Wall Street Investment Banking Model Collapses

Rakesh Saxena

Director, Risk Pr...

Since equity market participants have been busy finding answers to the challenge of unprecedented volatility (VIX), the decision by Goldman Sachs (GS) and Morgan Stanley (MS) to seek banking licenses has gone largely unscrutinized. As the official talking points suggest, a change in status will provide maximum flexibility and stability to pursue new businesses; in reality, if the facts are properly contextualized, it is safe to assume that elite institutions on Wall Street are abandoning the core components of the very business model which created the basis for phenomenal, sustained profits (and bonuses) over the previous three decades. And for good reason, one might add.

The widespread perception is that the more-than-impressive historical performance of New York\'s investment banks was a result of a superior balancing of leverage and risk. But, risk aside, the leverage employed was never fully captured in their financial statements. The crisis in the credit default swap market, for example, may well be a consequence of counterparties assuming insurance-related risks without sufficient actuarial foundations; but more importantly, the leverage itself violated all standard capital adequacy ratios. It is easy to blame the trading community for this mess; but, in essence, it is the abject failure of the accountants and auditors, and lawyers in many instances, to highlight contingent risks (in the event of default) which enabled the dealers to continue pricing an entire series of derivatives, day in, day out.

In other words, the classic investment banking model was, in a fundamental respect, incapable of generating the type of profits which featured in news headlines for so many years if prudent accounting governance was in place. The multi-faceted business models of Citigroup (C) and Bank of America (BAC) prove that the relationship between traditional banking and leverage-driven investment banking is nebulous, at best; the more reasonable conclusion, in fact, is that the two activities are predicated on completely separate parameters of risk management, asset behaviour, counterparty mechanisms and mark-to-market principles.

In specific terms, traditional banking incorporates counterparty risk on an asset-by-asset basis, while the investment banking model relies on the rating agencies to provide a broad evaluation of counterparty creditworthiness. Furthermore, to take the credit default swaps as a significant contrasting example, traditional banking effectively forbids short position on underlying assets or reference instruments. Finally, at the risk of being presumptuous, it is apparent that guiding (and indeed brilliant) minds at Goldman Sachs and Morgan Stanley have realized that the increasing demand to comply with rigid capital adequacy benchmarks will, inevitably, curtail the quantum of leverage, and reduce a large percentage of the related profit forecasts.

What impact will the adjustments in the investment banking model have on valuations? That is the question which investors should ask themselves in forthcoming weeks. It is simply not sufficient to say that free cash should be chasing Warren Buffett (GS) because, as the visionary himself has clarified more than once, his time horizons and objectives (and deep pockets) may well differ substantially from those of hedge fund managers, arbitrage traders and, for that matter, from the man on the street.

For starters, one still needs to wait for the losses to fully unfold. From that perspective, this freeze in the counterparty risk matrix has delayed a thorough and verifiable assessment of who lost, or is currently losing, how much from the tens of trillions worth of outstanding swaps, insurance and structured contracts. What has also been postponed is the potential need for another bailout by the Fed and the Treasury, not only for banks but also for corporations who populate the derivatives universe.