Commercial Banks 1; Investment Banks 0

Lessons from the Goldman Sachs and Morgan Stanley Conversions
Posted by Herb Addison, Jon Leaf, Leo M. Tilman, November 5th, 2008, 6:17pm

In American cinema, media, and popular opinion, the job of an investment banker has always been viewed as incomparably more glamorous than that of a commercial banker. Investment banks were portrayed to be on the forefront of innovation, complexity, and risk-taking. Commercial banks, on the other hand, projected a much more subdued and routine-driven image, inspiring such descriptions of their businesses as “borrow at two percent, lend at six percent, be on the golf course by 3pm.” Seemingly supporting the point, share prices of investment banks vastly outperformed those of their commercial banking peers between 2001 and 2006, with the wealth “spread around” among the executives and senior professionals accordingly.

So, not surprisingly, the conversions of Goldman Sachs and Morgan Stanley into bank holding companies at the peak of the credit crisis have generated a fair amount of nostalgia for a fast fading era. Throughout, the media attention largely focused on the implications of the conversions on corporate cultures as well as the potential for lower returns on equity going forward.

Both points are well-taken. It is entirely plausible that a culture of limited risk-taking will result in an outflow of talent from Goldman Sachs and Morgan Stanley into hedge funds, private equity firms, and investment banking boutiques. It is also likely that higher capital requirements and more stringent regulation will result in lower return on equity.

Is that all? The concept of risk-based economic performance introduced in Financial Darwinism leads to other interesting conclusions.

What happened to investment banks is a prime case study of the book’s thesis: as basic financial services (like equity and debt underwriting or trading commissions) of investment banks became commoditized over recent decades and their respective fees declined, so did the contribution of fees to their overall earnings. In response to fee and margin pressures, investment banks took on greater leverage and risk, and an increasingly greater proportion of earnings came to be derived from such active risk-taking activities as principal investments, financing, and proprietary trading. The increased riskiness of the business has translated into lower P/E ratios over time. When the lending environment became extremely stressed during the 2007-2008 housing melt-down and attendant financial crisis, business models of investment banks proved highly susceptible to runs on the bank, wiping out Lehman and Bear Stearns and forcing Merrill Lynch into a merger with the Bank of America.

When viewed in terms of risk-based economic performance,  business models of commercial banks have important distinguishing characteristics relative to those of investment banks. Their funding advantages related to retail deposits (and referred to as balance sheet arbitrage in Financial Darwinism ) serve as a separate, largely market-neutral revenue source and a very powerful stabilizer of the business mix that reduces earnings volatility, funding, and liquidity risks. Additionally, fee-based businesses of commercial banks contribute much more to the bottom line than those of investment banks – this being one of the positive side effects of deregulation (the repeal of the Glass-Steagall Act). Business model differences between commercial banks and investment banks proved to be a decisive factor during this financial crisis: those commercial banks that properly managed risks on their balance sheets ended up benefitting enormously from retail funding advantages.

The long-standing debate about the viability of the business models of independent investment banks is no longer academic: these business models proved too undiversified (in terms of risk-based business models) and leveraged to survive a major systemic financial crisis. On the other side, business models of properly managed commercial banks have proven viable. By applying risk-based economic performance as a guiding principle, top executives can formulate more effective business strategies related to business models, while regulators can improve their rules and amend them to account for systemic effects.

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Financial Darwinism explores the origins, drivers, and implications of the ongoing tectonic financial shift. It then equips executives and investors with actionable approaches to creating lasting economic value amidst complexity and uncertainty.

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