The rise and fall of investment banks

R. Viswanathan

Barely five months ago, five big investment banks straddled the five continents but now none of
them exists in its original form. All of them were based in Wall Street, New York and had
tremendous influence over financial markets all over the globe: only half their income came from
the US. Four of them have offices in India and their recent woes were considered largely
responsible for the violent gyrations in the Indian stock market.

The five big ones, called bulge-bracket, standalone investment banks (I-banks) were, in the order
of their establishment, Lehman Brothers (1850), Goldman Sachs (1869), Merrill Lynch (1914),
Bear Sterns (1923) and Morgan Stanley (1935).

All of them became the victims of the current financial turmoil in the US and have changed their
identity during the last four months. Bear Sterns and Merrill Lynch were taken over by
commercial banks, Lehman was wound up and the other two have now become commercial
banks.

I-bank model

The standalone I-bank model was unique to the US, born out of compulsion. Similar institutions
called merchant banks existed in the UK for well over two centuries. All of them in the UK were
bought over by I-banks of the US or big commercial banks.

The great stock market crash of 1929 in the US brought about drastic changes in the financial
sector, the most important of them being the Glass Steagall Act, 1933 which separated
commercial banking from I-banking. This was based on the premise that investment in markets
was too risky for commercial banks to undertake. From then onwards till late 1990s banks were
prohibited from engaging in share-broking or investing in shares. This gave a fillip to I-banks to
fill in the void and expand their activities. In fact, Morgan Stanley was started after this Act. The
Act was repealed by Gramm-Leach-Bliley Act of 1999 in the US and now commercial banks
there can be universal, viz., can engage in investment banking also.

Over a period, the juicy income from trading (buying and selling) on their own account was
alluring and they started proprietary trading. They could not, however, access funds from public
by way of deposits, but raised money in the markets, by way of commercial paper, bonds etc.
These funds were, in turn, provided by commercial banks, mutual funds and even members of
public. Thus, I-banks became one more tier between savers (depositors) and investors
(borrowers). However, Federal Reserve Bank in the US had no control over I-banks.

Poor regulation

Commercial banks were tightly regulated by authorities the world over as failure of one bank can
have ripple effect on the system (systemic problem). But, I-banks which borrowed from
commercial banks were lightly regulated by SEC in the US (the counterpart of our SEBI). And, it
is reported that SEC had, in the last few years, removed the ceiling of 12 times capital placed on
the borrowing limits of I-banks.

The result was that I-banks went on a borrowing spree: Bears Stern and Lehman had a leverage
of over 30, i.e., their borrowings were over 30 times their capital. With money easily available,
they invested in sub-prime mortgage loans, which were loans given to people called Ninja (no
income, no job and assets).

These loans were given by banks but they sold (transferred) them by packaging and selling
through special purpose vehicles. In structuring these transactions, it is alleged that the leading
credit rating agencies also played a part, by categorising a pool of loans as good, without full
enquiry.

A VICIOUS CIRCLE

It was a giant façade created a few years ago in the US and many financial institutions from
various countries were caught in the web. When the loans turned sour, commercial banks that
sold them realised that they were also affected, as many of the holders of sub-prime loans had in
turn raised money from banks.

Thus, the vicious circle was rounded. Banks lent to Ninja, sold the loans to I-banks, who
borrowed from banks and two big I-banks went broke, thereby endangering the banking system
itself.

Of the two, which went broke, one, Bears Stern was saved by absorption by a commercial bank.
Interestingly, the US Federal Government provided guarantee to the bank that took over Bears
Stern. The Government did not, however, provide any succour to Lehman. Merrill was also taken
over by a bank. The remaining two, Morgan Stanley and Goldman Sachs, stood as I-banks for a
short time but bowed to the inevitable and converted themselves as commercial banks.

CATASTROPHE, TSUNAMI

This means that they will be able to raise money from public by way of deposits: these are
cheaper and more stable than other resources. In return, they have to subject themselves to more
rigorous control from authorities and their borrowing powers are also likely to be curtailed. Thus
ended the saga of I-banks. Looking back, they became big because of the financial catastrophe of
twentieth century and have been swept away by the financial tsunami of twenty-first century.

There are two interesting lessons that can be learnt from the current turmoil. One, even the
grandmother of all capitalist regimes, the US, with unflinching faith in markets, will bend
backwards to intervene in the markets and nationalise or provide taxpayer’s money to save
imprudent financial institutions that got clobbered by the market.

So, the Indian authorities should remember that whether it is the US or the UK or Japan, the
authorities will all shed their faith in the market mechanism and protect the financial well being
of their citizens in the event of a catastrophe. Another lesson is that in so saving foolish financial
institutions, they will not help the smaller ones. The US authorities helped Bears Stern and not
Lehman, because the former had created a bigger mess than the latter. Truly, it is said that the
principle of “Too Big to Fail” would operate in such cases.

Big is bad?

This brings us to another interesting issue. Should financial institutions be allowed to become too
big? A very big one, especially in the private sector, might perhaps create huge problems for the
economy, if the management becomes lax and/or greedy. Therefore, there is a good case for not
passionately pushing for merger of big banks. In fact, this writer would argue for the growth of
regional banks in India. The three Southern States of Tamil Nadu, Kerala and Karnataka are
homes to good small banks in the private sector and these deserve to be nurtured along orderly
lines.

To conclude, all institutions that raise money from public, directly or indirectly, should be
properly controlled by the central bank of the country and fascination for big private banks is not
fully justified.

(The author is a former Deputy Managing Director, State Bank of India.)

Question:

Summarize the article and identify the reasons of systemic failures.