Functional Orientation of Investment Banks

In the modern market economy, an investment bank operates in an information marketplace. For investment banks with information superiority, it effectively creates that marketplace, providing a service contract with a self-implementation mechanism. It provides principal economic participants with a variety of financial services that are related to highly information-sensitive securities and assets (Zhanyu 2009).

Historically, investment banks in the early years of investment banking fit that functional orientation best. In the nineteenth century, however, when the concept of banking was much broader than it is now, many large banks emerged, offering both banking and securities services. Investment bankers in merchants banks in the United Kingdom or private banking partnerships in the United States engaged in a small range of activities, generally focusing on conventional investment banking (securities underwriting1 and M&A advisory services were the core activities) until the 1920s and 1930s. The information superiority that built on long-term relationships between banks and clients became the key for those investment bankers to expand the market.

The Glass-Steagall Act of 1933 specifically provides, for the first time, a separation of commercial banks from investment banks. Due to this separation, the financial giant dominating the U.S. financial industry at that time, J.P. Morgan, was confined to commercial banking and was forced to split its securities department and convert it into a new company, Morgan Stanley, which concentrated on stocks and bond-related activities. Dismemberment of large banks helped lay a foundation for the rise of investment banking. This became a match for large banks in New York in terms of economic and political influence in the 1970s and also in terms of a market-oriented financial system that enjoys the highest level of flexibility, innovation, and efficiency. The separation also helped investment banks further consolidate in practice their particular institutional and functional orientations. This enabled investment banks to focus more on innovation, professional skills, and information, significantly differentiating themselves from commercial banks (see Figure 3.1).

The Information Marketplace around Investment Banks Source: Morrison and Wilhelm (2007).

FIGURE 3.1 The Information Marketplace around Investment Banks Source: Morrison and Wilhelm (2007).

Overall, the Glass-Steagall Act, which separated securities business from commercial banking in an attempt to keep commercial banks away from risks, greatly constrained the business development of commercial banks and made them victims. The Act cost American commercial banking dearly, but it benefited investment banking. After a relative stagnation period between the 1940s and 1970s, American investment banking experienced a fast growth through the 1980s and almost controlled the market after the 1990s. Profitability in investment banking was much higher than that in commercial banking. Considering this situation, commercial banks put persistent effort into lobbying after the 1970s, requesting deregulation and business crossover to enable them to return to investment banking. After the 1980s, the regulatory authorities (the Federal Reserve) gradually eased the regulation and allowed commercial banks to participate in securities-related activities through bank holding companies. In 1989, J.P. Morgan was allowed to return to the securities industry, which set off a new wave among big commercial banks for limited crossover. The Financial Services Modernization Act of 1999 basically abandoned the "separation of activities" that the Glass-Steagall Act had emphasized, bringing the U.S. financial system into a new stage of crossover.

After commercial banks returned to the securities industry via bank/ financial holding companies, independent investment banks such as Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers, and Bear Stearns faced a competition that was never before seen. They began to adjust their business activities for a fundamental change. While maintaining conventional activities (e.g., securities underwriting, M&A services, and securities brokerage), investment banks caused asset management and proprietary trading to take a larger proportion of their business and revenue. As a result, U.S. investment banks were no longer confined to the functional orientation of a financial institution that mainly takes up low-risk activities and simply relies on relationships. They engaged heavily in asset management and proprietary trading activities on leverage and became financial intermediaries that take high risks. Due mainly to a range of creative "shadow banking" or "securitized banking" systems accompanied by securitization (see Figure 3.2), the line between investment and commercial banking became extremely blurred. Prior to the outbreak of the 2007 financial crisis, it was very difficult to determine with any accuracy, theoretically or practically, the institutional and functional orientation of the independent investment banks.

It is due to that change in business activities and institutional and functional orientation that when the U.S. subprime mortgage market collapsed in 2007, both independent investment banks (e.g., Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers, and Bear Stearns) and commercial

The Securitized Banking System: Basic Architecture

FIGURE 3.2 The Securitized Banking System: Basic Architecture

banking conglomerates (e.g., Citigroup and J.P. Morgan Chase) were unable to avoid the impact of the run on the repo market. As the value of assets slumped and liquidity dried up, they were all caught in unprecedented distress.

< Prev   CONTENTS   Next >