Is the Golden Age of Investment Banking Over?

Michael Butler is chairman and CEO of investment bank Cascadia Capital. He is writing a book titled Financing the Future and the Next Wave of 21st Century Innovation, and is serializing it here at peHUB. What follows is an excerpt from the fifth chapter.

The Big Guns have been weighing in on the state of investment banking lately, offering sage pronouncements and prognostications in the wake of Bear Stearns’ quick and calamitous demise.

Former Federal Reserve Board Chairman, Paul Volcker, still agile and analytical of mind at age 80, for example, recently predicted that “investment banks are going to end up with a leverage ratio imposed on them.”

Volcker’s regulatory broadside followed a memorable warning from Warren Buffett, who called Wall Street’s derivatives “the weapons of mass destruction” several years ago.

We know now that Buffett was a bit hyperbolic – but generally correct; we don’t know yet if Volcker, who has an exceptional track record when it comes to making the game-changing calls, will also be right.

But it may not matter.

The bottom line is that the investment banking industry is struggling and long overdue for reform – maybe even radical reform. I believe substantial changes are well on their way.

I say “substantial changes,” because the investment banking business model has actually been deteriorating for almost 20 years. The basic facts are that return on equity has been declining while risk and capital requirements have been increasing. With margins shrinking in core bread-and-butter underwriting and trading activities, for example, investment banks started leveraging up and relying on less traditional – and questionable – derivatives.
In addition to using increased leverage, Wall Street has turned to principal investing to generate returns.

As a result, many firms today look more like hedge funds than traditional investment banks serving as intermediaries between the users and suppliers of capital. This change in business model has two major ramifications for firms:

• The increased use of principal investing increases the risk to investment banks and makes for a very dangerous situation.

• Through their principal investing activity, Wall Street firms are essentially competing against their traditional client base, and this could lead to potential conflicts of interest.
For years, bull markets and lots of leverage obscured the softness in Wall Street’s business fundamentals. The junk bond surge of the early 1990s, the growth of emerging markets in the mid-1990s, the Internet and technology boom of the late 1990s, and the recent private equity euphoria made it possible for Wall Street to avoid looking in the mirror and facing the underlying problems.

The mortgage crisis – which brought Bear down and has caused havoc at Morgan Stanley, Merrill Lynch, Citigroup and Lehman Brothers, among others – was just a trigger (or should we call it a “smoking gun”?) that exposed two decades of quiet unraveling.

One could easily argue that the industry’s quiet unraveling and the resulting drift toward consolidation started back to the late 1970’s or early 1980’s. A look at tombstone ads from 25 to 30 years ago reveals a lot of now-extinct names like Dillon Read, White Weld and LF Rothschild. These once-powerful investment banks have either disappeared or been merged into other firms.

Consolidation moved to a new level with the repeal of the Glass Steagall Act. This allowed commercial banks to begin acquiring investment banks. Today, there are only four major independent investment banks – Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers. Commercial banks such as Credit Suisse, UBS and JPMorgan have entered the investment banking business and contributed to the industry commoditization.

The repeal of Glass Steagall was part of a major move toward deregulation; now, in the wake of the Bear Stearns episode, we’re beginning to see the beginnings of regulation take hold on Wall Street. Indeed, once the Federal Reserve injected itself into the Bear saga, the door was opened for further inroads by policy makers.

And even though a number of chastened firms have reduced their leverage from 30x capital to nearly 20x, it’s hard to believe that the once fairly independent investment banking industry won’t encounter some form of serious, formal and sustained regulation going forward. After all, only 20 percent of the loans currently being made originate from regulated banks. So, Volcker is probably right – we should expect more monitoring and maybe some sort of capital reserve requirement designed to reduce risk-taking.

Tougher regulations will almost certainly be hard for the bigger investment banks to deal with. But their oligopoly – based on huge capital and ever-expanding scale – will continue.

This – plus the scores of commoditized products – will force more and more mid-sized investment banks to consolidate or vanish in the face of significant industry over-capacity. Investment banks that offer full service – which includes investment banking and public market sales and trading – run the risk of disappearing unless they’re associated with a commercial bank or are one of the Big Four mentioned above.

Another good way to prevent extinction is by developing a strong product, geographic or industry differentiation.
And that’s why I believe there will be an explosion of smaller firms. Many of these new entities will be launched by investment bankers who have left established jobs to hang out their own shingles. Unlike the big players, these new entrants will rely on brains and relationships – not brawn and tonnage. And their focus will be narrower, too. The Gordian Group, for example, zeroes in on financial restructuring and reorganization; and Harris Williams specializes in the middle market. At Cascadia Capital, we view ourselves as a national investment bank with a regional orientation centered on the Pacific Northwest.

A number of these new boutique investment banks will have trouble getting off the ground, because even though business is good right now, it’s also starting to tighten; one statistic worth noting – annual M&A volume is off about 11 percent through May versus the same period in 2007.

Many of the best and brightest on Wall Street won’t leave and hang out their own shingles; instead, they’ll join a private equity or hedge fund. Also, many of the newer boutique investment banks – Weinberg Perella, for example – are combining private equity and investment banking.

In many respects, hedge funds and private equity funds, along with boutique investment banks, are like the investment banks of 20 to 30 years ago – very nimble, very profitable, and very driven by ideas.

That helps explain why Yahoo recently retained a boutique investment bank run by former UBS executives when it was confronting Microsoft’s acquisition bid; and why Google called on a fairly new boutique headed by ex-Credit Suisse stars in an effort to gain insight into a possible Microsoft-Yahoo link up.

Looking ahead, I offer four predictions for the investment banking industry. I’m obviously not as smart or prescient as Warren Buffett or Paul Volcker, but I have been at this for about 20 years, so I’m reasonably well grounded. Without further hesitation, here’s my crystal ball:

• First, the investment banking industry will be regulated in some form or fashion, and the impact will be less risk and slower, steadier growth. In addition to regulation, the marketplace will also impose limits on leverage.

• Second, consolidation will continue, and a well-managed commercial bank may soon be in a position to acquire a major bulge bracket investment bank. The major trends in consolidation will be the continued disappearance of the mid-sized investment banks and cross- border transactions that increase geographic reach.

• Third, boutique investment banks will thrive, thanks to trusted relationships, a focus on ideas, and strong service.

• And fourth, look for a major re-pricing in Wall Street compensation levels. Clearly, top performers who can demonstrate their value-add in terms of revenue contribution will continue to receive outsized compensation. But average performers are earning outsized compensation in many firms today. And – like excess leverage – this won’t continue.

Let’s re-convene next year and see if my assessment has any merit. In the meantime, here’s hoping that the worst fallout from the mortgage crisis is behind the investment banking industry. It’s crucial that the business start moving forward, adopting new models and setting itself up for solid and meaningful success over the next decade.