Risk Management

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Larry Tabb, Special Contributing Editor
Larry Tabb, Special Contributing Editor

The Dawn of a New Investment Banking Model

Rising from the ashes of the bulge-bracket investment banking model, a new breed of partner-driven merchant-investment bank is on the horizon, predicts Larry Tabb, special contributing editor.

The bulge-bracket investment banking business model is dead. With the downfall of Bear Stearns and Lehman, the Bank of America/ Merrill shotgun wedding, and the conversion of Goldman and Morgan Stanley to commercial banks, exactly zero of 2007's top five investment banks remain standing intact. Did you ever think you would live to see the day when Merrill, Goldman, Morgan Stanley, Lehman and Bear Stearns would either disappear or be transformed into commercial banks?

In this day and age, bulge-bracket investment banks need to be commercial banks. With fixed income in tatters, underwriting nonexistent and the equity markets in free fall, their revenue pictures didn't look exactly promising.

But why does the intrinsic value of an investment bank hinge on the fixed-income markets? Can't the equity business carry the burden?

The one thing that has become increasingly apparent over the past few years is the importance of inexpensive funding. While these businesses are known for their trading prowess, their stable sources of funding enabled these firms to not only generate significant leverage but also lock in a stable spread between their cost of funds and their investment returns.

A critical aspect of this low cost of funding was the credit rating and perceived soundness of these institutions. Once Bear Stearns went under, the sector became tainted. As the write-offs accelerated and firms' pristine ratings were challenged, it became more difficult to borrow cheap money. Once credit dried up, that "stable" funding source was no longer stable, which forced reduced leverage and began a drying up of profitability.

An unlevered investment bank has two choices: go bust, or become a commercial bank. Commercial banks have two advantages over investment banks: access to the discount window and FDIC-insured deposits. Discount window access in these days of bank runs and financial market turbulence is critical, as it enables the banks to borrow from the Federal Reserve, the most secure liquidity source. Access to deposit insurance provides the bank with access to the least expensive funding source: deposits.

While becoming a commercial bank enables ex-investment banks access to secure and inexpensive funding, the change does not come without strings. As commercial banks, we can expect, they will be precluded from taking certain risks and employing as much leverage as they have in the past. These strings, as well as regulations we anticipate will be implemented out of the $700 billion Rescue Fund, we believe will force the investment banks of yore to act more like the commercial banks of 30 and 40 years ago. Gone will be 30x leverage, gone will be some of their risk-oriented businesses, and gone will be their relatively light regulatory touch.

While this should be good for Main Street, as hopefully these banks won't need to be bailed out again soon, we can anticipate that these changes will impact a significant stratum of highly compensated staff that will no longer be able to run their business as before. A number of these disenfranchised and motivated individuals, we expect, will split off and start the new investment banks of the future.

So while it is the end of the bulge-bracket investment bank era, we believe it is also the beginning of a whole new era -- the age of formation. It will be an era of the rebirth of the partner-driven merchant-investment bank. It will be a time in which new and smaller boutique investment banks will be less regulated and more entrepreneurial than their alma maters. It will also be an age when these new boutiques will be much better governed, as the risk takers will be managed by the people with the most skin in the game -- the partners who, unlike today, are invested in the franchise and not pampered by it.

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