Can Investment Banks Avoid Structural Collapse?
By Matthew Lynn
London, April 29 (Bloomberg) -- Engineers have a variety of technical terms for why buildings can fall down: overload, brittle fracture and bearing failure are some of them.
Some of those terms might soon be needed by commentators on the investment banking industry. As the investigations and scandals gather pace, it is becoming apparent that many bankers work in buildings that could soon collapse.
Of the engineering terms, brittle fracture is probably the most appropriate -- for, in truth, the modern investment bank was always a flimsy edifice, likely to crack under stress.
Every day seem to bring a fresh set of allegations against the banking industry. Harvey Pitt, chairman of the Securities and Exchange Commission, last week announced the start of a formal investigation into conflicts of interest among analysts.
Separately, J.P. Morgan Chase & Co. was told it might be charged with illegally demanding excess fees for hot shares in initial public offerings. In a courtroom, Hewlett-Packard Co. has had to defend itself against the allegation that it effectively bribed Deutsche Bank AG into voting for its merger with Compaq Computer Corp. by offering investment banking contracts. And the $100 million that Credit Suisse First Boston paid to settle regulatory charges of abuse in its allocation of IPO shares is still fresh in the memory.
Silent Men
Suddenly, there are brittle fractures all over the place.
So far, the men in charge of the world's big investment banks have remained largely silent on the scandal washing over their industry. From the likes of Lukas Muehlemann at Credit Suisse Group, Rolf Breuer at Deutsche Bank AG, Henry Paulson at Goldman Sachs Group Inc. or Philip Purcell at Morgan Stanley Dean Witter & Co. not a word has been heard. Only David Komansky, chief executive of Merrill Lynch & Co., has made any acknowledgement that the waters his ship sails upon are anything but calm. And he has only said sorry.
That is odd. No doubt they hope the parade of scandal will soon be finished. A few hundred million might have to be paid out in fines, and a few analysts tossed into the slammer (where, if their jailers have a sense of humor, they'll be kept in cells marked ``hold''). Some pockets will be hurt and some careers broken, but no real long-term damage need be done. Soon everything will get back to normal.
Whole Barrel
In that judgment, they are almost certainly wrong. No doubt there are unprincipled and greedy people working for investment banks, but probably not a great deal more than in any other industry. The problem, though, is not just a few bad apples: it's the whole rotten barrel. That is the issue the people running the main banks will have to start thinking about. It is their own strategies that are now under attack.
As the investigations unravel, it will become increasingly evident that conflicts of interest are built into the structure of the modern investment bank. It won't be long before the cry is heard for that structure to be changed, and then the question will be whether the banks will reform themselves or let others do it for them.
The main point about all the big investment banks is they do everything. They arrange IPOs and bond issues, they advise on acquisitions and mergers, they make markets in stocks and bonds, they trade currencies and options, they manage funds, and they offer analysis and recommendations. Although there is occasionally a pretence of separation, in effect all those services are bundled together. The client is buying the whole package.
Comes Unstuck
If you look closely at all the recent scandals, it is that bundling that caused the problem. Take analysts' advice. If the bank did not both offer supposedly impartial recommendations on shares, and also act as an adviser to companies, there would be no problem. Or take Hewlett-Packard. If the bank was not both a seller of fund management, and a seller of corporate loans, the problem would disappear. Likewise, IPOs. If the bank wasn't both arranger of share issues and a distributor of shares, there'd be no problem.
Bundling can be a great business strategy when it works, but when it comes unstuck it can get you into a lot of trouble. Microsoft Corp., just about the most successful company of the last 30 years, is testimony to that. The strength of that company, and the source of its extraordinary profits and market dominance, has been putting operating systems and software into one big package. But it was also bundling -- in particular bundling of its web browser -- that prompted antitrust regulators to try to break the company up.
Not So Much Money
Investment banks could be broken up just as Microsoft could have been. It could happen voluntarily, because clients demand it. Or it could be forced, because regulators demand it. But there is no reason why all the various businesses that are currently grouped together should not be split up.
Firms of analysts could sell research on companies. Boutique advisers could sell M&A advice. Stockbrokers could make markets in shares and bonds. Compared with the big, giant investment banks of today, there could be clusters of much smaller firms specialising in smaller markets. All the temptations and conflicts of interest would disappear.
The problem is, they would not make so much money. The reason the big, global investment bank has emerged is not because the structure is practical or efficient -- it isn't -- but because it is uniquely profitable. Why pay all that money for M&A advice, if the bank can't guarantee the deal will be well received? Why go to them for a loan, if they can't guarantee votes will be cast for you at the next AGM? Bundling gives the big banks huge power over the capital markets, and that allows them to charge huge fees.
Investment banks could be unbundled, and might well be. But everyone in the industry will fight it because it will cost them a lot of money -- and that is the one thing they hate most.
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