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Not long ago, five pure play investment banks were masters of the global financial markets. Their massive profits were the envy of many on Wall Street. These banks were Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch, Lehman Brothers, and Bear Stearns. While these investment banks reveled in the limelight, commercial banks got less attention. Conventional banking has always been looked down upon by the pure plays because of the business model, one that caters to individuals and small to- mid- sized and large businesses in a risk-averse environment. Before 2008, few predicted that commercial bankers would get the last laugh.

Prior to 1999 and the repeal of the Glass-Steagall Act, pure plays operated independently from commercial banks. Their business model was based on high risk, in return for high reward. Furthermore, these investment bankers had a sense of superiority over commercial bankers because of the client base they worked with, including Fortune 500 companies and many on the Forbes richest people list. The pure plays offered investment banking services such as equity and debt underwriting, asset management for both institutional and private clients, and trading market making services. All of these services, however, have one thing in common: they’re all fee based, meaning clients have a large amount of buying power. Pure plays began to think of ways in which to reduce their reliance on these client-oriented services. The investment banks found their answer in proprietary trading.

Proprietary trading is the process in which a bank trades its own assets instead of client money. The perfect model was created. Economic booms in technology and housing created a large inflow of cash from the fee based services side. This cash was then used to fuel “prop” trading desks, leading to some of the largest profits ever witnessed. In the midst of all the cash flowing into the investment banks, less attention was paid to the commercial banking industry. However, pure play investment bankers wanted more money to speculate with, and began thinking of ways to get it.

Commercial banks were not considered “sexy” by those on Wall Street. They worked with consumers and businesses, provided them with credit cards, loans, and issued mortgages to potential homeowners. Their business has been around for generations. Yet, by the late 1990s, investment banks became extremely interested in this “boring” business model. Commercial banks had a large, non-exclusive client base. To investment bankers, this meant that they had ample deposits on their balance sheets, coming in at predictable and stable rates. More important, conventional banks generate low returns on their funds. Why let this cash go to waste, some investment bankers thought. Why not let that cash flow into the prop desks to generate higher returns?

The answer to “why not” was the Glass-Steagall Act, which was designed to regulate banking and prevented large investment banks from merging or taking any interest in commercial banks. Such an Act, thus, prevented large amounts of speculation with consumer money. Weaker pure plays, envious of the big five’s profits, pushed for the act to be repealed, finally succeeding in 1999. By merging with commercial banks, weaker pure plays became diversified banks and ensured that they had the resources on hand to compete with the stronger competitors. Goldman, Morgan, and the other three decided they would remain true to their original form, believing that remaining smaller allowed them to be more nimble and react faster to changing market conditions. By having others leave the pure play arena, the five remaining would also face less competition. Last, but certainly not least, the five still saw commercial banking to be a business model that was not suitable to their interests. A merger would dilute their prestigious brand names.

Even with the added strength from merging with commercial banks, the newly formed universal banks still lagged the big five major players. All that would change in 2008. The pure plays kept fueling their prop desks, leveraging them up 40 times to 1 in some cases. While this kind of leverage boosts earnings when the underlying asset increases in value, a downward move of just a few percentage points could trigger steep losses. What assets were they betting on? What was so safe that the possibility of a few percentage points drop was so remote? It was housing. Housing prices had never gone down over 60 years, and few believed they would.

A surge in the supply of housing starting from the early 2000s eventually caused prices to drop, bringing all the pure plays to the brink of bankruptcy. The world was now facing financial Armageddon. Merrill Lynch was forced to sell itself to Bank of America. Other CEOs on the Street proclaimed it was as if Tiffany’s (TIF) merged with Wal-Mart (WMT - Free Wal-Mart Stock Report). Bear Stearns was bought out at a large discount by JPMorgan Chase. Goldman Sachs turned to Warren Buffet for a cash infusion, in addition to becoming a bank holding company. Morgan Stanley reorganized itself as a bank holding company and sold an ownership stake to Mitsubishi UFJ Financial Group. Lehman Brothers was unable to find aid, and went bankrupt. Its remains were picked apart by Barclays and Nomura later on.

The only two survivors, Morgan Stanley and Goldman Sachs, now face a different world. Credit flow has dramatically decreased, as banks no longer trust each other. Regulation has also restricted leverage ratios and speculative trading activities that were previously used to make record profits. Both companies are now semi-pure plays, at best, as becoming bank holding companies allows them to access FDIC-insured funding. Pure plays are now less trusted, and more important, less profitable. Does this mean that universal banking is the model of the future? That’s not quite the case.

All models have their positives and benefits. Although the universal model is relatively safe, these banks are significantly bigger than the pure plays. If something catastrophic were to happen again, the universal banks would have a larger systemic impact. By having government deposit insurance, a moral hazard is induced. Measures to protect consumers may trigger bankers to take unnecessary risks. Universal banks are also harder to value, as many of their assets do not require mark to market pricing. Last but not least, large universal banks are conglomerates, which can be unwieldy to manage.

What Goldman and Morgan should do in the future is a topic of hot debate. Some say the banks should shed their bank holding status to avoid regulations. This strategy would have little effect it seems, as regulation would merely adapt to include the two banks. Financial reform proposals approved recently would include large non-banks deemed systematically important financial institutions, which would no doubt include Goldman and Morgan Stanley, even if they shed their banking charters. Where will profits come from in the future, as legislation may stifle financial innovation? Ultimately the answers to these many questions will be decided by the management teams of the two banks. Their culture has guided them through thick and thin, and will do so again. Whatever the companies’ leaders decide, they will need to move fast. Halfway around the world, overseas rivals are learning their own methods of financial engineering to garner massive returns. With balance sheets many times larger than some U.S.-based banks, they pose a serious threat. The Chinese banks are coming.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.