Investment banking

Charles A.E. Goodhart 31 October 2011

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Investment banking has attracted much vilification in recent years, being frequently described as “socially useless”, or a “casino”. Yet if its functions are not properly appreciated, the ‘reforms’ that are now being proposed could lead to further problems down the road ahead (see also the latest Vox eBook The Future of Banking, Beck 2011).         .

The historical roots of universal banking

Universal banking came into being on the continent of Europe in the late 19th century and in Japan in the early 20th century in order to connect banking with large-scale industry (steel, chemicals, pharmaceutical, electrical, cars, etc). With weak capital markets then, there was a need to channel retail savings into large-scale industry in order to promote industrialisation and growth.

The ‘haus-bank’ in Germany and Zaibatsu in Japan had close links with a stable of associated firms at the advisory, managerial, and equity ownership levels, as well as in the provision of loan finance. The contrast with the Anglo-Saxon tradition of “arms-length” banking, with no close involvement with associated firms, and bank lending supposed to be for temporary purposes, was often noted, frequently on the back of accusation that the British (retail-type) banks were not doing enough to support industrial development.

The other main root of investment banking was merchant banking. The growth of international trade, and the globalisation of supply chains, again largely carried out by large firms, rather than SMEs (small and medium-sized enterprises), led to a concomitant need for the provision of trade finance; and with that to a need for the development of an international information network on financial, especially foreign exchange, commercial, industrial, legal, and political conditions in all the major countries involved. While bits of such information could be provided by specialist boutiques, there were obvious advantages of scale and scope in having large information networks in large financial institutions.

Banking in a world with sophisticated financial markets

The (often implicit) argument is made that such roles, in supporting large industry and international trade, have been superseded by the growth of efficient capital markets. These allow (big) industry, and other big borrowers, often in the public sector (eg subsidiary governmental bodies as well as sovereigns) to finance themselves directly, allowing banks to concentrate on lending to households and SMEs. Similarly trade finance can rely on efficient markets for foreign exchange, and various hedging derivatives. This judgement would be wrong (if made). The informational requirements needed to navigate oneself around the complexities of the current financial scene, especially international, are vast, and most corporations, local governments, large charities, and even central governments know that they do not have that ability.

On the other (buy-) side of financial intermediation, most household savings are now channelled through institutional investors, pension funds, and insurance companies. Many people probably think that these institutional investors do all their investment analysis in-house, simply sending instructions to complete deals (at the best available price) to whichever broker offers the best immediate price. The reality is different. Most institutional investors have close relationships with one or more investment banks that provide analytical, financial, administrative, and deal-execution support. Besides their contact with (real money) institutional investors, investment banks provide a crucial link between all the major buy-side institutions and the financial/capital markets.

Thus the investment banks provide the key intermediation role both for the big sell-side borrowers and big buy-side borrowers. Much of this can, and is, done without the need to use such banks’ own balance sheet, eg analytical advice on mergers and acquisitions, etc, but much requires the need for at least temporary use of the balance sheet. Clients often want assured access to finance, and so investment banks have to be able to make markets without necessarily knowing in advance to whom and at what price they can offload such positions.

Investment banks as intermediaries between big borrowers and big lenders

So, investment banks are the main intermediaries between large-scale borrowers and lenders, and, as such, provide essential services in keeping wholesale capital markets functioning efficiently. Sometimes they even run such markets themselves, (eg dark-pools); more often they provide the channel through which almost all orders get transmitted to the market (eg derivatives markets). Such intermediation services are essential to the continued functioning of our complex modern economy. The chaos that occurred after the failure of Lehman Brothers, an investment bank without any retail banking involvement, is testimony to that. The idea that investment banks can be liquidated with far less social costs than ‘pure’ retail banks is incorrect, though alas common.

The temptation of knowledge

Investment banks, therefore, lie at the centre of informational and market networks, with ‘inside’ information of the positions and thinking of many of the big buyers and sellers. They have an informational advantage. There is an inevitable, indeed natural, tendency to exploit such informational advantage by taking positions for their own benefit, as well as – or instead of – for the benefit of the client. Moreover when such positions were ‘wrong’ for whatever reason, their size relative to the bank’s own capital could often endanger, and in several cases has endangered, the continued viability of the bank.

There is no question but there have been failures in risk management in recent years in investment banking. There have been equivalent failures elsewhere, but it is evidence of the central importance of such banks that their failures figure so prominently on the front pages of newspapers.

It has been argued that risk management in the large investment banks has worsened because of size (top management cannot get a knowledgeable grip on everything) and incentives (the switch from a partnership to a limited liability governance mechanism). While there may be some validity in such criticisms, the informational economies of scope and scale make it hard to reverse past trends. The Volcker rules in the US attempt to ban position-taking by investment banks, but, while many prop-desks have been shut down, it is difficult to distinguish pure position-taking from operations on behalf of clients or from day-to-day Treasury functions to finance the normal operations of a bank, even a pure retail bank.

Markets get made by participants taking positions. No one objects to agents taking positions if they bear the loss themselves. Problems arise when there are major externalities to society from such losses. It is the thesis of this note that the role of investment banks is so central to the efficient operation of our complex financial system that losses to such banks have major social externalities. The idea that, once you have carved out the ‘socially valuable’ parts of retail banking, ie the payments system and retail lending and deposit-taking, you can liquidate the rest without massive adverse effects is not only tragically mistaken but also horribly dangerous.

References

Beck, Thorsten (ed) (2011), The Future of Banking, A VoxEU.org eBook, 25 October. 

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Topics:  International finance

Tags:  financial regulation, investment banking