Business

When big ticket investment banks change their stripes

— FILE PHOTO

Morgan Stanley headquarters in New York.

The financial sector crisis in the U.S. continues to take its toll in a financial sense as well as in terms of reputations. Even as the Bush administration is trying to push through an unprecedented $700-billion package to rescue the financial sector, there has been a fundamental shift in the ways banking and related activities will be conducted in future.

Just a week after Lehman Brothers went bankrupt and Merrill Lynch was taken over by Bank of America, two other independent investment banks, Goldman Sachs and Morgan Stanley, sought to convert themselves into bank holding companies.

The development is significant for at least two reasons. The era of high flying investment banking is coming to an end.

Bear Stearns and more recently Washington Mutual Bank were taken over by JPMorgan Chase with the blessings of the authorities.

So in just over three months all the big ticket independent investment banks have disappeared.

Particularly dramatic have been the fate of the other four banks. The end came within a week.

There will be smaller entities engaged in investment banking alone while all the bigger players will resemble commercial banks. Since in their new incarnation they can undertake a variety of activities besides those that go under the name of investment banking, they can lay claim to being called universal banks.

Several advantages are claimed. They will have access to stable retail deposits. As investment banks they relied primarily on wholesale deposits, which, as a rule, are more sensitive to interest rate changes and as recent events tellingly demonstrate to changes in the environment. It did not take long for investors in these investment banks to desert them in droves.

Two, commercial banks are subject to a greater degree of regulatory oversight than investment banks. In the U.S., the Federal Reserve rather than the Securities Exchange Commission supervises commercial banks.

Investment banking, by and large, falls within the domain of the SEC.

Three, commercial banks have access to emergency funding by the Federal Reserve.

Four, by engaging in a range of activities, commercial banks are able to cushion losses in specific segments. This is demonstrated by the relatively good performance of big banks like Citi and JPMorgan Chase though they have not been immune to the crisis. Citi has been reporting huge losses periodically but neither of them has needed any official rescuing act. JPMorgan has actually aided the authorities by taking over Bear Stearns and now Washington Mutual.

The fall from grace of investment bankers leading to a radical change in the financial sector’s landscape in advanced countries is a significant development having many lessons for India too.

Investment banking, or merchant banking as it is called here, has been slow to develop in India.

Unlike in the U.S. where Depression era legislation segregated the two activities, banks here did not have any legal constraints. However, there were certain ‘non-banking’ activities such as hire purchase and leasing that could be done only by subsidiaries, which in course of time resembled the bigger NBFCs which are important niche players.

Significantly even when universal banking became the flavour of the season — commercial banks trying to open financial supermarkets — big banks undertook activities such as insurance only through subsidiaries and relied on the brand names of the parent banks.

It is not clear whether the universal banking model as it has evolved here has been a help or a hindrance to the promoting bank. In a regulatory sense there has been an overlap.

Other than the Reserve Bank of India, the Securities and Exchange Board of India and the Insurance Regulatory and Development Authority are also involved.

Of the many similarities between investment banks abroad and in India, the easily noticed one is the higher level of salary compensation paid to investment bankers compared to their more sedate commercial banking counterparts.

As in the West, the main investment banking activities in India are mergers, acquisitions, corporate finance and restructuring.

Even though some public sector banks are active in the field, the lion’s share of the business appears to have been grabbed by the big brokers acting as investment bankers, foreign banks and the branches of the foreign investment banks. Interestingly many big investment banks have had tie ups with broker-firms.

Sensing the potential in India many of them had started venturing out on their own. The serious crisis in the U.S. has put paid to their plans in India.

In many cases their continuance in India seems to be in doubt. With all their well publicised failings, will the erstwhile foreign investment banks continue to appeal to their major Indian clients? In the last ‘big bang’ disinvestment, involving ONGC and others, none of the public sector merchant banking subsidiaries had any role.

The field was dominated entirely by foreign investment banks. Arcelor Mittal was put together with the help of the (then) big players, all international investment banks.

The Tata-Corus deal and the Aditya Birla Group’s forays abroad were aided by foreign investment banks.

It is too much to expect that India’s public sector merchant banking subsidiaries will fill the void. But they can learn important lessons from the failure of investment banking abroad. One clear message for them is not to do a ‘regulatory arbitrage’ exploiting the lacuna in regulation.

Foreign banks could get away. Citibank and others, though named by the JPC as the biggest perpetuators of the 1991-92 securities scam, escaped unscathed. Public sector banks, including the SBI group, have fared far worse.

The second message of course is not to emulate the recently failed American investment banks in undertaking activities without fully comprehending the risks. Banks in India have so far disclosed relatively small exposures to ‘toxic’ securities that have brought down the big names.

The same degree of caution will serve them well in any other type of investment banking activity, however glamorous or profitable it may be.

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