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.
Going further back in time, the famous Glass-Steagall Act of 1933 was enacted in another time of severe financial crisis to actually separate ?risky? investment banking from retail and commercial banking?policymakers at the time felt that ordinary bank deposits should not be exposed to the fragility of investment banks. The wheel has come full circle and that conventional wisdom has been replaced by the opposite in 2008.
The risks, however, remain in the system. Universal banks with deposits guaranteed by the Federal government?thus making them low on risk?may use that as a base to take riskier bets after a short cooling off period in the aftermath of the crisis. In fact, it would be more viable to take bigger risks on deposits than on money borrowed from the wholesale money market, which, as has happened in the last few weeks, can completely dry up in the event of a crisis, leaving investment banks and their business models badly stranded.
So, while the current model of I-banking may be past its expiry date, newer models and newer instruments of financial engineering will come up to replace the rusted ones. Regulation, no matter how competent, is unlikely to be able to keep pace with smart financial engineering, and with giant banks as the main players, it is even tougher to keep a careful watch. In any case, evidence from past financial crises shows that regulators and governments, more often than not, end up reacting to events rather than acting in a pre-emptive fashion. That is unlikely to change.
Unless, of course, regulators come down hard, like in India, on the openness of the financial system and the kinds of instruments that can be used. Some may be tempted to ban credit default swaps or collateralised debt obligations but, as we know in India, a licence-permit raj just stifles innovation, dynamism and growth. The political economy of America is, fortunately, unlikely to accept financial repression of this kind. On balance, it is probably worth enduring a periodic crisis?which can be managed?in exchange for higher economic growth and benefits in the longer term.
The term ?moral hazard? has been much bandied about in the crisis. One would imagine that the battering shareholders and managers have taken in the bankruptcy of Lehman and the nationalisations of Freddie, Fannie and AIG is enough to warn others about the dangers of imprudence and the unpleasant consequences. So far, no shareholder has got a cash bailout at a premium price.
The other focus of many policymakers in this crisis has been the nature and structure of corporate pay. It has been argued, and with reason, that the system of annual bonuses led managers to take excessive and unnecessary risk to maximise short-term returns. Interestingly enough, the I-bank which gave the highest average bonuses in 2006, Goldman Sachs, was the one independent investment bank which may have survived the storm?its balance sheet was a lot healthier than, say Lehman or Merrill, which paid only half of the Goldman average to their employees. Still, Goldman may be the exception rather than the rule and there is a case to debate the way corporate bonuses should be paid out: should they be taxed extra? Should they be given out over five-year periods? Should they be given out in the form of stocks only? The jury is out and no one can claim possession of all the right answers at the moment.
Let?s face it, though: capitalism is the best system we have, even if it?s prone to ups and downs, booms and busts. Risk-taking is at the heart of a successful capitalist system. We can find ways to prevent outright imprudence, but clamping down completely on risk will be like killing the goose that lays the golden egg.
dhiraj.nayyar@expressindia.com