The REAL Challenge for Investment Banks: Part 1

Posted by Peter Orr on Feb 08, 2009

"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….