glass-Steagall Act are fairly adequately addressed by much more sophisticated regulatory regimes. This is well recognised – hence the repeal of the law in 1987, and the rise of universal banks such as Citi and JP Morgan even in the US. Large but separate investment banks present too much risk to the system to be sustainable. They are relics of history, and their demise can only be a good thing for the market system as a whole.

Update The Monday after I wrote the above, the final two independent investment banks, Morgan Stanley and Goldman Sachs, announced that they will cease to be investment banks and become commercial banks (“bank holding companies”) for regulatory purposes. Essentially, this means they will be subject to more regulation, will vastly expand their retail deposit base, and will have cheaper and easier access to credit. Commentators suggest that Morgan Stanley’s announced merger plans may be on hold, and that it will look towards acquiring a commercial bank with a solid deposit base.