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  1. 1. Is the investment banking model flawed? Philip Augar augar@btinternet.com Draft paper. Not to be reproduced in whole or in any part without the author’s permission. Abstract Investment banking is under pressure this year. Not only are firms’ profits falling amidst reduced business levels in the bear market, but in the US regulators, government agencies, the courts and unhappy investors are asking questions about how the banks behaved during the froth of 1999-2000 at the top of the last bull market. Is this scrutiny simply a case of ‘bear market blues’ that will pass when the market recovers or has investment banking evolved into a model that requires reform? Is the investment banking model flawed? 1. The current model The chief characteristics of the investment banking industry today can be summed up in three words: ‘American’, ‘scale’ and ‘integrated’. Investment banking in its current form originated in the US after the Crash of 1929 when legislation (including the Glass Steagall Act of 1933) was drawn up to protect investors. Investment banking was to be closely regulated and was to be separated from commercial banking. The regulation encouraged good management and the separation fostered investment banks’ distinctive culture and together they ensured that the industry in the US developed deep roots. According to Jim Hanbury an analyst who has been following Wall St’s investment banks for many years: ‘Glass Steagall gave us a critical incubation period. Prior to the 1960s we learned the hard way and firms regularly went bust. Then we started to manage and plan the business and it got better. There is a self-selection and a management process to the American firms… that gave the investment banks great management in depth.’i It was the deregulation of Wall St in 1975 and the spate of corporate finance activity brought on by the free market policies of the Reagan and Thatcher Governments that first helped the investment banks to develop still further in the final quarter of the 20th century . Then in the 1990s the huge bull market and the globalisation of big business encouraged the American investment banks to expand overseas. Through a mixture of acquisition and organic growth, the leading US investment banks came to dominate in the UK, the Continent and Asia. Take any set of league tables in any of these areas and the names of Goldman Sachs, Merrill Lynch and Morgan Stanley will be found in the leading positions with a handful of other American firms not far behind. Even for those few European and Asian firms still trying to compete, it is the American business model that is usually followed. Integration is a key 1
  2. 2. characteristic with potentially conflicting activities being carried out within the same group but separated by internal barriers. Thus banks advise the corporations that issue securities at the same time as they advise the institutions that buy them. They recommend and execute market transactions on behalf of investors at the same time as they are carry out similar transactions on a proprietary basis. They advise asset management firms and simultaneously compete with them through their own in-house fund managers and private equity funds. To ensure that such conflict of interest does not disadvantage the clients, a separation of functions is policed by regulators and internal compliance departments and underpinned by a voluntary code of practice. Investment banking is organised along these lines in all of the world’s major economies and when individual markets do change it is usually the integrated structure that is adopted for example as occurred in London in 1986 when Big Bang enabled firms to bring together the previously separate functions of broking, jobbing and corporate finance. The third characteristic of the industry, scale, is itself a product of the globalisation of big business, a trend that the investment banks encouraged their clients to follow. Globalisation amongst their customers required the investment banks to follow suit if they were to offer a comprehensive service. Although specialised regional banks do exist, the industry leaders are all global. Any bank that pulls back from a commitment to global full service is immediately considered to be sub-scale, as recent events have shown at the European firms of Dresdner, ABN and ING. The perceived need to achieve scale has caused a variety of structural changes throughout the investment banking industry. Small and medium sized firms have been bought up, partnerships like Goldman Sachs have gone public and firms previously considered each to have critical mass like Morgan Stanley and Dean Witter have merged. The movement to scale in investment banking has also been encouraged by regulatory changes in the US, in particular the partial dismantling of Glass- Steagall in the past few years. This has enabled financial services groups to combine commercial and investment banking and acquisitive commercial banks like Citigroup have bought up investment banks and brokers and stitched them together as part of huge financial conglomerates. If anything the movement to scale will continue as the availability of ‘one stop shopping’ enables clients to obtain financing and advice from a single bank. Balance sheet strength is therefore likely to become an even more important factor in customer service thus reinforcing the need for scale amongst those institutions seeking a position at the top table. 2. Under pressure As the movements to globalisation and to scale gathered pace in the 1990s and the range of financial services that were being offered by each group proliferated, so the degree of integration increased. During the bull run in world markets in the nineties, no one questioned the model that was being operated by the investment banks. This was the era of the free market economy and shareholder value, doctrines that were endorsed and 2
  3. 3. propagated by the investment banks and that seemed to offer prosperity all round. But last year the bubble burst. Much of the “shareholder value” that had been created was destroyed as the share prices of high tech companies throughout the world collapsed amidst falling demand for the products of many well established companies and doubts about the revenue assumptions that had backed many dotcoms. People wanted to know what had happened, especially in the US, where boom had turned to bust in the most spectacular fashion, and the investment banks have come under close scrutiny. Retail investors have been especially active, seeking to recoup their losses through the courts and arbitration panels. Most investors signed agreements with the brokerage firms that they used which mean that they cannot use the court system but they can file arbitration claimsii. By the end of July, claims filed to the biggest of the arbitrators, the National Association of Securities Dealers totalled 3925, up 24% on last year’s levels. In August six leading investment banks were named in a class action suit and were accused of ‘systematically issuing glowing buy recommendations for securities of technology companies that defendants knew or should have known had dubious financial histories, negative cash flows, insufficient revenues to cover operating expenses and overall deteriorating fundamentals.’iii Action from private investors has been accompanied by interest in Washington through the House of Representatives sub-committee on capital markets. During the summer, having heard evidence about bias in analysts’ research recommendations, the committee warned that legislation might be needed to shore up the Chinese Walls between investment banking departments serving corporates and brokerage departments serving investors. There will be further hearings into the role of institutional investors and the financial media after which, according to the chairman, Richard Baker, ‘the committee will either help develop a best practices standard, make recommendations to regulators or propose legislation if warranted.’ There are several other official inquiries that are underway involving the Securities and Exchange Commission, the National Association of Securities Dealers and the judiciary. Amidst various allegations of wrong doing by investment banks in the underwriting system, a federal grand jury in New York is investigating claims that investment banks received inflated commissions from investors in return for favourable allocations of shares in hot new issues. This spate of inquiries in part reflects bull market excesses and bear market blues. During the peak years of the bull market in 1999 and 2000, when the first day premiums on new share issues appeared to offer guaranteed returns, private and institutional investors saw the chance of easy gains. Speculative investors became very active, investment bankers came under pressure to look after their best clients and in a market where prices seemed only to go up, greed overcame fear. But like all bubbles, this one burst and as usual, investors looked round for someone to blame. Questions about the performance of the investment banks are asked every time there is a major 3
  4. 4. fall in markets. As a fund manager in the Crash of 1987 I remember calling in the brokers to explain ‘their’ actions to my organisation’s investment committee. Later as a Head of Research in the recession of 1991 I remember setting up training programmes to teach the firm’s analysts how to spot warning signs of companies in difficulties and encouraging them to make more Sell recommendations. On both occasions once markets had recovered, we tried to remember the lessons we had learned but within a few years we had fallen back into our old optimistic ways. Much of the current round of discontent is a rerun of such bear market introspection. When prices recover the investors will feel happier, the official inquiries will drop down the political agenda and the pressure on the investment banks will ease. However that would not necessarily mean that everything is all right and there is some evidence that as a result of recent changes in the investment banking industry, there are more fundamental problems. Those working in the industry freely acknowledge that ‘relationship banking’ where the investment banker was primarily committed to the long term relationship with the client has given way to ‘transaction banking’ where the commitment is to the deal not the relationship. One Wall St veteran explains this as follows: ‘It takes a certain level of sanctity for a banker to say “Don’t do this acquisition” when the rewards are so high. Today Wall St is driven by league tables, promotions and bonuses not necessarily what’s good for the client.’iv Another believes: ‘Wall St has always attracted greedy power hungry people. But people obeyed certain rules. Then the old rules fell away and water went to the lowest level.’v If these anecdotes are typical they point to a breakdown in the industry’s ability to police itself, a change that would be important because a measure of self-regulation has always been used to justify integration. Investment banking plays a key role in the operation of global capitalism especially now that shareholder value and the free market economy have become the guiding principles of modern business. Any malfunctioning on the industry’s part would have serious consequences for the operation of the free market economy. It is beyond the scope of this paper to carry out a detailed survey of the investment banking industry’s performance but it is hoped to show that the matter is at least worth further inquiry. Three key areas of investment banking are considered as test cases of the industry’s performance: raising equity capital through Initial Public Offerings (IPOs); research advice; and mergers and acquisitions. A failure in these three areas would require explanation and would point to the need for further investigation. 3. Performance evaluation Initial Public Offerings. In the year 2000, the peak of the cycle, US initial public offerings totalled $100 billion, European IPOs raised E83billion, and UK IPOs a further E14 billion. The market had doubled in size in two years and 4
  5. 5. over a thousand companies floated in a single year. The investment banks can take much of the credit for creating this extra liquidity. However in the US at least, where there is a body of research on the subject, companies have been paying more and more for their IPO. In effect the price charged in IPOs consists of two parts: the commission received by the underwriting syndicate, known as the gross spread and a hidden charge whereby shares are issued at a discount to the price at which they are expected to trade. The discount is expected to be narrow enough for the parties raising capital to believe that they have received a fair price and for the buyers of the shares being issued to believe that they offer a risk adjusted reflection of the company’s prospects. In recent years both of these elements have been increasing. In the US the gross spreads received by underwriters have long been established at 7%. This is about double the level that prevails in Europe and Asia. Jay Ritter at the University of Florida and others have shown that: ‘In recent years over 90% of deals raising between $20-80 million have spreads of exactly 7%, three times the proportion of a decade earlier.’vi In effect this has increased the weighted average spread on IPOs in this size bracket. A similar trend to increased pricing is evident in the second element of charging. Over the last twenty years the discount to the issue price has been steadily widening from 8% over the period 1978-1991, then up to 12% from 1991-1994. In 1995 the initial gain on IPOs exceeded 20%, averaged around 15% in 1996-8 and then soared to 69% in 1999 and 56% in 2000.vii Getting the discount right is the nub of the investment bankers’ job in capital markets activity. It is the part of the process that requires the greatest skill and judgement and it is one of the most important characteristics used by the banks to justify their fees. It is important for the bank to create an active after market and an underpriced issue clearly helps in this. However, the steady increase in the size of the discount to get the deal done raises some questions about the investment banks’ role especially since the lead bank that sets the price is the principal beneficiary of the aftermarket where it dominates tradingviii. The increase in the amount of underpricing and in the prevalence of 7% gross spreads in US IPOs suggests that sell side clients are paying more and more to raise capital. It may be that this is a function of size, that investors require a greater inducement to take the scale of new issues that are now on offer. However the intricate relationship between investment banks and their clients in the corporate and institutional sectors puts the onus on the investment banks to demonstrate that they are handling the conflicts of interest in a way that serves both parties. The increased prices would appear to argue against this. Research advice. The quality of advice given to buy side clients in the form of published research is the second criteria chosen for assessing the performance of the investment banks. Giving research advice to investors is 5
  6. 6. an important part of the investment bank’s role. Analysts’ reports provide the basis on which institutional and other investors make their decisions and research services make up a significant part of the package that is provided to investors. Investors pay for the research by giving the analysts’ firms trading business and commission. As a former analyst with more than my fair share of recommendations that went wrong, I would not like to minimise the difficulties of forecasting nor to draw general conclusions from what happened during a speculative bubbleix. However, if research is providing a value added service it ought to be apparent in the way that analysts’ recommendations perform in the long term and a number of academics in the US and the UK have tracked this. Most measure the success of recommendations by the extent of abnormal performance: did buys outperform the market and did sells underperform the market? These studies generally show that while analysts’ recommendations do produce an abnormal market variance, the scale of that performance is so small as to be virtually useless for fund managers hoping to act on it: ‘high trading levels are required to capture the excess returns generated by the strategies analysed, entailing substantial transaction costs and leading to abnormal net returns for these strategies that are not reliably greater than zero.’x On balance sell recommendations produce a more significant abnormal market variance than buys.xi The problem is that there are very few sell recommendations. The SEC heard recently that 98% of recommendations tracked by the Securities Company were Buys but a more typical pattern is for over 90% of published brokers’ recommendations to be ‘Buy’ and for under 10% to be ‘Sell.’ There are various reasons for this. Analysts are by nature an optimistic bunch: pessimistic introverts would not be able to do a job that requires a willingness to take a view, to get noticed, to endure endless rounds of marketing presentations and to be wrong for a lot of the time. The characteristics needed to succeed as an analyst tend to get reflected in the view that they take, most of them being more likely to describe a glass a half full rather than half empty. This optimism is nurtured by the companies that the analysts follow. Chief executives see delivering shareholder value as their top priority. Helped by a barrage of spin from the investor relations professionals they present to analysts the information on their company in the best possible light as they endeavour to keep their share price up. The analysts are willing supporters since commercial reality gives them every reason to come up with a recommendation to buy. The universe of potential buyers is much greater than the limited number of shareholders who would form the audience for a sell recommendation. Markets have tended to go up in recent years, the institutions are usually cash flow positive and are looking to invest so there is every chance that a Buy recommendation will generate more business for the analyst’s firm than a recommendation to Sell. 6
  7. 7. These bullish tendencies in the system are compounded by the added complication of corporate finance. Under the prevailing American model of investment banking, analysts work for both the corporate finance and brokerage departments. The support of the firm’s analyst is a major influence on an investment bank winning a position in a deal and on how the bank performs in the transaction. Because of the syndicate structure that operates in equity issues most of the leading analysts are working for firms that are involved in big deals or that would hope to be involved in future deals organised by the lead bank. The pressure on analysts to conform is immense. Earlier this year analysts at one American bank were told that all new research on corporate clients had to be seen in advance by an investment banker, a rule that caused a storm in the press but was really doing no more than codifying practice at most other firms. One major European issuer took things to an extreme by writing to all brokers inviting them to pitch for a piece of business but only on condition that all future research on the company would be vetted for a period of 40 working days before and 40 working days after the issue. Although investment banks and the Securities Industry Association have introduced measures to ameliorate the worst of these abuses in recent weeks, they address the symptoms not the cause, which is the difficulty of giving impartial advice to all concerned when working for both the buyer and the seller in a single transaction. Institutional investors have learned how to use brokers’ research: ‘Fund managers accept that even where analysts’ views are compromised by investment banking interests, their insight into a company’s management and performance can still be valuable’xii. However, the interests of transparency and of retail investors who are less likely to be ‘in the know’ than the institutional investors require a less opaque system than the current product which owes more to conflict of interest than to objectivity of research. Mergers and acquisitions. The third area where there is a strong body of academic research to enable us to measure the performance of investment banks is in mergers and acquisitions with most studies focussing on the US and the UK.xiii For shareholders in the companies being acquired, the research points consistently to the creation for them of abnormal positive returns reflecting the premium prices usually paid. But for shareholders of companies doing the acquiring the evidence is more mixed. At the headline level the message is quite strong: ‘A long list of studies have reached the same conclusion: the majority of takeovers damage the interests of the shareholders of the acquiring company….Mark Sirower, visiting professor at New York University and an adviser to the Boston Consulting Group, says surveys have repeatedly shown that about 65% of mergers fail to benefit acquiring companies, whose shares subsequently underperform the sector.’xiv More detailed analysis however shows that different classes of takeovers have different results. Tender offers- public offers to purchase the securities of 7
  8. 8. one company by another- generally create value for acquiring shareholders: ‘while there is strong evidence in our opinion of negative abnormal returns following mergers there is no similar evidence following tender offers. Abnormal returns are predominantly positive not negative’.xv Moreover, hostile takeovers do better than agreed mergers: ’bid hostility has a significant impact and adds 3% to shareholder returns compared to friendly acquisitions’xvi. The merger and acquisition sector appears to support the case for market forces. The transactions with the greatest fees for the investment banks- contested public takeover bids- create the best value for shareholders and in one sense this vindicates merger and acquisition activity. However the results could be read differently if it is argued that away from the area of public scrutiny the investment banks are quite happy to talk their clients into mergers and acquisitions that in the main do not create long term value: ‘While the superior performance of hostile acquirers may be consistent with the disciplinary model of takeovers, the documented evidence that a large number of acquisitions, including many friendly ones, experience negative wealth gains, suggest that acquirer managers are making value destroying acquisitions through hubris, overpayment of bid premium, inappropriate strategy for corporate advantage etc. It also raises disturbing questions about the efficacy of corporate governance in acquirers.’xvii Scoring the three tests. The three areas that we have looked at do not represent a complete range of the investment banks’ activities, excluding, for example important areas such as fixed income, structured finance and project finance but they cover businesses which are substantial and high profile. In IPOs, although liquidity is good in that massive sums can be raised, the extent of the underpricing- generally accepted as the benchmark for the banks’ performance- is widening over the long run whilst the 7% price is holding steady and is becoming the accepted standard for more and more deals. The combination of a fixed spread and widening underpricing means that in effect the issuers are paying more for their capital. In investment research the critical test is whether analysts’ recommendations are right. Only if dealing costs are ignored and if investors acted on a recommendation the moment that it came out can abnormal performance be found. Given the huge sums of money that are paid to and for research, it is doubtful whether investors are getting value and at critical moments, for example during the dotcom bubble, they were let down by the absence of objective analysis. The imbalance between buys and sells is a factor in this lack of success and points to one of the reasons for it, namely a conflict of interest with corporate finance. In our final test, advice on mergers and acquisitions, the evidence is that corporate transactions of this kind destroy value for shareholders in acquiring companies unless the discipline of market test is applied in the form of tender offers or hostile bids. Whilst the poor outcome of non-public mergers does not speak well for the corporations involved or the investment banks that advised 8
  9. 9. them, the results in public bids- the major part of investment banks’ income in this area- suggest that some value adding activity is being performed. 4. Investment banks and the free market economy If the market economy was operating correctly in investment banking, given the explosion in business that has occurred, it might be expected that there would be more competition resulting in falling prices and lower returns for the industry as a whole. In fact the high returns achieved by participants in the industry and pricing trends in certain sectors suggest that the market has not been operating efficiently. One possible explanation for this is that the barriers to entry and the means needed to survive in the industry have been raised, thus reducing the number of competitors and facilitating strategic pricing by those remaining. Rates of return as a measure of competition. The industry is generally regarded as being high risk and volatile but if the market economy is working, it could be expected that through the peaks and troughs there would be some evidence of margin pressure. The investment banks are broadly based financial services conglomerates with a large degree of cross-subsidy and transfer pricing between product lines and it is difficult for an outsider to establish the profitability of individual areas. Brokerage is generally believed to be more volatile and more competitive than any other part of the business. Using Securities Industry Association data on the brokerage activities of the large US investment banks over the last two decades as a proxy for the investment banking industry, the picture that emerges is of much less risk and volatility than might be expected. The average return on equity of large investment banks as defined by the Securities Industry Association was 48%, 1980-4; 22%, 1985-9; 14%, 1990-4; 21%, 1995-9; and an estimated 30% in 2000. In the twenty year period the large investment banks collectively posted a loss only once, in 1994, a year in which bond markets turned suddenly and unexpectedly. The results from individual firms, which reflect the broad spread of investment banking activities and not just brokerage, bear out the high level of returns being achieved. During the 1990s Merrill Lynch’s return on equity fell below 20% in only two years (1998 when it was 13% and 1994 when it was 18.6%), a healthy rate of real return given how low inflation was during this period. Goldman Sachs’ return on average equity in 2000 was 24% and Morgan Stanley’s was 30% in the same year. Goldman Sachs’ results before incorporation are stated before partners’ take and the absolute returns are not comparable with the incorporation but the five year record reveals a healthy trend after the firm’s bond market related problems of 1994-5. The industry’s rates of return are high in an era of low inflation and low interest rates. There is an element of volatility in the results and the slump in markets and market related activity suggests that 2001 will be a depressed year. But over the long run the evidence suggests that after a period in which 9
  10. 10. the industry’s results were unsustainably high ended in 1983, profitability settled down into a relatively stable and lucrative pattern. Only if the boom in capital markets activity in the 1980s and 1990s is considered to be a one-off anomaly can these returns be justified. However this has gone on long enough for it to be considered as a secular pattern rather than as a cyclical event. The rule of markets and the establishment of shareholder value as the goal of business appear to be established. Whilst there will be periods of recession, capital markets activity at these enhanced levels has become the standard operating environment and the investment banking industry has been able to make very large returns. What is remarkable about these returns is that they are struck after substantial increases in compensation. The annual compensation of a good senior analyst trebled from $800,000 t0 $2,600,000 between 1994 and 2000 whilst scores of star analysts working in hot areas of investment banking activity earned a multiple of these numbers. Investment bankers, traders, salespeople and many others enjoyed similar gains. The ratio of compensation to net revenues remained a steady 45-50% during the 1990s, suggesting that employees held on to their share of the massive increase in turnover in this period. The overall effect is that compensation has risen to levels which leave the outside world speechless or not quite in the case of Jack Welch upon his retirement from GE: ‘There are more mediocre people making money on Wall Street than any other place on earth…The outrageous pay in a good year was bad enough. It really drove me nuts in a bad year.’xviii Strategic pricing. Falling prices would demonstrate that competitive forces were working freely as banks strove to win market share by offering customers the best possible price and customers responded by choosing the cheapest top quality supplier. Although in parts of the securities industry commissions are being squeezed and there is price competition in aspects of corporate finance work, in general pricing is not a major factor when investment banks compete for business. Academics such as Chen and Ritter have observed that: ‘Investment bankers readily admit that the IPO business is very profitable and that they avoid competing on fees because they “don’t want to turn it into a commodity business”.’xix Another investment banker is quoted as saying: “The fact is, we’d be cutting our own throats to compete on price.”xx Whilst this raises suspicions of collusion, Chen and Ritter prefer to use the term strategic pricing: ‘The high average spread and the concentration of spreads at 7% is consistent with strategic pricing on the part of investment bankers. In other words even though investment bankers are acting independently, average spreads are above competitive levels. We argue that several features of the IPO underwriting market are conducive to spreads above competitive levels. The importance of analyst coverage and buy recommendations and the perceived importance of underwriter prestige, facilitate high spreads.’xxi 10
  11. 11. The strategic pricing, or implicit collusion, theory has been rejected in another academic study on the grounds that: ‘Low concentration and ease of entry characterise the IPO market. Moreover the 7% spread is not abnormally profitable, nor has it been diminished by public awareness of collusion allegations.’xxii However statements about profitability on individual product lines are meaningless without taking account of higher employee remuneration and the degree of cross-subsidy from other areas. At this stage the case for or against collusion is unproven but it is already clear that the absence of price erosion in investment banking requires further investigation. Barriers to entry. Whilst investment bankers may prefer not to compete on price, there are more important factors than strategic pricing in the apparent failure of market forces to bring down prices or rates of return. Chief amongst these is that barriers to entry exist which has had the effect of reducing competition. Some academics believe that the investment banking market is fluid and very competitive: ‘During the 1980s and 1990s the number of different lead banks grows annually’. The same writer also considered entry ‘into the prestigious top 15 IPO lead banks featured in the Investment Dealer’s Digest League Tables. Seven of the 1998 top-15 are not in the 1985 top 15. Further, over 15 different banks have been a top-five bank at least once since 1985.’xxiii However, this situation requires more analysis. The notion that a top 15 position could be considered ‘prestigious’ would surprise most investment bankers who more commonly regard a top five position as being the minimum for a full service bank. Although fifteen banks have held a top five position since 1985, this high turnover actually illustrates how hard it is to gain entry as more and more banks try and fail to gain a foothold and are forced to give up. Furthermore, the position changed once scale became such a critical factor in investment banking in the 1990s. In the US and in the UK, medium sized players were bought up by their larger rivals as the giants jostled to achieve critical mass. Combinations of businesses on the scale of Citigroup/Travelers/Salomon/Smith Barney/ Schroders, Morgan Stanley Dean Witter, Bank of America/NationsBank/Montgomery Securities, CSFB/DLJ redefined scale. It became all or nothing as firms decided that if they could not achieve a position in the global top six they needed either to redefine their business to a focussed niche or merge with a bigger player. The need to achieve scale in order to compete became a major barrier to entry and a pre-requisite to survival that few were able to meet. The grip of the bigger firms can be illustrated by reference to the league tables for Global Mergers and Acquisitions over a period of time. In 1999 the global top three advised on transactions that were in total 50% bigger than those of the rest of the top ten combined. A decade earlier in 1989, the top three’s total was smaller than that of the rest of the top ten combined. The top three banks are Goldman Sachs, Merrill Lynch and Morgan Stanley with JP Morgan Chase, Citigroup, and CSFB not too far behind. Outside of this group are some excellent firms including a couple of Europeans with realistic 11
  12. 12. aspirations to join the bulge bracket, but market power, including the power to set the terms of trade lies with primarily the top three firms. 5. A rich person’s club This paper has tried to test whether the current round of criticism facing the investment banks is anything more than a case of sour grapes inspired by losses in the bear market. Using three tests, there is some evidence that the investment banks are not delivering to clients in the areas sampled. IPOs are becoming more expensive, research advice is often biassed and mergers and acquisitions are delivering mixed results. Ironically given that the investment banks were the chief proponents of the principles of free market competition and shareholder value that now shape business in the developed world, there is some evidence that the leading investment banks have been sheltered from these forces. High rates of return and increased prices in certain areas are not what we might expect from a maturing industry if open market competition applied. In fact competition reduced once scale became necessary in order to compete as an investment bank. The need to be big to compete forms a major barrier to entry and to continued success. The investment banks in the US and the UK have consolidated as a result and market power is now in the hands of three, arguably six, American firms. It is beyond the scope of this paper to judge whether they are abusing that power but it might form a fair topic for future research. The current round of complaints and investigations might unearth some form of misuse of market power or they might conclude that speculative excess is a normal bull market phenomenon. Either way the investment banking industry would be a lot more transparent if it was structured differently. A starting point would be to separate brokerage and corporate finance activities leading to a different structure for syndicates that would exclude the client’s adviser from capital markets syndicates. This would do much to resolve the inevitable conflicts of interest that arise when advising both parties to the deal. Similar separation might also be strengthened between brokers’ proprietary trading and customer execution departments. It is surprising that neither the regulators nor the investment banks’ clients have done much to force change. The industry’s chief regulator in the US is the Securities and Exchange Commission, a body that has imposed structural change on the auditing profession to resolve a conflict of interest between audit and consulting clients and a price fixing settlement on Nasdaq in 1999 yet which seems to ignore the more blatant conflict in investment banking. Sceptics will point to the impeccable political connections of senior investment bankers who glide effortlessly between Wall St and Washington. More likely however is the crucial role that investment banks play in the global economy leaving Governments reluctant to disturb them. 12
  13. 13. Buy side clients- the investing institutions- have been more active in exerting pressure on the investment banks than have corporate clients on the sell side. Buy side clients have squeezed commissions down over the years and increased the amount of net trading. They have been less active in addressing the conflict of interest issues but they know that research advice is tainted, treat it accordingly and do not put a high value on it. A more significant conflict of interest occurs in execution between client and proprietary trading but this is less visible and more difficult for them to tackle and this is one area where stronger external regulation is required. Corporate clients have been less active in forcing prices down. To some extent this is because unlike institutional clients who transact many times a day, a corporate action is a rare event. Chief executives dare not get it wrong and they tend to choose the most prestigious names to act for them and not to argue with the terms that they set. The consequences of having a disgruntled financial adviser are much worse than paying a point or two more for the transaction. I was recently asked to advise a company on its investment banking relationship and suggested that fee negotiation might form an element in the discussion. The company’s management raised it with the lead bank and were told that they never negotiated on fees. This is supported by other evidence:’ When clients demand a reduction, investment banks dismiss the subject. It’s not that firms conspire to fix fees. Each one simply refuses to compete on price and since Wall St is a clubby enclave dominated by half a dozen players that regularly participate in one another’s deals, it’s hard for low cost gate crashers to break through. Cutting fees would mean reducing bonuses which is anathema to Wall St.’xxiv Although authors have been proclaiming an end to the club since Chris Welles first coined the term in his review of Wall St in 1975xxv, the evidence in fact suggests that Wall St is indeed ‘a clubby sort of place’. Despite the talk of level playing fields and open market competition, Wall St and its little brother in the City of London still show the characteristics of a rich person’s club in the form of barriers to entry and survival. In many respects, including the gulf in compensation between investment bankers and the rest, the club lives on. 13
  14. 14. i Philip Augar Death of Gentlemanly Capitalism Penguin London 2001 page 72 ii As occurred recently between Merrill Lynch and a retail investor seeking redress against one of the firm’s star analysts, these are often settled between the parties. iii Financial Times 6 August 2001 iv Felix Rohatyn, former Wall St banker and US Ambassador to France in Fortune, 14 May 2001 vol 143 issue 10 pages 84-88 v Michael Tennenbaum, former vice chairman investment banking, Bear Sterns, ibid vi Hsuan-Chi Chen and Jay R Ritter, The Seven Per Cent Solution, Journal of Finance, vol 5 June 2000 pages 1105-1131 vii Robert S Hansen, Do investment banks compete in IPOs?, Journal of Financial Economics 59 (2001) 313-416, page 337 and Jay Ritter, University of Florida, bear.cba.ufl.edu/ritter viii One of the lines of enquiry in the current round of investigations is the National Association of Securities Dealers interest in whether the banks have been favouring certain clients with generous allocations in the hottest new issues in return for commission paying business later. ix Richard Barker, ‘Determining Value: Valuation Models and Valuation Statements’, FT Prentice Hall, London 2001 x Barber et all, Can Investors Profit from the Prophets?, The Journal of Finance, vol 56: issue 2 pages 531-563 xi Richard Taffler and Paul Ryan, ‘Do Brokerage Houses Add Value?’ Cranfield School of Management Working Paper, xii James Rutter, Global Investor, Financial Times, 7 September 2001 xiii A Agrawal and J F Jaffe, The Post Merger Performance Puzzle, Advances in Mergers and Acquisitions Volume 1 pages 7-41 and P Sudarsanam ibid pages 119-155 xiv Financial Times 12 April 2000 xv Agrawal and Jaffe op cit page 14 xvi P Sudarsanam, op cit page 143 xvii ibid xviii The Guardian 6 September 2001 xix Chen and Ritter op cit xx Ibid xxi ibid xxii Hansen op cit xxiii Hansen op cit page 329 xxiv ‘Betrayal on Wall St’ ,Fortune, 14 May 2001 vol 143 issue 10 pages 84-88 xxv Chris Welles, The Last Days of the Club, E.P.Dutton & Co. New York 1975 David Kynaston, The City of London: A Club No More, Chatto & Windus, London, 2001

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