Capital spenders

May 17th 2007
From The Economist print edition

Relentless competition is forcing financial firms to take more risks with their own capital


INVESTMENT bankers would hate to admit it, but traditionally they have borne some resemblance to estate agents, matching buyers and sellers of financial assets instead of houses and land and taking a fee on the transaction. Yet investment banks have recently changed out of all recognition. These days, if they were estate agents they would not only suggest a suitable property to buy and offer to handle the transaction but also propose a loan, come up with sophisticated products to offset the risk of rising rates, provide help with the down-payment, sell you funky insurance products and, if they decided the property was a bargain, even buy it from under your nose.

In short, investment banking has migrated from an agency model towards a principal one. The industry is not just offering its clients a growing array of products to buy and sell; it is making bigger bets with its own capital, too. According to Merrill Lynch, in 2005 one-third of the industry's revenues came from principal trading of debt and equity and only 15% from the commissions business, once the industry's bread and butter.

Maria JeevesThe main engine of transformation has been competition. Wall Street's sensitivity to charges that it operates as an underwriting oligopoly dates back at least to the Glass-Steagall act of 1933 when commercial banks were forced to sell or close their underwriting business, in effect reinforcing the franchises of “bulge-bracket” securities firms. But since the repeal of Glass-Steagall in 1999, commercial banks and investment banks have jumped onto each other's turf. JPMorgan, elbowed out of securities trading by Glass-Steagall (Morgan Stanley was carved out of the old House of Morgan to become the underwriting business), is now near the top of the global M&A league tables. Its market share has grown by about 50% since 2001, says Mr Moszkowski at Merrill Lynch.

European universal banks such as UBS, Credit Suisse and Deutsche Bank, constrained by the lack of opportunities in their overbanked home markets, have also muscled into the American big league. UBS was one of the top share underwriters in America last year. Barclays Capital too, the investment-banking arm of the British bank, has successfully targeted America, concentrating on fixed-income products and commodities.


At the same time private-equity firms and hedge funds have mercilessly fished in Wall Street's talent pool. Some, such as Citadel, a hedge fund, have ventured into market-making in securities, an old Wall Street role. Others have gone for niche markets. Star-studded boutiques such as Greenhill and Perella Weinberg compete with banks in M&A. In trading, margins on cash equities, which used to be Wall Street's signature business, have been hit by electronic platforms and by rules to increase price transparency, such as Regulation National Market System (known as Reg NMS) in America.

The result, according to industry leaders, is growing pressure to explore new sources of profit. “I don't know an industry that is more competitive,” says Lloyd Blankfein, boss of Goldman Sachs. “That is what is driving the innovation cycle.”

The colour of their money
As commercial banks with trillion-dollar balance sheets compete with them for deals, the big five Wall Street securities firms are finding themselves under growing pressure to provide clients with financing as well as advice. Advising on mergers and acquisitions is still the most profitable, and headline-grabbing, business on Wall Street (and Goldman remains top of the tree). Lending on deals offers lower margins if higher volumes. But, as Mr Blankfein puts it, “you have to offer advice and capital together.”

Citigroup, for example, claims to earn $5-8 from funding and other fees for every $1 it gets from advising clients on acquisitions. Thanks to debt underwriting, last year Citigroup and JPMorgan Chase bagged more investment-banking business than many of their Wall Street rivals. Those banks can rely on huge balance sheets, backed by cheap retail deposits, to make loans. The loans also give them recurring income to fall back on when market conditions worsen. Wall Street securities firms do not have access to such a stable supply of funding, so they have to raise capital in fickle markets instead.

Still, they have found inventive ways to take on commercial banks at their own game. Goldman, for example, secured a backstop facility of at least $1 billion from Sumitomo Mitsui when it bought a stake in the Japanese bank in 2003. Merrill Lynch, Goldman and other Wall Street firms have acquired banking charters in America to gather deposits.

Owners beware
Increasingly the firms are buying their own investment assets too. For years they have been using proprietary trading desks to take positions. Now they have ventured into private equity as well, putting a growing proportion of their capital into long-term, illiquid investments, such as property or companies. Merrill Lynch, for example, holds a stake in Bloomberg, an information provider. Goldman has stakes in power plants across America, golf courses in Japan and a $5 billion stake in the vast Industrial and Commercial Bank of China. Brad Hintz of Bernstein Research notes that the share of the industry's capital held in such illiquid investments is growing very fast. At Merrill Lynch and Goldman they accounted for about half of the firms' equity capital last year, up from just over a quarter in 2005. That could be alarming if markets dry up and asset values plummet.

According to Dominion Bond Rating Service, all five Wall Street firms, Goldman, Merrill, Morgan Stanley, Lehman Brothers and Bear Stearns, almost doubled their equity capital between 2001 and 2006. Their assets grew just a tad faster, suggesting that they are expanding their businesses on firm foundations. Regulators have also had a clearer view of their capital since 2004 when their holding companies became Consolidated Supervised Entities, globally supervised by the Securities and Exchange Commission and subject to Basel Committee capital guidelines. Some of the supervisors believe their capital cushions are more substantial than they used to be.

There is no reason for complacency, however, because markets can respond in unpredictable ways, and nobody knows how severe such “tail events” could be. According to Timothy Geithner, president of the Federal Reserve Bank of New York, which keeps a close eye on Wall Street's exposures, “risk management is better and capital cushions are stronger than they were, relative to risk. But the banks are not invulnerable. We'd like to make sure that they're sufficiently strong to withstand adversity in the tail. The shape of the tail is very uncertain.”

Shareholders are not entirely sanguine either. Investment banks are mostly measured on their price-to-book value. Unlike the assets of a bank or an industrial company, most of the securities on their balance sheet have a book value that can be calculated daily and can be easily liquidated. That puts a floor under their price. Currently the big Wall Street firms are trading at more than twice their book value, reflecting last year's average returns on equity of about 25%, which is higher than their cost of capital. Their long-run average is 16% (see chart 5). Goldman, with a staggering 33% return on equity last year, has the highest valuation. But with so much more capital now deployed, the banks have to work harder to improve returns.

There is growing uncertainty about future earnings, however, pushing price-earnings multiples close to historic lows. This is partly because investment banking is a cyclical business, which may be peaking. It is also because their earnings are, to put it mildly, opaque. As Mr Hintz (a former chief financial officer of Lehman and treasurer of Morgan Stanley) candidly admits: “We can't be totally confident how they make money trading or how sustainable trading is.”