Column : I-Banks, rest in a different piece

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The conversion of Goldman Sachs and Morgan Stanley—for reasons of pure survival—into regular bank holding companies to be regulated by the Fed rather than the SEC, admittedly signals the end of big independent investment banking, as we have known it. Yet, it may be premature to bury the entire edifice of investment banking altogether, just as it may be premature to bid farewell to risk taking and crises in financial systems.

Some functions performed by the previously big independent investment banks will now fall to smaller, boutique investment banks—or merchant banks as they were known in the past. These institutions will advise corporates on subjects like stock listings, IPOs, and mergers and acquisitions—an advisory market that the Big Five of Goldman, Morgan, Lehman, Merrill and Bear had earlier cornered. These boutique firms—Lazard and Greenhill come prominently to mind—will also perform the function of advising clients on how to invest their money and may even manage their clients’ portfolios. What they will not do is leverage to invest in risky financial assets like mortgage-based securities.

That will now fall to investment banking division within large universal banks, which encompass retail, commercial and investment banking. The nature of this investment banking conducted under the Fed’s banking regulations will, of course, be different from the deregulated, SEC supervised sphere that I-banks operated in earlier. There will be strict capital base requirements. And there will be limits on the amount of leverage that can be taken. Estimates suggest that independent investment banks lent $20 for ever $1 they held. For commercial banks this ratio is $10 for every $1. Obviously these rules will reduce risk and reduce profit but eliminate neither completely.

It is easy to forget, amidst the mayhem of the last few weeks, that the universal banking model was under threat as recently as last year, when Citibank and UBS had to take cash injections and bailouts from liquid sovereign wealth funds in order to offload their exposure to subprime mortgages. Despite the tighter regulations, these banks too were exposed to excess risk, but perhaps not as fatally as investment banks.