Investment banks’ future questioned

By Peter Thal Larsen and Francesco Guerrera in London

Financial Times | September 15 2008 20:26

When Chase Manhattan bought JPMorgan in the autumn of 2000, many thought the deal would trigger a series of mergers in the investment banking business. Senior bankers predicted that other Wall Street firms such as Bear Stearns, Lehman Brothers and Merrill Lynch would have to join forces with larger lenders or risk being marginalised.

Eight years on, those predictions are finally coming true. After an extraordinary weekend on Wall Street, Lehman on Monday filed for bankruptcy protection while Merrill Lynch rushed into the arms of Bank of America, its larger rival. Combined with the collapse of Bear Stearns earlier this year, the ranks of the Wall Street banks have been cut in half. Among the so-called “pure” investment banks, only Goldman Sachs and Morgan Stanley remain.

That process continued on Monday. Shares in Morgan Stanley were down almost 9 per cent by early afternoon in New York on Monday, and have lost almost half their value in the past 12 months. Goldman Sachs, which has survived the credit crunch in better shape than any of its direct competitors, was down 7 per cent. The cost of buying protection on a default of both banks also jumped sharply on Monday as traders absorbed the consequences of the decision by Hank Paulson, the US Treasury Secretary, not to support Lehman. “What’s got everyone on edge is that Paulson has effectively declared that the broker-dealer model has no backstop,” one banking executive said, referring to the fact that there is no regulator standing behind it.

For executives at larger universal banks – which combine deposit-taking activities with their investment banking operations – the turmoil is long-awaited proof of the vulnerabilities of Wall Street banks, which tend to have smaller balance sheets and rely entirely on the wholesale markets for their funding. They believe the recent takeovers are merely a delayed consequence of the 1999 repeal of the Glass-Steagall Act – the depression-era legislation that separated commercial banks from Wall Street broker-dealers.

“This is a tough time to be an investment bank,” a senior executive at a US commercial bank said on Monday. “Given the events of the past few months, it is difficult to argue that it is better to be monoline at anything, be it investment banking, credit cards or insurance.”

Vikram Pandit, the former Morgan Stanley banker who now heads Citigroup, made a similar point in an internal memo aimed at reassuring the financial giant’s 360,000-plus employees of the company’s ability to weather, and even profit, from the current turmoil.

“Our industry is in a state of change, but I am confident that this should be an opportunity for Citi,” Mr Pandit wrote. “Citigroup continues to boast a strong deposit base that is diversified across products and regions.”

But others dismiss the idea that the business model of investment banks such as Goldman Sachs and Morgan Stanley, is broken and that they are doomed to merge with a deposit-taking institution as too simplistic.

They argue that the disappearance of three fierce competitors in the space of a few months would benefit the two surviving firms.

“Capital markets are not going to disappear, the investment banking business is still going to be there and you will only have two companies exclusively focused on it: that does not sound like a recipe for disaster,” a senior investment banker said on Monday.

With Goldman considered a notch above the rest due to its trading prowess and enviable client base, much of the spotlight will be trained on Morgan Stanley, which reports third-quarter results on Wednesday. John Mack, the firm’s chief executive, on Monday was at pains to stress that Morgan Stanley’s solid capital position and healthy revenues put it in a good position to benefit from the industry’s re-shaping.

However, stand-alone investment banks face two fundamental challenges: capital and liquidity. The bursting of the credit bubble and the drying up of the securitisation market favours banks that can put large balance sheets to work in support of their clients.

The turmoil has also highlighted the vulnerabilities in the investment banks’ dependence on the short-term repurchase market for secured funding. Wall Street banks, which have historically been overseen by the Securities and Exchange Commission, are also set to be brought under the supervision of the Federal Reserve, leading to tighter regulation of the risks the banks can take.

“The brokers may not be broken, but in future we expect the financial system in general – and the brokers in particular – to become shadows of their former selves,” Matt King, a strategist at Citigroup, wrote in a recent note.

None of this means Goldman or Morgan Stanley will be forced to surrender their independence. In the past, Wall Street banks have proved adept at reinventing themselves and adapting to a changing market. For the time being, however, the Wall Street banks must be feeling increasingly lonely.



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