Death of Investment Banking - The New Wall Street

September 21, 2008 will be etched on the tombstone of the investment banking industry. The day marked the death of investment banks in America. On that day, the last two remaining independent U.S. investment banks, Goldman Sachs and Morgan Stanley, converted themselves into commercial banks, which take consumer deposits, a more conservative source of money. With the move, Wall Street as it has long been known - a closed group of independent financial institutions which advise clients, buy and sell securities, provide brokerage services, etc, and are less regulated than traditional, old-fashioned banks - will cease to exist.

Goldman & Morgan will now be under stricter Federal regulations that govern bank holding companies. This followed the earlier transforming events with the other three major Wall Street investment banks: Merrill Lynch, Lehman Brothers and Bear Stearns sought bankruptcy protection or merged into larger commercial banks. The immediate motivating factor for the move by Goldman & Morgan, given their precarious financial health, was to gain eligibility for the Federal financial support that is available only to commercial banks.

The two main reasons, in my opinion, that brought the end of investment banks were:

• High financial leverage: Banks operated by borrowing extremely high level of debt compared to their asset value. Lehman Brothers financial leverage was 32 to 1 when it was swallowed from the brink of bankruptcy by Barclays Capital - meaning, Lehman held $32 of debt on its balance sheet for every dollar of equity. Bear Stearns' leverage was 33 to 1 when it failed, and during the last quarter, Goldman Sachs and Morgan Stanley had leverage ratios of 24:1 and 25:1, respectively.

• Playing with complex derivative securities: Banks engineered complex financial derivatives - securities that derive their intrinsic value from other underlying assets - which were too difficult to fully comprehend, and hence manage. As it turns out, some of my undergrad engineering classmates from IIT were among the architects of these financial instruments. In recent years, many investment banks had hired a slew of mathematicians and engineers with PhDs and other advanced technical degrees to design new, complex financial derivatives in order to spread risk of their bets and increase liquidity. These derivatives were openly traded, changed hands several times over, and ended up finding home into the balance sheets of banks and even some non-financial institutions all over the world. The process got so deep rooted, that at some point it became impossible to estimate the true risk exposure of institutions holding these securities. Risk management function therefore got severely compromised. So, when the underlying assets of these derivatives, the U.S. real estate, crashed in value, there was a domino effect across all entities holding assets tied to it.

Let me share a personal account about my own career decision. In the summer of 1996, I did two internships while I was in the business school. I had moved to the U.S. from India a year earlier for my MBA, and had never worked before in the U.S. I therefore wanted to maximize my industry exposure in the country before picking up my career field upon graduation. One internship was in investment banking with Smith Barney, and the other was with an Internet start-up. Smith Barney paid me three times more money than what the start-up could, but I had at least three times more fun with my start-up gig. I felt I added significantly more value at the start-up - I helped it grow revenue by 50%+ and played a key role in its successful IPO later that winter. Upon graduation, I chose a career in the Internet/technology space. Investment banking, a much more financially rewarding career, was however never going to be personally as fulfilling for me.

Investment banking is a support industry that provides services for corporations which build real products for the consumers. That notion somehow got lost in the era of excess over the last couple of decades, when investment bankers took home obscene amounts of cash by taking unduly high risk with other people's money. Twenty-something years old making seven figures trading mortgage-backed securities was an example of such excesses.

Risk taking was encouraged, with limited downside. If your bet worked, you could make several multiples of your base salary in bonus. If your bet failed, you could still walk away with the salary, loosing just the bonus. That is assuming the results of the failure showed up during the same period when the bet was made - in many cases, the incentive structure allowed bankers to postpone repercussions of their actions sometime in the future while reaping the rewards today.

This mismatch in the real world between activities that allowed accumulation of significant personal wealth and activities that created and sustained real value in the economy obviously affected how young students made their career decisions. Investment banking became the most sought-after and glorified job in business school campuses.

I don't have any objection with, for example, hedge fund managers making ten figures - that's right, over billion dollars a year - gambling with rich people's money (only high net worth individuals or institutions are allowed to participate in hedge funds). Until, of course, hedge funds become "too big to fail" and taxpayers have to bail them out (remember Long Term Capital Management), but that's a debate for some other time. The investment bankers however were playing around with funds tied to the Main Street, e.g., pension funds and 401ks of the common man. No wonder there is a huge public outrage with current bail-outs being handed out at taxpayers' expense to the Wall Street.

In a related distortion, CEOs of corporate America started demanding higher salary seeing tens of hundreds of million dollar payouts to their Wall Street counterparts. In 1970, CEOs in America were paid 28 times more than the salary of an average worker (vs. lowest paid worker) in the country. By 2005, the salary gap had ballooned up to 485. That's right, a CEO got paid more in one day than what an average worker earned during the entire year.

So, what will change now. The new Wall Street is going to look very different. The industry will be much smaller. Excess risk taking is a thing of the past. Since high risk enables high rewards, executive payouts on the Wall Street will reduce substantially. The party is over. Many old functions and practices will no longer exist.

The most important change however will be in the new funding architecture of financial institutions. Until now, banks operated in a totally free market funding environment that provided plenty of sources with just-in-time capital availability and extreme liquidity. That will change. In the current crisis environment, central banks globally have become the sole source for large funding needs of financial institutions. FDIC insurance is needed if large debt has to be raised in the U.S. This is, obviously, not sustainable.

The President-elect Barack Obama's new administration will need to work with financial institutions to establish the norms of a new funding architecture for the industry. Given the global nature of today's capital markets which enable global access and movement of capital, a level playing field will need to be created across different jurisdictions globally. The G-20 countries will need to work together to ensure this. The joint communique issued by the G-20 leaders during this month's hastily arranged economic summit by President Bush in Washington D.C. seems to be a good start, but real work has been postponed until April 2009, in order to let Barack Obama settle down in the Office after assuming the U.S. Presidency in January. Lastly, the new Wall Street will have to settle for much greater Federal regulations, and higher transparency, at least to the regulators who will provide the oversight.