How Securities Firms Function: Information Network, Reputation Management, and Tacit Skills

In those circumstances in which a covenant is not an option given the particularity of price-related information, it is natural for investment banks to make use of their goodwill to build and maintain a functional information marketplace for the purpose of a well-ordered exchange of information and capital flows. Reputation management is therefore crucial to securities firms. To maintain a good reputation, securities firms perform due diligence for every finance request, reject the securities of a company that is involved in fraudulent disclosure or poor performance, offer reasonable compensation in consideration of useful information provided, and make it possible for liquidity providers/investors to get reasonable returns in the secondary market. (This requires certain premiums to be offered to investors who subscribe to IPOs in the primary market.)

In a knowledge-intensive industry in which players invest heavily in human capital, conventional securities firms build their reputation on good performance and stable customer relationships over the years. For example, Goldman Sachs has been acting as financial advisor for the Ford Motor Co. for decades. Achieving consistently good business performance and maintaining a long-term customer relationship both require great efforts and commitment over a long period, rather than hard work in a short period. Because of this, securities firms make demanding requirements of their employees in terms of technical skills and connections. They also heavily invest time and effort in training, particularly apprenticeship programs in which masters teach apprentices the essence of business and secrets to success, known as tacit skills.

For investment banks, such investment in employees is costly. It also comes with a risk of possible loss of customers and market share if elite employees leave for competing firms. To cope with such a risk, conventional investment banks have introduced partnerships to improve employee cohesion and loyalty. It was for this reason that Goldman Sachs and Lazard struck a partnership until they went public and became corporations in 1999 and 2005, respectively, even though they had faced capital limitations and restrictions.

The development and widespread application of information technology, as well as structural changes in capital markets accompanying IT development and application, have led investment banks to become more concerned with capital than human resources. Rapid IT development and widespread application in financial markets have greatly expanded and increased the complexity of market transactions. The information network established by conventional investment banks is being eroded as the public and investors have greater access to private information that was previously nonexistent in the information marketplace. There is also a growing number of business school programs that integrate such subjects as asset pricing and valuation techniques, making secrets that once were exclusively owned by investment banks more accessible and less mysterious simply with the help of a computer. This has presented a challenge to investment banks' apprenticeship programs.

However, modern financial markets with a great variety of financial instruments and huge trading volumes pose a more challenging test of the financial strength of investment banks. Increasing competition and decreasing commission rates are resulting in declining contributions of conventional brokerages to profits. Proprietary trading and investment backed by strong financial strength seems to be the only way to make money and survive in fierce competition. Unlike commercial banks, which have customer deposits as a stable financial source, investment banks have to incur debts constantly and increase financial leverage by financing in money and repossession markets or by issuing bonds and other securitized products. Therefore, modern securities firms build their business activities on tacit and technical skills, while money and expertise play other important roles (see Figure 2.2).

M&A advisory services rely on reputation and connections and have high requirements of employees in terms of tacit skills. IPO services equally rely highly on brokers' private information network and connections. Conversely, secondary market trading is a well-marked technical skill-oriented activity. Computer technology and sophisticated engineering modeling

Relative Importance of Tacit and Technical Skills for Investment Banking Activities

FIGURE 2.2 Relative Importance of Tacit and Technical Skills for Investment Banking Activities

Source: Morrison and Wilhelm (2006).

techniques have been introduced into this market. Many transactions in the secondary stock market today do not even involve actual human participants. Computers can complete transactions automatically, once the preset conditions are met. Skills used in the financial markets for derivatives (e.g., swaps and options) and structured products are no longer tacit, and can be acquired and copied by technicians. Also, unlike activities relying on tacit skills, such trading has transaction records, even for high and ultra-high frequency trading, in which transactions are executed thousands of times per second. Such records provide evidence that can be proved and that is legally admissible.

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