The problem with investment banking (part 1)

The Problem with Investment Banking (Part 1)

Bankers would like us to believe that what they do is fantastically sophisticated and requires huge talent and massive intellectual prowess. It is on these largely false grounds that they try to persuade us that they deserve the often obscene levels of pay that they award themselves.

I am a firm believer in the profit motive and the incentive for progression of civilisation that the markets provide for society. I am a particular supporter of the market when it comes to entrepreneurs taking real risks with their own capital to create products which are needed by mankind.

But when we read about a British oil trader working for Citigroup who is apparently in line for a $100m (£60m) bonus, we are bound to ask how can any employee deserve to be paid such unbelievable amounts of money? What risk was this person taking with his own capital that makes him deserve such a huge payday? What Andrew Hall (for that is his name) does is take huge bets with Citigroup’s clients’ money (leveraged to increase total exposure) and receives a commission/performance bonus depending upon results. Does he risk his own money NO! If he bets the wrong way and clients and his employer lose billions does he have to chip in and repay bonuses earned in earlier years? NO! OK he may lose his job but how difficult is that going to be for someone who has extracted such huge value from the market and from his own employer – who, by the way, has lost $30bn over the last year and is now effectively owned by the US taxpayer.

My point is that this situation is reflected not only on the trading floors of these financial behemoths but throughout the investment banking universe. The risk reward profile exemplified by the likes of Mr Hall is completely unacceptable in all other walks of life – so how is it allowed to continue to exist in the largely discredited and dishonest world of investment banking?  The chemist who creates a new top-selling anti-biotic or the person in McDonald’s who came up with the chicken nugget have ultimately made hundreds of millions of dollars for their employer but do not expect to receive millions of dollars in bonuses.

Banking is a utility more akin to the provision of electricity or telecommunications than a normal competitive market. Anyone who wants to take part in modern society needs to have money and almost everyone who has money has to have a bank account. Similarly investment banking has strong utility like aspects particularly in areas such as advice on mergers and acquisitions and IPO‘s for example. Worse still, the limited number of firms that are able to offer such advice (due to, among other things, their required balance sheet strength or regional representation) means that the industry operates more like a fantastically expensive and monopolistic cartel than the highly competitive marketplace that they would have us believe.

This leads to fee structures for, say, a $500m convertible bond issue that are almost the same whether you go to JP Morgan, Goldman Sachs or Morgan Stanley. In fact, pick any 2 significant investment banking deals of a similar class over the last 20 years which were led by different global banks and you will find that the total fees earned by the advisers are statistically so similar as to make no difference.

Bend over it’s Investment Banking time!

All bankers know what fees are charged as the ‘market rate’ in their part of the business and it is in none of their interests to compete on price. Indeed, I have been present when one senior banker at my firm went into a rage and threatened to chase a competitor “around the world with a red-hot poker” when he had the temerity to make an amusing comment involving the implied reduction of an underwriting fee for future deals. So instead of fierce competition between banks to attract clients, you have the façade of competitiveness based upon much less meaningful issues such as which bank has completed the most deals, research coverage of  a potential client’s sector etc. There is too much work for only one bank to execute so this way everyone gets at least a few deals and given the fixed pricing even a few deals means bumper pay days for all involved.

The general rule of thumb for a M&A transaction is that the advisor(s) will take one half of one per cent of the total value of the deal in advisory fees whether they win or lose – win only success fees are increasingly prevalent although these tend to be agreed only when the bank believes it is almost certain to be on the winning side and the associated bump in fees will often be multiples of what would normally be expected. Additionally, there will be significant fees for underwriting and other structured products that follow-on from the deal. This means that advisers on a $100bn deal (for example, the disastrous RBS takeover of ABN Amro) will often walk away with over $1bn in fee and related income. Not bad for a typical 10 man deal team working for 3-6 months. I cannot think of any other job where such huge fees can be earned for such little work – of course I have never been on the receiving end of the Bush regimes’ multi-billion dollar largesse to service providers in Iraq so I accept that I may be wrong.

Some bankers will try to confuse the issue by suggesting that they take risks with their own capital by underwriting deals. Such underwriting is an important function of the banks and without it deals would happen far less often and would be far riskier for the companies involved. But reward for risk? There are two main types of underwriting that banks take part in. The first and overwhelmingly most prevalent is known as “soft” underwriting.

Soft underwriting is a virtually risk free activity which in an IPO, for example, involves a bank finding buyers for 100% (or usually more than 100%) of the stock it would potentially have a risk of owning itself before it will agree to sign the underwriting agreement. This means that even though the bank never actually bears the risk of owning any stock itself it can quite happily charge a client, say, 1% for the ‘underwriting risk’ – usually this will amount to several million dollars.

So called hard underwriting is extremely rare and commands higher fees. In this case, the bank will actually commit to buying some stock at a pre-agreed price. The key here is that the bank will charge higher fees (at least double for underwriting alone) and then will insist on receiving the stock at a deep discount to the prevailing market price of the shares. The discount is usually so deep that the bank can also make a considerable return on the margin i.e. the difference between what it pays the company for each share and what it sells that share for in the market place.

This anti-competitive and oligopolistic pricing behaviour leads to a massive mis-allocation of capital away from businesses that produce wealth to bankers who are doing little more than leveraging their position as a utility by providing the pipe work for completing a merger or an IPO.

Amongst the industry’s greatest successes has been its ability to persuade us that it is somehow more than it is.  Its use of opaque terminology like “collateralised debt obligations”, “swaptions” and “credit default swaps” helps to perpetuate a mythology that bankers have some extraordinary ability that makes them deserve to be paid 100 times the average UK salary.  Well it is simply not true and if we honestly want a fairer society it is about time that we all woke up to this huge deceit and did something about it.

*1.7.13 Addendum: Remember that the Conservative Party (George Osborne and David Cameron in particular) wanted to REDUCE regulation on the banking sector in 2007. For a party still funded largely by financial services companies that is hardly a surprise; but you should look for the parts of the Independent Commission on Banking’s report that are not part of the Banking Reform Bill to see how truly invidious the City’s influence over the Conservative party has become. More about which I am sure will appear in future posts.

Written 6 August 2009 (Updated 2.7.13)

A bit of fun: The Great American Bubble Machine. by Matt Taibbi in The Rolling Stone Magazine (http://tinyurl.com/american-bubble-machine)

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