More on why big capital markets players are unmanageable

Submitted by Edward Harrison of Credit Writedowns.

Yves had a very good post yesterday called “Why Big Capital Markets Players Are Unmanageable” on banks: the former i-banks and commercial banks. The biggest takeaway for me came from her statements regarding the level of responsibility that a junior level employee in an investment bank can have. She says:

What makes capital markets businesses different from any other form of enterprise I can think of is the amount of discretion given of necessity to non-managerial employees, meaning traders, salesmen, investment bankers, analysts. In pretty much any other large scale business, decisions that have a meaningful bottom line impact (pricing, new sales campaign, investment decision) are deliberate affairs, ultimately decided at a reasonably senior level. The discretion that customer-facing staff have in pretty much any business in limited. At what level does someone have the authority to negotiate a contract? And even then, how many degrees of freedom do they have?

That is a very significant factor in investment banking that makes it risky. Think about the blow-ups that have occurred in trading enterprises from SocGen to Sumitomo to Barings Bank. In most enterprises, most junior-level employees don’t have the decision-making authority necessary to allow these mistakes to happen.

But, Yves’ post got me to thinking a bit more about investment banking itself and the change in emphasis within firms. John Gapper at the FT had a revealing post yesterday on just this subject. He writes:

There is excited talk of investment bankers reclaiming the power and mystique that veteran rainmakers such as Joe Perella, Robert Greenhill and Roger Altman (all of whom now ply their trade at boutiques) once enjoyed at big banks, rather than being trained as technicians and treated as such.

How seriously should we take this? Not as seriously as the bankers do, it is safe to say. There will always be a place in the boardroom for a few senior advisers with the skills and temperament to give thoughtful and unbiased advice to chief executives facing big, risky decisions.

“Sometimes a chief executive needs a surgeon to operate but sometimes he needs a GP who understands people and politics and governance. The best banker can rise above the short-term deal,” says one.

But, valuable as that job may be to the client, it is a niche activity for large banks. Investment banking – advisory work and underwriting – brought in less than a tenth of Goldman Sachs’ net revenues in the first quarter and was dwarfed by trading and principal investing.

When a bank can earn $30m for making a lending commitment to a company that is acquiring another and only $5m for advising on the merger, it tends to value the former over the latter. Advisory work brings prestige, while financing and lending bring in the big bucks.

Did you see where Gapper says only one-tenth of the earnings comes from traditional advisory work? Today’s investment banks look nothing like their brethren of yesteryear. For all intents and purposes, banks today are giant hedge funds – at least in comparison to what they once were. It is sales & trading that is dominant at today’s firms and that has great significance regarding risk and compensation.

A brief history

Before I get into what things look like today, let me give you a (very) brief history of Wall Street’s structure from the 1920s onward. Back in the roaring 20s, the United States had the Universal banking model. JP Morgan was the king of the hill, with a huge advisory, lending and international operation (The House of Morgan is a good book detailing the history). JPMorgan was so big that the firm and the man literally saved the street during the Panic of 1907 (also chronicled in a book aptly titled The Panic of 1907). It was this event that got us a central bank in America because no one wanted another 1907 and no one wanted the whole system dependent on one private citizen.

Now, the Universal banking model has a few problems that created huge conflicts of interest in the 1920s. Many believe the excess wrought by these conflicts contributed to the Depression. So, we got a fix via Glass-Steagall in 1933, whereby commercial banking and merchant/investment banking activities were separated. In the case of JP Morgan, it was split into three: JP Morgan, a commercial bank, Morgan Stanley, an investment bank, and Morgan Grenfell, a British merchant bank (and also former employer of mine). Other banks had to split too: Bank of Boston – First Boston, for example. Others exited one business or another (Goldman got rid of commercial banking).

As before, money center banks like National City (now Citigroup), Chase, Chemical Bank, Bankers Trust and JP Morgan dominated the wholesale market while other smaller banks concentrated on retail banking, what most of us see on the high street. JP Morgan and Bankers Trust, in fact, had no retail banking whatsoever.

By the 1980s, these banks were chomping at the bit to get into investment banking because the retail banking had been disintermediated and was much less profitable. As a result, there was a relaxation of Glass-Steagall whereby commercial banks were permitted to earn up to 25% of their revenue from investment banking activities like trading and advisory work. The money center banks, already having significant business relationships through their huge wholesale businesses, jumped in. At some point, the 25% restriction became onerous for the bankers as they bumped up against the ceiling. JPMorgan was the bank that was most affected by this rule as it developed a very large advisory and trading business.

By the 1990s, the slippery slope made it inevitable that Glass-Steagall was to be repealed. After all, no one blew up due to the 25% rule. Granted Bankers Trust permanently damaged their franchise in the early 1990s with a huge derivatives scandal. But, the bank lobby was still pushing for Glass-Steagall to be repealed.

Of course, it was eventually repealed in order to retroactively allow the Citigroup-Travellers merger to occur. The rest of the history you know.

Moving into trading

What is not evident in this history is that investment banks used to be dominated by dealmakers. The advisory work was considered the main focus. Look at any Wall Street book before “Liar’s Poker.” Almost none of them talks about trading. Sales & trading as considered the bucket shop department where guys whose knuckles were dragging the floor worked. These men – invariably from Brooklyn and sporting ethnic names – were looked down upon by the white shoe investment bankers.

Back when Wall Street was run by partnerships, there was a bulge bracket of firms whose names came fist on any prospectus for bond or equity offerings. This group consisted of Goldman Sachs, Morgan Stanley, Lehman Brothers, Dillon Read, and First Boston. Names not on that list were Salomon Brothers (too much trading), Merrill Lynch (too much retail client focus), and Drexel Burnham (not classy enough). Clearly, the hierarchy was white shoe Investment Bankers first, knuckle dragging traders and middle brow retail shops last.

This all changed, starting in the 1980s. There are a number of factors why, but the change in focus brought Salomon, Merrill and Drexel into the big leagues. As time went on trading became more and more dominant. In my view, a lot of this had to do with economies of scale. Yves says:

So the scale of operation required to be competitive is too large for it to be managed by player-coaches who had deep expertise, and like the Dimon example, were more expert than the people working for them. But the normal corporate/commercial banking management structure, with more managerial layers, and the top brass having broader spans of control, was devised in earlier stages of industrial organization, when you had factories or service business with a great deal of routinization of worker and middle manager tasks. Traditional commercial banks are on the same factory format.

Now, she is focusing on why commercial banks differ from investment banks. I would use this same paragraph to also highlight the difference between an OTC derivatives operation at JPMorgan Chase and the advisory work at a firm like Greenhill or Lazard, the former bread and butter of I-banks. The sales and trading operations benefit from scale in a way advisory work does not. And what that means, given Yves’ quote is that you have a lot of junior people making big decisions.

What’s more is the fact that banks are not acting as passive conduits who ‘make markets,’ their traditional function. They are now taking risks with their own capital. One reason Goldman bounced back from the crisis so well is that it has a large proprietary trading operation that was able to make a lot of money, not through facilitating transactions, but through making trades for Goldman’s own account. In essence, Goldman Sachs is today as much a hedge fund as it is a bank.

The problem with this model, moving from advisory work to trading and from facilitator to principal, is that it is riskier. The reason this past crisis was so devastating has much to do with the move to the bank-trading-as-principal-actor business model. And since scale is a large part of why this works, these firms are not just risky, they are also enormous – which makes them a systemic risk.

Going forward, I hope we see regulators address this problem. Banks of today look nothing like banks of just twenty-five years ago. And investment banking today looks nothing like it did a generation ago either. In both cases, the operations are larger and riskier, a situation which must be addressed if we are to avoid another crisis of this magnitude.


Big banks look to rainmakers again – John Gapper, FT

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. George

    In the paragraph just above your last block quote from Yves, you probably meant to say "1980s" not "1990s." Drexel wasn't a factor in the 1990s.

    Of course this trend of sprawling financial services behemoths was a direct result of the deliberate destruction of the US's manufacturing industries. Since there was little growth in actually making things, where was the best and the brightest to go?

    It is also why Obama is hesitant to deal with the FIRE industry. Which voter would you like to piss off by pushing policies that will lead them to be laid off: – the illiterate obese Wal-Mart greeter or the young MBA grad whose roommate at Ivy U is the son of a Congressman?

    Obama has a lot more to lose from a revolution brewing in the affluent suburbs than he does from the hoi-polloi. Besides we aren't some inept Islamic Republic – we would never let popular protests actually take to the streets. We would stop them cold before they ever happen, just like we did the last 8 years, and our media would play along.

  2. Doc Holiday

    This all gets back to financial models that are built on thin air and engineered to bias information for the sheep that need faith in the future. Banks in general are filled with a very long chain of crooks that play con games (with other peoples money).

  3. MarcoPolo

    Thank you, Edward. That’s a helpful understanding. But you left out the part about how the Reagan administration, in a moment of ideological stupor concerning 401k’s & such, built the mutual fund industry, empowered “money managers”, the parasitic nature of that kind of “investing” and the political power & influence of building a national economy around those parasitic investors, as opposed to savers. Parasitic investment, Edward. You’ve heard it called “creating shareholder value”. It does nothing of the sort. It advances a series of flows to NPV – at a discount. As a consequence productive companies are forced to defend themselves by leveraging in the capital markets forcing themselves deeper into the arms of the very same lecherous, knuckle draggers, who are raping them.

    Yes, it’s a sore spot. Want more? I thought not. I could become quite an ogre about it myself.

  4. D

    Precisely what was Goldman doing with the proprietary trading unit?

    Do they use the order flow data to help them trade?

    Are they tracking their best performing customers closely and following?

    Isn't there a fundamental conflict of interest when a broker also trades on their own account?

  5. Yves Smith


    Welcome to the world of OTC markets.

    The firms are not "brokers" in these markets. A broker has a fiduciary duty (believe it or not, even real estate brokers supposedly have fiduciary duties) and collects a fee. In an OTC marker, there is no fee, just a bid an offer price (and if you ask for a quote, you have to say what size and whether you want to buy or sell. Bloomberg and other services show only indicative prices).

    Historically, order flow traders (who made money in theory made money off the bid and offer) always did a position trading too, shading the size of their inventory based on short-term market views.

    Prop trading made that position trading a separate activity and also gave them license to play with more capital and go over longer time horizons.

    And in unregulated OTC markets like FX, front running customer orders is perfectly kosher and therefore done all the time.

  6. D


    I really wonder what was in the software that Russian stole.

    That was an awful lot of code… millions of lines of code or more.

  7. Eric L. Prentis

    What Caused the Credit Crisis and Do Banks Have Too Much Power?

    The majority whip in the US Senate, Dick Durbin (D- IL), who unsuccessfully fought the banks to allow bankruptcy judges to renegotiate mortgage principal amounts said, “the banks are the most powerful lobby on Capital Hill and frankly, own the place.”

    We are bailing out Wall Street because the banks convinced politicians that this will revive the economy, but I don’t believe the economy is benefiting. The politicians are bailing out the status quo by not allowing capitalism to work; instead, zombie banks responsible for this credit crisis should be allowed to fail and thereby, reduce debt. There are now no legal restrictions on what banks can do with the bailout money from the Federal Reserve, consequently, I believe zombie banks are using this money to speculate in the stock market rather than making new loans. The value of loans from 21 of the largest banks getting bailout money fell in June, 2009 to $4.34 trillion dollars, down 0.8% or $35 billion dollars. Instead, bailout money should be going to Main Street rather than simply propping up Wall Street and the stock market. I believe we are in a secular bear market which have occurred 50% of the time since 1900 (i.e., 1906-1921; 1929-1949; 1966-1982; 2000-?) and will not abate until 2017, assuming we take correct actions politically. Japan has been in a secular bear market for the past twenty years, with their stock market down 76% to date (Nikkei Index: 38,916 to 9,421), and we following in Japan’s footsteps.

    Americans are not benefiting from a free and open discussion in Congress concerning the causes of the 2008-09 credit crisis and the proper remedial actions, nor, I believe, within academe because banks sponsor academic journals and consequently, greatly influence their publication policies. The existing financial economic theory which governs how the stock market functions is incorrect, but profits Wall Street so it remains in place and is taught to all business college students. The current theory assumes that the stock market is a huge casino where stock prices incorporate all available information, so beating the market, when controlling for risk, is impossible, resulting in the standard recommended strategy for the investing public, i.e., put your money in the stock market, hold on and hope for the best. Risk management, as a consequence of this outdated financial theory, is useless which is a major cause of the 2008-09 credit crisis [along with control fraud and changed/repealed US financial laws]. I’ve written a research paper that disproves the outdated financial economic theory that Wall Street so desperately clings to; but, I cannot get it published in a good academic journal. I am happy to e-mail a PDF copy of my paper entitled “Credit Crisis, Systemic Risk and Economic Analysis” to anyone interested:

  8. juan

    George, right, we may not be ' some inept Islamic Republic' but something more closely approximating Argentina…social pressures develop, spontaneous orders appear. the old control becomes uncontrollable and new emerges.

  9. Edward Harrison

    Thanks Yves for responding on prop trading vs. 'broker-dealer' function and George I fixed the error you noted. Thanks.

  10. Hugh

    "One reason Goldman bounced back from the crisis so well is . . ."

    that it has so successfully penetrated government. When the meltdown happened, our Treasury Secretary Hank Paulson, former Chairman and CEO at Goldman was working a deal to takeover AIG. Lloyd Blankfein the current CEO of GS was the only banker allowed into those meetings. Saving AIG saved GS. At the same time, Lehman a company that Paulson disliked was allowed to go into an uncontrolled bankruptcy sparking the meltdown. Paulson put a GS board member Edward Liddy in to run AIG and Liddy just happened to OK to paying off a major chunk of AIG's CDS portfolio at full value and before any default, creating a $13 billion windfall for Goldman. Paulson also named another protégé from Goldman Neel Kashkari to run the TARP with its opaque non-accountable loans to "banks" like Goldman. Paulson also greased the wheels to rename GS a bank holding company, a laughable fiction, so it could have access to more government credit lines, another way he saved the company.

    Meanwhile the Chairman of the NY Fed was Stephen Friedman another former head of Goldman. When Geithner moved to Treasury, he made Mark Patterson, a Goldman lobbyist, his chief of staff. His former job as President of the NY Fed was given to William Dudley, who had been GS's chief economist.

    With connections like these you don't have to be smart or even good. Having the Treasury and the Fed as your piggybank, would allow anyone to "bounce" back no matter how many catastrophic decisions one made.

  11. Richard Kline

    So Ed, that is a very useful summation, putting the position and trajectory of change for the ibanks with clarity.

    I would say that the principle systems problem is, as you say, one of scale, but it isn't necessarily a white shoe vs. track shoe struggle. Both advisors and traders are in a position to know how _their own_ position stands, at least in principle. This promotes a culture of the 'captain of capital,' where smart guys of either footgear expect to know what they are doing and where they stand on a given day if they're competent to play this game. But the positions taken by the traders now, or for that matter the complexity of securitized and derivate bolstered LBO deals is such that nobody really knows where the deal stands. Individuals still want to run their positions and shops like captains but they're directly too many pixels for the latter to hear the trumpets call above the din. One needs a talented staff whose sole function is to know where all the pieces are all the time.

    The scale and speed of the flows don't allow for individual control, one needs systems of control and teams of controllers, in a phrase. But the culture of the ibanks calls for 'rainmakers,' just as we see: these boys all think they're up to it, but the scale is bigger than their egos are, even. Imagine that, folks.

  12. ComparedToWhat?

    I was living in Tokyo late 80s and viewed the Japanese bubble as to considerable extent a response to London's "Big Bang" of 1986. It seems to me the Big Bang was in turn a response to changes in the US such as the consequences of deregulating brokerage commissions (1975) and the rise of the shadow banking system (first money market fund created in 1971).

    NC has been on fire lately with terrific posts and great comments. I should just sit back, shut up and enjoy but I can't resist encouraging everyone to tie things together on the international level. The story of competition between Wall Street, the City of London and Kasumigaseki — in "private" and "public" sectors — is essential for understanding this mess.

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