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The REAL Challenge for Investment Banks, Part II…

  
  
  
  
  

"Finally, the business model of the investment banks is almost certainly going to change. Over the last 20 years, investment banking went from primarily an advisory business to being mostly a business where firms traded their own accounts – so-called proprietary trading."

- It's Not the Bonus Money. It's the Principle. New York Times, January 30, 2009

In Part 1 I described how investment banks in the current day are no longer organized to adequately address the needs of their clients. This will take a great deal of soul searching to correct. If this weren't challenge enough, the longer term secular trend is a more fundamental problem resulting from the information age and how it affects the traditional IB business model. In fact, I spoke to a comptroller of a state agency just last week on this very topic. His situation embodied the challenge (details below).

The Rise of Navigators

We live in an age of practically boundless information; we can consciously process far less than the 20 Mb/s rate I have at this computer. This information deluge, unorganized, paralyzes and renders us fearful of making suboptimal or just plain bad decisions. What has naturally emerged to help us cope with all this data is the information aggregator, or "navigator", which at this point we all find pretty valuable. There are many types of navigators, from Consumer Reports to Orbitz to the parent most qualified to give advice about raising the kid(s). In this day, the canonical ones are those with the big market caps: search engines like Google, Yahoo, YouTube, etc. Now we even have social navigators to organize our professional and personal relationships i.e. LinkedIn, Spoke, and Facebook. The feature that navigators share is that they aim to be (largely) unaffiliated with any particular buyer or seller. In fact, information businesses everywhere must understand that affiliation is now a very real and powerful axis of competition.

So what does any of this have to do with investment banks? Don't they sit at the top of the economic food chain above all of this stuff? Not remotely. This leads me back to my story about the comptroller. This particular state finance official was wrapping up an advisor request-for-proposal process and was curious about our capabilities. In response to why he was going through this process now, he told me that for the decade plus that he'd worked there, their investment bank (whom they only changed once) had run all of the numbers. But now, they're planning on a financial advisor running the numbers because, "We want to make sure the advice we're getting is solely in our interest."

The REAL Challenge for Investment BanksWhat Information?

Obviously, one instance does not make a rule. But the increasing awareness and commensurate skepticism associated with the sources of our information is surely not an isolated trend. Investment banking clients want either unaffiliated information or better yet, information that they feel is purely and unfailingly affiliated with them. Investment bankers always walk through the door with their bank's name on their business card. In the back of the client's mind is that name. Rightly or wrongly, along with it is an ongoing question of whether the information coming from that banker isn't perhaps a bit influenced by the interest of her/his employer.

Bankers are hardly defenseless; they can do a great deal to fight the good fight. I personally haven't seen it yet, but that's a topic for another post…

ps Many thanks to Professor Orr for the penny image above.

The REAL Challenge for Investment Banks: Part 1

  
  
  
  
  

"Number 10: Never give up on an idea simply because it is bad and doesn't work. Cling to it even when it is hopeless. Anyone can cut and run, but it takes a very special person to stay with something that is truly stupid and harmful…"

Wall Street Michael Douglas- George Carlin, Fifteen Rules to Live By

It's popular these days to jump onto the "Wall Street versus Main Street" bandwagon and say all investment banks are inhabited by dark lords of money, all blood relatives of Gordon Gecko, though more greedy and substantially less charming. I'll go out on a limb here and say that I generally don't agree. I've known plenty of investment bankers – many of them extremely dedicated, hard working, and bright, and in my experience kind (unless you're a starting analyst, but that's another story…). Yes, they're commercially minded but that's the nature of the business. And though I admit that the ego/ability ratio by which I occasionally assess a finance professional can be skewed towards the numerator (sometimes grotesquely) all in all these are usually talented, driven professionals.

That said, whatever new financial regulatory system comes down the pike, investment bankers will still exist and will still serve a critical function as capital raisers for companies that need it. However, they've got two big problems that need to be addressed: one is a functional and organizational misalignment with clients (discussed below); the other is a more fundamental conflict between the information age and the traditional IB business model.

The Organizational Challenge – Misalignment with the Client

Investment banks are not organized in a way to efficiently provide services that the client wants. To a large degree, investment banks today remain silos of product knowledge organized through a traditional command and control hierarchy with managers and staffs. Each business manager and her/his team tries to achieve certain budgetary goals and targets set at the beginning of each fiscal cycle. Within investment banks these groups tend to line up with the various services and products that the bank provides. Many are divided along market lines: interest rate, currency, energy, commodity, etc. This structure has been exacerbated in recent years as IBs have moved more and more away from their traditional roles as consultants and deal-makers for raising capital, to levered risk takers managing the IBs balance sheet aggressively through prop-trading. To add to the problem, every two or three years the IB alternates between organizing across market lines and geographic lines. In both cases, IB management seems to either ignore or misunderstand the functional needs of their clients.

Investment banking clients by contrast are concerned with some combination of risks due to the nature of their current or anticipated balance sheets. However, concepts behind risk across multiple asset classes are subtle and often counterintuitive. Standard deviation or "volatility", the most frequently used proxy for a risk measure is not a simply additive term. In volatility terms, one plus one can equal anything between zero and two, and is usually somewhere in between. This truth currently manifests itself in the frequently misunderstood topic of "asset/liability management".

In short, clients face multiple market risks at once and are managing them in a portfolio. A bank is a conglomeration of products that buy/sell each of the risks the client faces but have little cross-product interaction or understanding. And the incentive structure internally at an investment bank amplifies the silo problem. An investment bank is not functionally aligned to understand its clients perspective, and therefore, to really address their needs. Investment banks are set up to sell products; IB clients want to receive high quality analysis of those products in aggregate as it relates to their specific situation, as a service. Do banks want to provide this service and if so, what does it look like? How does the bank get paid for it? Why should the client believe in the analysis? Does the banker's affiliation with her/his employer result in an increasingly skeptical client perspective? I'll leave some answers to that for part II….

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