Risk and reward A special report on international banking May 19th 2007 Maria Jeeves
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The alchemists of nance Also in this section
Black boxes Investment banks’ inventions for transform- ing risk are ingenious, but hard to fathom. Page 4 Les eurs du mal Exotic instruments are not for everyone. Page 5 Capital spenders Relentless competition is forcing nancial rms to take more risks with their own capital. Page 6 Merchants of boom Advising on, nancing and investing in buy- outs is a great business. But banks should not be too greedy. Page 7 Share-cropping Hard-hit equity traders are ghting back. Page 9 Global investment banks are taking ever more risk, and are devising ever more sophisticated ways of spreading it, says Henry Tricks. Is that Here, there and everywhere reassuring or worrying? Investment banks are scouring the globe for T LEAST since 1823, when Byron’s Don investment banking. And European war- new business. Page 10 AJuan described Jew Rothschild, and horses such as Deutsche Bank, UBS and his fellow Christian Baring as the true Credit Suisse have joined the race for The art of courtship Lords of Europe , investment bankers global supremacy. The bets, and the pro- In Asia, banks have to try harder. Page 11 have inspired awe, envy and, rightly or ts, have got bigger, though investment wrongly, a measure of disdain. Exactly banks are trying to keep quiet about that, Comeback kid 100 years ago the undisputed patriarch of for several reasons. After two decades in the wilderness, Japan is the modern industry, J. Pierpont Morgan, First, they are under more scrutiny. slowly returning to the international nancial stemmed the Panic of 1907, a nancial cri- Wall Street rms had their wings clipped scene. Page 13 sis caused by unregulated trusts (the hedge by Eliot Spitzer, New York’s former attor- funds of their day). Acting, in e ect, as ney-general, for plugging worthless shares The wobble factor lender of last resort from his Wall Street of- during the dotcom era. Being publicly Regulators are doing their best to ensure - ce, he was brie y feted before Americans traded companies has tamed some egos, nancial stability, but they don’t have all the realised the danger of having such power too. Star traders do not enjoy the same answers. Page 14 vested in one man. Cartoonists then mer- headroom on salaries (albeit very large cilessly mocked him. After his death in salaries) as they did when they were part- Eggheads and long tails 1913 the Federal Reserve was set up. ners in the business. At UBS, a Swiss bank The investment-banking industry was which in 2000 moved into the American Investment banks are a high-wire act. How further constrained during the Depression equity markets by merging with Paine- good are the safety nets? Page 15 of the 1930s, when Wall Street rms such Webber, a brokerage, efs are explicitly as that founded by Morgan were split into banned. Richard Fuld, boss of Lehman Spreading the muck commercial banks and securities houses. Brothers, a fast-growing Wall Street rm, Is risk ending up in the right places? Page 17 The latter today’s investment banks un- imposed a one- rm culture when it was derwrite stocks and bonds and advise spun o from American Express in 1994. companies on mergers and acquisitions, Now, says Scott Freidheim, a top executive, rather than collect deposits and make Mr Fuld uses culture in speeches more loans. In the 1980s and 1990s they de- often than any other word except the . veloped a reputation for gluttonous ex- Meanwhile another group has over- A list of acknowledgments and sources is at cess. But a lot has changed since then. taken the investment banks in the excess www.economist.com/specialreports Intensely private partnerships have be- stakes: their money-spinning clients in the come publicly traded companies. Com- private-equity and hedge-fund industries. An audio interview with the author is at mercial banks such as Citigroup and Already they throw the biggest parties, do www.economist.com/audio JPMorgan Chase have muscled back into the boldest deals and launch the most cele-1 2 A special report on international banking The Economist May 19th 2007
the way. The stockmarket crash of 1987 Apple’s rewards for inventing the iPod, he Rich list 1 and the seizing up of credit markets after points out. Yet in investment banking there Investment-banking revenue, by activity Russia defaulted in 1998 both exposed is nothing nearly so tangible to which to 2006, $bn huge aws in the industry, forcing central ascribe the gains. Advisory Debt underwriting banks to step in to prevent what they Bankers themselves are fuzzy about ex- Equity underwriting feared might be lasting damage to the real plaining their trading pro ts, bandying economy. Even so, regulators reckon that about phrases such as deploying our 0123 on balance the growth of markets has intellectual capital . But it is clear that Goldman Sachs been a good thing, making the nancial three powerful forces are at work, all of Morgan Stanley system safer than more traditional forms them overlapping and mutually reinforc- of bank lending. The trouble is that given ing, and all fundamental to the gushing li- JPMorgan the complexity of the new instruments quidity the world is currently enjoying. Credit Suisse* and the range of clients and countries in- The rst is the alchemist’s trick of turn- volved, they can never be absolutely sure ing debt (mostly leaden) into derivatives Citigroup that a monumental crisis is not brewing (mostly liquid); the second is the emer- Merrill Lynch somewhere. gence of a new class of leveraged client Deutsche Bank What worries both bankers and regula- (hedge funds and private equity); and the tors is not so much the threat from hedge third is seeking out new capital markets, Lehman Brothers funds or private-equity groups but the im- and clients, around the world. Moreover, Bank of America plications for the nancial system of a pos- in all these pursuits the rms are now us- sible collapse of an investment bank (or ing not just their clients’ money but, to dif- Source: Dominion Bond Rating Service *Annualised using Q1-Q3 large complex nancial institution, as they fering degrees, their own too. clumsily call it). At a time when America’s Joseph Perella, an industry veteran 2 brated initial public o erings. The IPO of housing market has exposed the danger of who last year struck out independently part of Blackstone, a private-equity group, overexcitement on Wall Street, it is worth with an advisory boutique, Perella Wein- might well raise more money than Gold- exploring how these institutions are berg, observes that putting a rm’s own man Sachs’s did in 1999, when even the evolving, how they handle the risks at- capital into mergers, acquisitions and company’s doormen and drivers became tached to what they do, and how well other transactions is one of the biggest extremely rich. those risks are spread around the nancial changes in investment banking since the Yet when investment bankers discuss system. That is what this special report sets 1980s. It’s not just one rm sticking its the fabulous fortunes accruing to these out to do. neck out. It’s across the board. rms’ founders, they do so without envy. But using the banks’ own capital creates Theirs is a truly pioneering role, says An- Risk-takers Anonymous potential con ict. Not only do they risk shu Jain, head of global markets at Deut- Investment banking is in a state of evolu- putting their own interests before those of sche Bank, one of the world’s top trading tion rather than revolution. The essence of their clients; they are also increasingly ex- banks. Pioneers in any industry get a dis- the business has always been taking calcu- posing themselves to the dangers of an proportionate share of the spoils. lated (and sometimes miscalculated) risks. abrupt turn in the credit cycle. They are ar- Even if they are no longer the pioneers, But now traders place bets in more places, ranging ever bigger debt issues for private- the investment banks have played a cru- with more clients and using more compli- equity rms and hedge funds and so are cial part in bringing about the extraordi- cated gambling devices than ever before. encouraging a borrowing binge that could nary changes seen in the nancial mar- Brokerage used to be described as a breed nancial instability. For the time be- kets, starting in the 1980s and accelerating haulage business, lugging money, as a ing all this is hugely pro table. But it is also dramatically in the past ve years. Tech- member of the Rothschild dynasty once making the banks far too complacent for nology and innovation have brought un- put it, from point A, where it is, to point B, their own good. precedented breadth, depth and richness where it is needed . The idea of describing The driving force behind all this has to nancial instruments. According to themselves as glori ed delivery men may been an unusually benign economic cli- McKinsey, a consultancy, the stock of well still appeal to the cynics on the trad- mate. The global economy is at its least vo- shares and public and private debt securi- ing oor who work with shirtsleeves latile since the 1960s, real interest rates are ties held in America grew from 2.4 times rolled up and hail each other loudly in low and companies are generating huge GDP in 1995 to 3.3 times in 2004. In Europe Brooklyn or mock cockney accents. But pro ts. What some call the great modera- the increase was even more dramatic, al- any haulage rm would be abbergasted tion has been a boon to nancial markets beit from a lower base. These gures do by the trading pro ts and returns on equity around the world, particularly those trad- not include derivatives, notional amounts seen in investment banking in recent ing in the multifarious debt instruments of which traded privately, or over-the- years, especially among Wall Street’s big concocted in the laboratories of Wall Street counter securities, which had soared to bulge-bracket rms. Svilen Ivanov, head and the City of London. The opening up of $370 trillion by last June, from $258 trillion of capital markets at Boston Consulting Asian economies has brought down the less than two years earlier, according to the Group, notes that earnings from capital- price of traded goods, helping to ght in a- Bank for International Settlements (BIS). market-related activities at the top ten tion. Meanwhile, high savings rates in that Given such torrid growth, the markets are global investment banks have risen by al- part of the world, combined with ageing becoming increasingly vital to global - most two-thirds in two years, from $55 bil- populations in the West, have helped to nancial stability. lion in 2004 to $90 billion last year. That push up demand for long-term investment There have been thrills and spills along sort of pro t increase is comparable with instruments such as bonds. 1 The Economist May 19th 2007 A special report on international banking 3
2 At the same time the search for yield, as investors seek to compensate for low re- turns in high-quality markets such as gov- ernment bonds, has increased demand for instruments of greater complexity, such as credit-default swaps (CDSs), collateralised debt obligations (CDOs) and other deriva- tives. That has pushed down implied vola- York, Chicago, Houston and Washington, suring the correlations between instru- tilities to multi-year lows, arguably mak- DC, rolled into one, because it trades all the ments that are supposed to spread risk but ing the assets appear more reassuring than assets of the rst three and is regulated on may do the opposite if liquidity dries up. It they actually are. the spot as well. Instead of Greenwich, is mildly reassuring that hardly a week Regulation has helped, too. Under the Connecticut, it has Mayfair for hedge goes by without regulators in the world’s Basel 2 banking accord, whose trickier pro- funds. London, moreover, is a hub for Eu- main markets pressing the industry to im- visions are due to come into force in the rope, and stronger economies on the conti- prove its risk-management techniques European Union next January and in nent mean growing markets for capital; but rather worrying that the same regula- America starting a year later, capital will typically, such markets increase at double tors pay considerably less attention to be allocated according to the riskiness of the rate of GDP when economies expand. where the risk may end up. assets. That has encouraged banks to make London’s position as a springboard for Investment bankers themselves have a more use of credit derivatives to diversify emerging markets vastly increases its al- vested interest in not blowing up their their credit portfolios, and to sell more as- lure. America and Europe between them rms. The biggest banks are thought to be sets into the capital markets to be repack- may still account for almost four- fths of investing hundreds of millions of dollars a aged into debt securities. all investment-banking revenues, but fees year in technologies to measure risk and All of which means that investment are growing fastest in the developing stress-test it. Comfortingly, regulators who banks have generated many of their trad- world. That re ects the might of compa- scrutinise the banks’ risk-weighted capital ing pro ts from derivative trades with nies such as Gazprom, Russia’s energy be- say it is stronger than ever. But capital is each other, with their banking clients or hemoth, and the recently listed Industrial only one line of defence. The banks’ ability with hedge funds which increasingly use and Commercial Bank of China, which Mr to cope with liquidity crises and credit the instruments as speculative tools. The Klein admits are both vying with Citi- crunches is harder to gauge. demand for loans to repackage into securi- group in size. He notes that 140 of Citi- Financial markets send out mixed mes- ties, such as CDOs, has helped fuel the gen- group’s top 1,000 clients are from emerg- sages about the con dence of investors in erous credit conditions that have under- ing markets, whereas 15 years ago the the institutions themselves. The invest- pinned private equity’s leveraged buy-out number was only 40. Russia and China are ment banks’ share prices appear to re ect (LBO) boom as well. among the world’s biggest IPO markets. the belief that their equity will be safe- And many developing countries are seek- guarded rather than that earnings will be The wild east ing to strengthen their domestic capital stable. As David Viniar, chief nancial o - To cap it all, over the past few years mar- markets, which means that the biggest cer of Goldman Sachs, puts it, the rm, kets around the world have opened up in a global investment banks such as Citi whose risk appetite is second to none, has way unmatched since before the rst hope eventually to deploy enormous re- increased revenues in 18 out of the past 21 world war, and investment banks have sources there: trading desks of perhaps years, but quarterly income has been more seized the opportunity to expand interna- 1,000 people, not 25. volatile. It’s a growth business and it’s not tionally. Since the start of the 20th century, Given the markets’ increasing complex- going to get more stable, he says. when America rst emerged as an econ- ity, how do investment banks manage the Taking risks and managing them is an omic power, the world’s nancial-market growing risks they face? There are lots of investment bank’s core business. Bankers activity had increasingly gravitated to- things they need to do, from nding believe risk-taking is how their industry wards American share and bond markets. enough brainboxes capable of handling supports entrepreneurs and hence econ- The introduction of the euro in 1999, and the intricate assets being created to mea- omic growth. The trouble is that new risks the rapid growth of economies in Europe are almost invariably explored before and Asia, lured investment bankers in the there is a good way to measure them. other direction. The share of investment- A good spread 2 Ultimately, business and credit cycles banking fees earned from Europe was Revenues of investment banks by region tend to reveal which risks are excessive growing long before America’s regulators 2006, $bn and whatever junior traders may think, % of total woke up to the damage caused to Ameri- Corporate Sales & investment- the business cycle is far from dead. Richard finance & trading banking can markets by aspects of the Sarbanes- advisory revenues Portes, professor of economics at the Lon- Oxley act and other red tape. Last year, by don Business School, recalls rst debating some estimates, revenues from Europe 0 20406080100 its possible demise back in 1969. Since then and Asia overtook those from America for The Americas 43 he has discovered a comment by Leon Fra- the rst time (see chart 2). ser, an American banker, speaking after Europe, Middle In the meantime London has become 36 the great crash of 1929, which convinced an impressive rival to New York as a global East & Africa him that boom-bust cycles in nance will nancial centre. Michael Klein, the boss of Asia-Pacific 21 always be with us. Mr Fraser’s immortal corporate and investment banking at Citi- words were: Better to have loaned and Source: Boston Consulting Group group, describes Britain’s capital as New lost than never to have loaned at all. 7 4 A special report on international banking The Economist May 19th 2007
Black boxes
Investment banks’ inventions for transforming risk are ingenious, but hard to fathom
DVANCES in technology and informa- vestment banks’ trading accounts known Ation have always been good for capital as FICC, for xed income, currencies and A better way to borrow 4 markets. Richard Sylla of New York Uni- commodities. For the ve big Wall Street Debt issuance in the US, $bn versity’s Stern School of Business argues rms (Goldman Sachs, Morgan Stanley, that nancial globalisation started earlier Merrill Lynch, Lehman Brothers and Bear 2.0 than previously thought, around 1816. At Stearns) taken together, these revenues that time packet sailing ships began to have quadrupled since the start of this de- 1.5 make regular scheduled crossings be- cade, according to Dominion Bond Rating Straight corporate debt tween New York and British ports, cutting Service, a rating agency (see chart 3). Back 1.0 the average time it took for mail and in- in 2000, when stockmarkets were boom- formation about securities prices to cross ing, share-trading generated twice as much 0.5 the Atlantic. Later that century the tele- revenue as did xed income. But it has Asset-backed graphic transatlantic cable, along with been growing far more slowly, to only $27 debt steam shipping, heralded the huge growth billion last year, against $44 billion for 0 1985 90 95 2000 06 of global markets between 1870 and 1914. xed income. The computer is the cable of our age, Source: Dominion Bond Rating Service and it has turned investment banks into From copper to catastrophe hothouses of nancial innovation. The - FICC encompasses a broad swathe of as- of Wall Street and London have found nancial principles are not new: parallels sets, from American subprime mortgages ways of bundling indexes of CDSs to- have been drawn between the spectacular to Japanese yen, copper futures to catastro- gether and slicing them into tranches, growth of credit derivatives in recent years phe insurance, General Motors bonds to based on riskiness and return. The most and the introduction of wheat futures in Zambian debt. Some of the fastest growth toxic tranche at the bottom exposes the America in the mid-19th century. But has been in tried-and-tested asset-backed holder to the rst 3% of losses but also thanks to computing power the products securities such as commercial and residen- gives him a large portion of the returns. At have become in nitely more malleable. tial mortgages, which have soared since the top, the risks and returns are much They are designed to appear complex and 2000 whereas straight company debt issu- smaller unless there is a systemic failure. impenetrable. But they are not patented, ance has stagnated (see chart 4). But the CDOs grew out of the market for asset- and sta turnover across the investment- most pro table area has been the growth backed securities which took o in the banking industry is estimated to be up to of derivative and structured credit pro- 1970s and encompassed mortgages, credit- 20%, so ideas travel quickly. Margins fall, ducts, such as CDSs and CDOs. card receivables, car loans and even re- products go through the inevitable boom- These have enabled banks to separate cording royalties. The structured CDO is a and-bust cycle and the whole thing starts credit risk from interest rates and trade that more complex variation, using lots more all over again. risk among those who want to hold it and leverage and bundling bonds, loans and The peephole into this mysterious those who don’t. This process has freed CDSs into securities that are sold in world of debt is a single line in many in- credit risk from the underlying bonds, tranches. According to the Bond Market leading to an explosion of secondary-mar- Association, an industry body, $489 bil- ket activity. For the banks it has been a lion-worth of CDOs were issued last year, A tale of two markets 3 goldmine, but for outsiders it is devilishly twice the level in 2005. One-third were Debt and equity revenues Value, hard to know how much risk the new in- based on high-yield loans and are known $ terms*, 2000=100 2006, $bn struments entail. as collateralised loan obligations (CLOs). 44.4 The cornerstone of the new market is The rest involved mortgage-backed securi- 400 the CDS, a form of insurance contract ties, CDSs and even other CDOs (which be- Fixed-income capital markets linked to underlying debt that protects the come supertankers of leverage, known as 300 buyer in case of default. The market has al- CDO2 and CDO3 ). most doubled in size every year for the Investment bankers are fascinated by 200 past ve years, reaching $20 trillion in no- the possibilities created by structured pro- 27.0 tional amounts outstanding last June, ac- ducts, which they think o er almost limit- 100 cording to the Bank for International Set- less ways for their clients to manage risks. Equity capital markets tlements. That makes it far bigger than the Some of the more ambitious are working 0 2000† 01† 02 03 04 05 06 underlying debt markets. Some 70% of on risk-transfer instruments that deal with *For Bear Stearns, Goldman Sachs, Lehman these products are linked to an individual weather, freight, emissions, mortality and Source: Dominion Brothers, Merrill Lynch, Morgan Stanley longevity (see box, next page). The most † issuer and are not much more complex Bond Rating Service Approximated for some broker-dealers than selling a bond short. The fun starts immediate opportunities, though, may be with the other 30%. The mathematicians in asset classes such as property deriva-1 The Economist May 19th 2007 A special report on international banking 5
2 tives that have already proven successful and central and eastern Europe, says it sells in America but are still emerging in Europe 40 billion-50 billion ($54 billion-68 bil- and barely exist in developing countries. lion) of loans a year and would eventually Anshu Jain at Deutsche Bank says over like to make it a lot more. half of the rm’s trading pro ts last year Such nancial innovation not only came from this ill-de ned area, which he spreads the risk for investment banks’ cli- loosely calls intellectual capital . About ents. It may also make the banks them- one-third of the business was done with selves more diversi ed as they search for hedge funds and the other two-thirds with the holy grail of nance: unrelated portfo- nancial institutions needing to match as- lios that do not all melt down at the same sets and liabilities, such as insurance com- time. There is little correlation between panies. He believes that this aspect of trad- credit and government bonds, for exam- ing may be less cyclical than other sources markets in order to diversify their portfo- ple. When credit spreads widen, investors of revenue, such as proprietary positions. lios. Huw van Steenis of Morgan Stanley ock to safe haven products such as gov- Matt King, a credit strategist at Citi- estimates that some 78% of senior secured ernment bonds. group, says that demand for CDOs has loans in America have now been sold in That is the theory, at least. But there are lately been stimulated by the approaching this way, compared with 29% in 1995. In doubts, which may help explain the low implementation of the Basel 2 capital ac- Europe 53% are now securitised, up from multiples on investment banks’ earnings. cord, which encourages banks to swap 12% in 1999, still leaving considerable room Guy Moszkowski, securities industry ana- risky loans on their books for CDO for expansion. Alessandro Profumo, boss lyst at Merrill Lynch, describes the institu- tranches to avoid high capital charges. This of UniCredit, a booming bank that has tions as black boxes , revealing little has been helped by the increasing willing- stitched together an investment-banking about their overall exposures. A senior ness of banks to sell loans into the capital franchise across Italy, Germany, Austria banker agrees. There is a total lack of1
Exotic instruments are not Les eurs du mal for everyone
HEN investment banks talked experimenting with markets in event- Roberts. Even the mortgage-backed se- Wabout exotic assets in the 1990s, loss swaps natural-disaster versions of curities market in Europe has developed they generally meant tiger-cub or puma the debt market’s credit-default swaps. in ts and starts and has yet to be fully in- economies such as Vietnam or Peru. To- The risks of less unexpected deaths are tegrated. It takes time for legal frame- day the frontiers of nance involve any- also being packaged and traded. Accord- works and market infrastructures to thing from weather to mortality risk, from ing to Fitch, a ratings agency, bonds adapt. Catastrophe bonds which o er emissions to catastrophe insurance. linked to life insurance and mortality protection against severe environmental Now that technology and nancial en- rates and sold to hedge and pension shocks have been under discussion for at gineering have made it possible to isolate funds reached $5.4 billion last year, from least a decade, explains Mr Roberts, but and trade all manner of risks, the insur- next to nothing a few years ago. have only recently started to take o : ance industry is marching ever more ea- So far, so ghoulish. But the principle There’s collective agreement that the gerly into the capital markets. Last year could be extended to all walks of life. Per- capital markets have been slow to deliver AXA, a French insurer, issued so-called haps farmers will be able to buy weather to the insurance industry. mortality catastrophe bonds to protect it- products at their local bank as a hedge For those who see themselves as pio- self in the event of large death tolls against a poor harvest. Or emissions trad- neers in these new markets, there is an caused by, say, avian u or terrorism. The ing, which investment bankers love to unhappy precedent. Charles Sanford, bonds were put together by Swiss Re, a re- discuss to display their green credentials, who from 1987 to 1996 was chairman of insurer, which had hired Jacques Aigrain, might become a vibrant global market. Bankers Trust, an American bank, was a a former JPMorgan Chase investment Not so fast, says Tim Roberts, head of visionary when it came to risk. He de- banker, as its chief executive. It expects McKinsey’s nancial-institutions practice veloped the concept of particle nance the market for insurance-backed bonds to in London. This being a risk-taking busi- in which every form of risk could be iso- leap from $25 billion now to at least $150 ness, investment bankers are naturally lated and sold to the buyer with the big- billion by 2015. testing the boundaries. But it takes two to gest appetite for it. But during his tenure The investment banks are not stand- make a market, and many more to create Bankers Trust was hit by huge lawsuits ing idly by. ABN Amro, a Dutch bank now a mass market. Hedge funds have over sales of derivatives, which it was in a takeover battle, late last year led a col- emerged to hold some of the more exotic forced to settle with clients such as Proc- lateralised debt obligation packaging the risks, perhaps waiting for markets to de- ter & Gamble. It never quite recovered its natural catastophe risks of Catlin, a Ber- velop. Insurance products, unlike mort- standing before eventually falling into the muda-based insurer. Deutsche Bank is gages, are not standardised, says Mr arms of Deutsche Bank in 1999. 6 A special report on international banking The Economist May 19th 2007
2 transparency. We make it impossible for the way banks value deeply subordinated faults were to hit. The attraction for the our investors and analysts to understand portions of CDOs. They o er very attrac- CDS seller, as with any insurance contract, what is going on. He thinks that investors tive returns, but could fall o a cli if is receiving a steady stream of payments would be more impressed than scared if something goes wrong, he says. Lombard for a risk it hopes will not occur. If its cal- there were more disclosure, but accepts Street Research, a rm of economic an- culations are wrong, the result can be dev- that it is di cult to reveal all unless com- alysts, calculates that such parts of a CDO astating. The BIS says the best way to gauge petitors do the same. might be geared up about nine times, and the total volume of CDS exposures is by that the leverage will be many times their gross market value, which was $294 Astronomical leverage greater still if a hedge fund has invested in billion last June. That is a small fraction of CDOs and CDSs generate other concerns them with borrowed money. The leverage the $20 trillion in notional amounts out- too. One is the leverage embedded in becomes astronomical , the rm reckons, standing, and the whole lot would never them, which does not appear on banks’ when the CDOs are based on other CDOs. blow up at once. But there would still be balance sheets. A senior European nan- The second concern is the possible tidy sums involved if the sellers including cial regulator draws particular attention to need to pay out on CDSs if a wave of de- investment banks ever had to pay up. 7 Capital spenders
Relentless competition is forcing nancial rms to take more risks with their own capital
NVESTMENT bankers would hate to ad- other’s turf. JPMorgan, elbowed out of se- and hedge funds have mercilessly shed Imit it, but traditionally they have borne curities trading by Glass-Steagall (Morgan in Wall Street’s talent pool. Some, such as some resemblance to estate agents, match- Stanley was carved out of the old House of Citadel, a hedge fund, have ventured into ing buyers and sellers of nancial assets Morgan to become the underwriting busi- market-making in securities, an old Wall instead of houses and land and taking a ness), is now near the top of the global Street role. Others have gone for niche fee on the transaction. Yet investment M&A league tables. Its market share has markets. Star-studded boutiques such as banks have recently changed out of all rec- grown by about 50% since 2001, says Mr Greenhill and Perella Weinberg compete ognition. These days, if they were estate Moszkowski at Merrill Lynch. with banks in M&A. In trading, margins on agents they would not only suggest a suit- European universal banks such as UBS, cash equities, which used to be Wall able property to buy and o er to handle Credit Suisse and Deutsche Bank, con- Street’s signature business, have been hit the transaction but also propose a loan, strained by the lack of opportunities in by electronic platforms and by rules to in- come up with sophisticated products to their overbanked home markets, have also crease price transparency, such as Regula- o set the risk of rising rates, provide help muscled into the American big league. tion National Market System (known as with the down-payment, sell you funky UBS was one of the top share underwriters Reg NMS) in America. insurance products and, if they decided in America last year. Barclays Capital too, The result, according to industry lead- the property was a bargain, even buy it the investment-banking arm of the British ers, is growing pressure to explore new from under your nose. bank, has successfully targeted America, sources of pro t. I don’t know an industry In short, investment banking has mi- concentrating on xed-income products that is more competitive, says Lloyd grated from an agency model towards a and commodities. Blankfein, boss of Goldman Sachs. That principal one. The industry is not just of- At the same time private-equity rms is what is driving the innovation cycle. fering its clients a growing array of pro- ducts to buy and sell; it is making bigger The colour of their money bets with its own capital, too. According to As commercial banks with trillion-dollar Merrill Lynch, in 2005 one-third of the in- balance sheets compete with them for dustry’s revenues came from principal deals, the big ve Wall Street securities trading of debt and equity and only 15% rms are nding themselves under grow- from the commissions business, once the ing pressure to provide clients with nanc- industry’s bread and butter. ing as well as advice. Advising on mergers The main engine of transformation has and acquisitions is still the most pro table, been competition. Wall Street’s sensitivity and headline-grabbing, business on Wall to charges that it operates as an underwrit- Street (and Goldman remains top of the ing oligopoly dates back at least to the tree). Lending on deals o ers lower mar- Glass-Steagall act of 1933 when commer- gins if higher volumes. But, as Mr Blank- cial banks were forced to sell or close their fein puts it, you have to o er advice and underwriting business, in e ect reinforc- capital together. ing the franchises of bulge-bracket se- Citigroup, for example, claims to earn curities rms. But since the repeal of Glass- $5-8 from funding and other fees for every Steagall in 1999, commercial banks and in- $1 it gets from advising clients on acqui- vestment banks have jumped onto each sitions. Thanks to debt underwriting, last The Economist May 19th 2007 A special report on international banking 7
2 year Citigroup and JPMorgan Chase how severe such tail events could be. Ac- bagged more investment-banking busi- Handsome 5 cording to Timothy Geithner, president of ness than many of their Wall Street rivals. Return on common equity for major broker-dealers* the Federal Reserve Bank of New York, Those banks can rely on huge balance % which keeps a close eye on Wall Street’s ex- sheets, backed by cheap retail deposits, to 30 posures, risk management is better and make loans. The loans also give them re- AVERAGE, 16% capital cushions are stronger than they curring income to fall back on when mar- 25 were, relative to risk. But the banks are not ket conditions worsen. Wall Street securi- 20 invulnerable. We’d like to make sure that ties rms do not have access to such a they’re su ciently strong to withstand ad- 15 stable supply of funding, so they have to versity in the tail. The shape of the tail is raise capital in ckle markets instead. 10 very uncertain. Still, they have found inventive ways to 5 Shareholders are not entirely sanguine take on commercial banks at their own either. Investment banks are mostly mea- game. Goldman, for example, secured a 0 1985 90 95 2000 05 07 sured on their price-to-book value. Unlike backstop facility of at least $1 billion from *Bear Stearns, Goldman Sachs, Lehman Brothers, the assets of a bank or an industrial com- Sumitomo Mitsui when it bought a stake Merrill Lynch, Morgan Stanley, pany, most of the securities on their bal- in the Japanese bank in 2003. Merrill Source: Merrill Lynch PaineWebber (now owned by UBS) ance sheet have a book value that can be Lynch, Goldman and other Wall Street calculated daily and can be easily liquid- rms have acquired banking charters in year, up from just over a quarter in 2005. ated. That puts a oor under their price. America to gather deposits. That could be alarming if markets dry up Currently the big Wall Street rms are trad- and asset values plummet. ing at more than twice their book value, re- Owners beware According to Dominion Bond Rating ecting last year’s average returns on equ- Increasingly the rms are buying their Service, all ve Wall Street rms, Gold- ity of about 25%, which is higher than their own investment assets too. For years they man, Merrill, Morgan Stanley, Lehman cost of capital. Their long-run average is have been using proprietary trading desks Brothers and Bear Stearns, almost doubled 16% (see chart 5). Goldman, with a stagger- to take positions. Now they have ventured their equity capital between 2001 and ing 33% return on equity last year, has the into private equity as well, putting a grow- 2006. Their assets grew just a tad faster, highest valuation. But with so much more ing proportion of their capital into long- suggesting that they are expanding their capital now deployed, the banks have to term, illiquid investments, such as prop- businesses on rm foundations. Regula- work harder to improve returns. erty or companies. Merrill Lynch, for ex- tors have also had a clearer view of their There is growing uncertainty about fu- ample, holds a stake in Bloomberg, an capital since 2004 when their holding ture earnings, however, pushing price- information provider. Goldman has companies became Consolidated Super- earnings multiples close to historic lows. stakes in power plants across America, vised Entities, globally supervised by the This is partly because investment banking golf courses in Japan and a $5 billion stake Securities and Exchange Commission and is a cyclical business, which may be peak- in the vast Industrial and Commercial subject to Basel Committee capital guide- ing. It is also because their earnings are, to Bank of China. Brad Hintz of Bernstein Re- lines. Some of the supervisors believe put it mildly, opaque. As Mr Hintz (a for- search notes that the share of the indus- their capital cushions are more substantial mer chief nancial o cer of Lehman and try’s capital held in such illiquid invest- than they used to be. treasurer of Morgan Stanley) candidly ad- ments is growing very fast. At Merrill There is no reason for complacency, mits: We can’t be totally con dent how Lynch and Goldman they accounted for however, because markets can respond in they make money trading or how sustain- about half of the rms’ equity capital last unpredictable ways, and nobody knows able trading is. 7 Merchants of boom
Advising on, nancing and investing in buy-outs is a great business. But banks should not be too greedy
HE de nition of merchant banking has a better way to get the attention of kings boom times, only to rue it bitterly after- Tchanged many times over the centu- and emperors than shearing sheep. wards. In the past three years acting as a ries. Jews in medieval Italy, unrestrained Today Wall Street banks are once again principal has again become a big source of by the Catholic ban on usury, advanced investing large quantities of their own and pro t, and also of controversy, as banks money at high interest rates to grain farm- their clients’ capital in businesses, enjoy- try to negotiate the blurry line between ad- ers to secure an option on their crops and ing the same easy credit as their private- vising clients, lending to them and pouring then shipped the grain. One of the great in- equity clients. They call it merchant bank- their own money into deals. vestment banks of the 19th century, Bar- ing, taking their cue from the grandfather Advising companies in the S&P 500 and ings, began life as a London outpost for the of the industry, J. Pierpont Morgan, who the FTSE 100 used to be the pinnacle of an family’s West Country wool business, op- created the world’s rst billion-dollar com- investment banker’s ambitions, and merg- erating as both merchant and banker. But pany in US Steel. Since the 1980s Wall ers and acquisitions among listed compa- it soon discovered that trading capital was Street has built up merchant banking in nies still account for 75-85% of global M&A1 8 A special report on international banking The Economist May 19th 2007
2 volumes. But in the past three years priv- balance sheets to be judged as investment sign of distress. Steve Miller, who tracks le- ate-equity rms have been lining the bank- grade by rating agencies. In the heady days veraged loans for S&P LCD, says that since ers’ pockets. Freeman & Co, a New York of the 1980s, leveraged buy-outs relied on the formation of the market in the 1980s, consultancy, reckons that buy-out rms junk bonds. But leveraged loans are now spreads and leverage have risen and fallen paid $12 billion to investment banks last more popular than junk bonds, because like hemlines and only covenants have year, more than three times as much as they are quick to arrange and put a lender remained constant. four years ago. The top private-equity fee- closer to the front of the repayment queue But now, he says, new covenant-lite payer, Kohlberg Kravis Roberts (KKR), if the borrower runs into trouble. loans give borrowers rather greater lati- spent $783m. The top payer among the According to Standard & Poor’s LCD, a tude if their market sours. Such loans publicly listed companies, Xstrata, a global division of the rating agency, the rst three amounted to $48 billion in the rst quarter, mining group, spent only $245m. months of 2007 were the busiest ever for or one-third of the entire market, com- the American leveraged-loan market. New pared with just over 1% in 2005. He expects Nice little earner loans totalled $183 billion, up 55% from the the covenant-lite market to slow, but still A fringe bene t of advising on buy-outs is rst quarter of 2006. The fastest growth believes there has been a big relaxation of the invitation to invest in them. Here in- came from private-equity groups, which lending standards. As he puts it, this is not vestment banks may use their own capital, raised $53 billion in three months, two- your father’s market, or your older sister’s, as well as raising funds from outside inves- thirds more than a year earlier. for that matter . tors in the hope of making money along- As in other parts of the debt markets, Regulators, too, have begun to express side their private-equity clients. Indeed the the liquidity has been fed by the large concern, seeing parallels, perhaps, with banks’ own funds sometimes put those of number of investors willing to buy the over-optimism about the subprime their clients in the shade, though you tranches of collateralised debt obligations mortgage market. We are not entirely rarely hear them trumpeting the fact. This or, in the case of leveraged lending, collat- comfortable with the very high degrees of year Goldman Sachs set itself the task of eralised loan obligations, a market which leverage in some company borrowing situ- raising a mammoth $20 billion for its latest has rallied since 2002. Once bankers have ations, such as private equity, says private-equity venture. It already has $145 underwritten the loans, they can sell them Thomas Huertas of Britain’s Financial Ser- billion of assets under management in its on to CLO funds rather than keeping them vices Authority. We take the old-fash- alternative investment funds, and $70 bil- on their books, which may help to explain ioned view that the business cycle hasn’t lion of committed equity capital in its mer- their willingness to take greater credit risks been repealed. When we see these types chant-banking arm. than before. of deal structures it looks like the corporate Being one of the world’s biggest priv- However, developments in the past equivalent of saying ‘house prices will al- ate-equity funds, as well as one of the big- year suggest that borrowers now call the ways go up’. gest advisers to them, could cause serious shots and raise nagging concerns about Bankers are not unaware of the risks con icts of interests. Goldman is likely to underwriting standards. Buy-out rms they are running. As one senior nancier provide the third-biggest equity portion, have squeezed spreads on loans and in Europe confesses, It’s a bit like lending behind TPG Capital and KKR, of the $45 bonds to levels that make bankers’ eyes money to your children. But the pro ts billion bid for TXU, a Texas energy com- water. And despite the record investment they can earn from the so-called triple pany. The TXU bid could become the big- pouring into private-equity funds, their play advising on, nancing and investing gest buy-out ever. At times it was hard to principals have lately been passing round in buy-outs make it hard to resist. Merrill tell whether it was Goldman’s deal or that the hat among investment banks for Lynch, for example, reportedly earned of its clients. bridge equity as well as bridge loans to $75m in fees for advising on the buy-out of Yet investment banks serve so many do the largest deals. HCA, an American hospital operator, help- masters at the same time that sometimes For the rst time, borrowers have also ing to underwrite $22 billion in bank loans. they cannot avoid ru ing feathers. Gold- convinced banks to relax terms on cove- It also took a $1.5 billion equity stake. man, along with other banks, has ap- nants the checks in place to make sure the But the banks would be wise to look pointed senior people to prevent this hap- issuer comes back to the table at the rst back on recent history. The exuberant pening or at least minimise the e ects. We junk-bond era of the 1980s, when high- can’t avoid con icts, says the rm’s Mr Vi- yielding debt securities fuelled a wave of niar. We have to manage them. Living dangerously 6 takeovers, ended with the bankruptcy in In 2004 Credit Suisse (then called CSFB) US leveraged lending, $bn 1990 of Drexel Burnham Lambert, which and JPMorgan Chase went head-to-head Of which: Private equity* had dominated the market. During the fol- with private-equity paymasters such as lowing decade, banks such as Chase Man- TPG, KKR and Blackstone and won a $1.6 500 hattan formed venture-capital arms to in- billion battle for Warner Chilcott, a British 400 vest in technology start-ups. They lost pharmaceuticals company. It proved a heavily when the tech bubble burst. pyrrhic victory because it upset some of 300 Perceived con icts of interest have led the banks’ biggest clients. Unusually, one 200 some investment banks to give private of them, TPG, aired its grievances in public. equity a wide berth. JPMorgan Chase, UBS, But the most gripping action in private 100 Deutsche Bank and Morgan Stanley have equity is in nancing. The main funding 0 all retreated from merchant banking in the tool of the buy-out boom is what is known 1997 98 99 2000 01 02 03 04 05 06 past half-decade, a move which some of as leveraged lending: essentially, loans to *Includes M&A refinancings their bankers now rue bitterly but may borrowers with too much debt on their Source: Standard & Poor’s LCD and recapitalisations eventually give thanks for. 7 The Economist May 19th 2007 A special report on international banking 9
Share-cropping
Hard-hit equity traders are ghting back
T IS not just in the debt markets that risks This type of fund requires greater stock- Iare being divided into their component Competed away 7 picking skills from a manager than a plain parts. The equities business, too, is split- US equity-trading commissions per share, $ variety and commands much higher fees. ting the nancial atom. The pro tability of It is also subject to the law that not every- share-trading by large investors, which 0.4 one can beat the market all the time. used to be at the heart of brokerage, has fallen since the collapse of the dotcom 0.3 Brokers go for broke boom. The old system, in which brokers NYSE Brokers, for their part, are also putting provided money managers with research 0.2 more of their capital into supporting their as well as orders, in exchange for plump own and their clients’ equity punts, ie, act- commissions, has been overtaken by elec- 0.1 ing as principals rather than agents. Equity tronic transactions in which shares are OTC derivatives are ourishing, which means processed cheaply in vast shoals. Since brokers are increasingly making their own 2003 the 20-year decline in commissions 0 leveraged bets in order to write hedging 1980 85 90 95 2000 06 at the largest rms has been accelerating contracts for clients. Rohit D’Souza, head (see chart 7). Firms have weathered the Source: Bernstein Research of global equities at Merrill Lynch, de- storm because of a pick-up in equity un- scribes this as providing capital to sup- derwriting, which is highly pro table. But The increasingly clear divide between port our clients’ ideas much as his xed- when the cycle turns, equities trading and active investments those that attempt to income counterpart would. research will need to change. Big wallets beat the market and passive investments, On top of this, proprietary risk-taking is and sharp wits will be needed to survive. which attempt to track it, is also changing increasing. According to Mr Hintz, Wall The biggest clients, such as mutual the business. For example, the mutual- Street’s equity-related value at risk (VAR), funds, did themselves a lot of damage fund industry is becoming split between which estimates the amount it could lose with their lemming-like behaviour during dirt-cheap algorithmic index-tracking and in a short period if markets fell sharply, the internet bubble, and are exposed to higher-margin products that either include has soared from about $80m in 2002 to up- competition on many fronts. Hedge funds hedge funds or try to emulate them. wards of $140m last year. Somewhat reas- are chipping away at their business, charg- One of the fastest-growing segments is suringly, pro ts appear to be rising faster ing high fees in exchange for the promise 130/30 funds, which borrow heavily from than the VAR. Clients, however, worry (often unkept) of performance above the long/short hedge-fund model. Merrill that their ideas could at best be copied, at stockmarket benchmarks. Cheaper index- Lynch estimates that assets under manage- worst used against them, by the propri- linked products such as exchange-traded ment in such funds total about $50 billion. etary-trading desks. Some of this, such as funds have also undercut the money-man- Besides making it possible to carry long- front-running (a broker trading on its agement business. Mutual funds, in turn, only positions (a bet that selected stocks own account before executing orders sub- have taken their troubles out on brokers, will rise), they also allow 30% of long mitted earlier by the customer), is illegal, squeezing trading costs even lower. stocks to be leveraged and 30% to be sold but is thought to go on all the same. As commissions have fallen, hedge short (or borrowed and sold on the as- Their excesses during the dotcom funds have helped ease the pain for the sumption that the price will go down). boom are coming to haunt equity traders.1 brokers. They turn over share portfolios so quickly that they partially make up in in- creased volume what dealers lose from lower fees on each trade. Hedge funds have also developed lucrative prime-brok- ing relationships with a trio of investment banks that moved into the business early Morgan Stanley, Goldman Sachs and Bear Stearns borrowing money and shares from them and often paying a lot for ad- vice. But the pro tability of the prime-bro- kerage business has attracted many other investment banks: Lehman Brothers, Mer- rill Lynch and Deutsche Bank are all ener- getic late entrants. Mr Hintz of Bernstein Research reckons this may have brought down prime-brokerage returns for all. 10 A special report on international banking The Economist May 19th 2007
2 America’s Regulation National Market tors are forcing banks to disentangle the statements predicting the demise of re- System and the European Union’s Markets cost of research from the cost of trading, search carried out by investment banks, in Financial Instruments Directive (MiFID) which leaves many wondering how an- and vowed to deny non-clients access to will require brokers to pursue the best pos- alysts will pay for themselves. such research. sible deals for clients rather than automati- In fact, investment-banking research cally funnel them through their own sys- Who needs research? departments do have a future. Like trading tems. This has already produced quite a But there is a ghting spirit in the research desks, they have to become more bespoke, urry of rival electronic platforms o ering departments, just as there is on the trading catering to hedge funds and others who low prices. oors. Candace Browning, head of global want ideas that will generate fast pro ts. Analysis of companies, too, is under research at Merrill Lynch, displayed it in But they will live and die by their quality, pressure. In America research was split o March with a letter to clients complaining not by the big names of their employers. If from investment banking in 2003, with bitterly that research was being Napster- their independence is compromised, as it painful e ects. Mr Hintz reckons research ised (referring to Napster, the website that so often has been in the past, there are budgets on Wall Street fell by a third be- pioneered free music downloads). She plenty of up-and-coming boutiques to tween 2000 and 2005. In London regula- condemned the never-ending litany of steal their clients from them. 7 Here, there and everywhere
Investment banks are scouring the globe for new business
AKE the mistake of describing Gold- ties in the future euro-zone countries was Mman Sachs as sort of a global bank 1.3 times the size of their collective GDP. By Golden opportunities 8 to Lloyd Blankfein, its boss, and you get a 2004 it had grown to 2.4 times. But it still Trading revenues of investment banks’ thundering response: Sort of! What do fell short of America’s, where the capital European subsidiaries*, $bn you mean, sort of? markets were more than triple the size of Empire-building is as important to in- the economy. Investment banks’ sales and 15 vestment banks today as it was to their trading revenues in Europe still represent 12 forebears more than a century ago, when only 50-60% of those in America. Citibank had o ces from Mexico City to Gregory Fleming, the ebullient head of 9 Manila and Deutsche Bank nanced rail- markets and investment banking at Merrill 6 ways from the Wild West to Baghdad. As in Lynch in New York, predicts that in per- that earlier era, capital now moves e ort- haps only seven years’ time up to 75% of 3 lessly across time-zones, political systems his rm’s global markets and investment- 0 and asset classes. Within the past decade banking revenues may come from outside 2000 01 02 03 04 05 Europe’s single currency has taken root America, compared with 50% now. This *Bear Stearns, Goldman Sachs, and China and India have grown ush is not because of a lack of growth in this Source: Bernstein Research Lehman Brothers, Merrill Lynch with capital, as have oil exporters such as country. It is more because of growth of Russia and the Gulf states. Japan, too, has economies around the world, he says. ent. They are not just seeking to sell cheap begun to emerge from a decade of stagna- For the rst time there is a broad-based emerging-markets assets to investors from tion. America, meanwhile, has wrapped global nancial system. the rich world. The developing world, up its own nancial markets in red tape with big, commodity-rich companies and and may be losing its hegemony. Next stop the N11 surplus savings looking for safe returns, is Huw van Steenis at Morgan Stanley in Having already occupied Europe, the top itself shopping in the West for everything London estimates that securities markets ten investment banks have set their sights from Treasury bonds to wax museums outside America are expanding three on the rest of the world, too. Almost all of and steel plants. times faster than those within, which they them are now increasingly involved in the The abundance of petrodollars and overtook in size in the rst half of 2006. so-called BRIC economies, Brazil, Russia, hard-currency reserves is one reason why The pace of debt and share issuance in Eu- India and China. Next in line may be some the world is awash with liquidity and rope since 2002 has easily outstripped that of those Goldman has dubbed the N11 (for long-term interest rates are low. But many in America. Since 2005 volumes of merg- next 11); in alphabetical order, Bangladesh, emerging markets have lower domestic ers and acquisitions outside America have Egypt, Indonesia, Iran, South Korea, Mex- borrowing costs too, thanks to investment- been larger than inside. And revenues of ico, Nigeria, Pakistan, the Philippines, Tur- grade debt ratings and nascent domestic the biggest Wall Street banks’ subsidiaries key and Vietnam. capital markets. Mr Klein of Citigroup generated from trading in Europe have Banks have travelled these trade routes notes that it now costs the same to borrow doubled since 2000 (see chart 8). before in moments of global bullishness, overnight from a bank in China as from Yet there is room for further growth. probably once a decade, only to retreat one in Germany. The last remaining wall McKinsey calculates that in 1995 the out- hastily after some emerging-market crisis. separating emerging markets from de- standing stock of debt and equity securi- But this time they believe it will be di er- veloped markets, the cost of capital, has1 The Economist May 19th 2007 A special report on international banking 11
2 been almost eliminated in the past four come by that the best people shuttle be- years, he says. tween global and local banks. As a result, large developing-country Caution is indeed warranted. Credit companies with global ambitions, such as Suisse lost $1.3 billion after Russia de- China’s CNOOC, Russia’s Gazprom or In- faulted on its domestic debt in 1998, and dia’s Tata Steel, can get access to interna- Merrill Lynch sacked sta just after the de- tional nance as readily as their counter- fault (only to re-hire them months later parts from the rich world. That means when the markets proved more resilient investment banks have to deploy more than it had expected). Earlier this year Mer- sta on the ground to nd out what these rill secured a broking licence in Moscow, rms are up to. These are large, highly but has moved cautiously. complex companies with increasingly To underline these new priorities, the Many investment banks expanding in complicated needs. To really understand a lifts in Morgan Stanley’s headquarters in emerging markets have trouble nding lo- company like Gazprom requires more London’s Canary Wharf display posters cal people whom they can trust to main- than just an occasional visit from head of- about the rm’s growing involvement in tain the rm’s risk-management culture. ce, explains Jonathan Chenevix-Trench, the Middle East. The rm has moved 40 This has become all the more important chairman of Morgan Stanley Interna- bankers to Dubai, and has recently signed because investment banks are increas- tional. a joint venture with the Capital Group in ingly devolving risk-taking responsibility Saudi Arabia, where it acts mainly as an in- to regional hubs and even local o ces. Putting down roots termediary for the region’s vast wealth. In Risk management is following. But what is the best way to tackle global ex- Russia, where it has a bigger presence, dat- As recently as ve years ago, Merrill pansion? Citigroup, for example, has of- ing back to before the dark days of 1998, it Lynch had a New York-centric operating ces in 106 countries and can a ord to de- is targeting not just initial public o erings model with a lot of global products man- ploy lots of sta . For the rst time this year and acquisitions but also a growing do- aged from here, says Mr Fleming. This is it has put large emerging-market compa- mestic market. Last year securities trading changing. Banks now tend to believe that nies under the leadership of a single global in Russia rose by over 60%, it estimates. the closer they are to their markets, the bet- corporate bank. It is also betting heavily on Morgan Stanley is also one of many ter they are able to assess the risks. stronger domestic markets in countries banks excited by talk of a resource-rich Lehman Brothers is also actively con- such as Russia and China. Its philosophy, great crescent stretching from Russia sidering decentralisation, says Jeremy says Mr Klein, is when you enter a coun- through Central Asia to North Africa. The Isaacs, its chief executive in London. Until try, you don’t leave. optimists of whom there are many in in- now the people running its main global di- The philosophy of pure investment vestment banking believe this region visions have been based in New York. But banks, such as Morgan Stanley, is chang- could eventually provide the equivalent of in early May the rm announced that the ing too. Banks used to take a cyclical ap- another Germany to capital-markets reve- new head of its global xed-income busi- proach to emerging markets, investing nues. McKinsey expects the share of petro- ness would be working from London. when assets were cheap. When there was dollar-related revenues in the industry to The region that probably has a greater trouble, they would sell, says Mr Chene- grow between 9% and 15% in a decade. The variety of local peculiarities than any- vix-Trench. Now it’s not a matter of trad- potential pitfalls, however, are huge, espe- where else and where investment-bank- ing assets in these countries, it’s a matter of cially in Russia, where the rulebooks are ing revenues have grown fastest re- building businesses. new and untested and talent is so hard to cently is Asia. 7 The art of courtship
In Asia, banks have to try harder
N THIS part of the world relationship into the World Trade Organisation, to take tures in China’s brokerage industry will Iis everything, says a seasoned British tea with the country’s leaders in Beijing. have to wait, because China has stopped banker in Hong Kong. UBS, a Swiss bank, These attentions paid o earlier this issuing new licences. has learned that lesson too. In 2002 it year when UBS won permission to take Goldman, too, has practised the art of helped the Chinese government with a control of its joint-venture partner, Beijing courtship. Hank Paulson, now America’s landmark initial public o ering for Bank Securities. If everything goes as planned, treasury secretary, is said to have visited of China in Hong Kong. At about the same that will make it the only foreign bank be- China at least 70 times when he was the time it worked with China to design a sides Goldman Sachs to manage under- rm’s chief executive. There is a lot at stake. quota system allowing foreign banks lim- writing in the local market. Morgan Stan- A senior UBS manager acknowledges that ited rights to trade Chinese shares (and ley has a 34% stake in China International his rm could be called upon to help bail won the rst quota). And it employs Leon Capital Corp, which was the top share un- out other brokers if something went Brittan, the former European Union com- derwriter last year, but it is a passive one. wrong. But both UBS and Goldman are un- missioner who negotiated China’s entry Other banks keen to establish joint ven- doubtedly delighted to be rmly en-1 12 A special report on international banking The Economist May 19th 2007
2 sconced in China as their rivals watch in which issued a record-breaking $22 billion- traded in China. Currency controls im- envy. For China is arguably the most im- worth of new shares last year; Merrill pede all manner of things that could be portant prize as investment banks scram- Lynch and the Royal Bank of Scotland tri- useful to Chinese rms. Hedging is ex- ble back into Asia, putting the mishaps of pled their money from investing in Bank of tremely di cult. For banks such as Morgan the late 1990s behind them. China. Liquidity is abundant because the Stanley, which has acquired a local licence According to Freeman & Co, investment region saves so much. Yet no bank has es- by buying a small bank, each new product banking fees from Asia grew at 18% a year tablished a fully integrated investment- it hopes to sell requires a separate stamp of between 2001 and 2006, faster than in Eu- banking model in Asia, which means all approval, which can take months. And be- rope and three times as fast as in America. comers have a chance to make their mark. cause local banks still account for almost Growth was strongest in India, rising by Merrill Lynch believes India may be the all domestic lending, there is no securitisa- 47% a year from a low base, but the fee pool land of greatest opportunity in the near tion of bank loans. in China and its region was almost the size term, judging China more of an IPO pros- Yet even with such constraints, there of Japan’s, which has a much larger do- pect (the bank was lead bookrunner for are plenty of ways for banks to make mestic market (see chart 9). Most rms the ICBC otation, which paid it hand- money in China. IPOs are the biggest, and predict that double-digit revenue growth somely). Last year it paid $500m to raise its even if the giant listings of recent years are will continue across the region in the next stake in DSP, a leading Indian broker, to close to exhausted, there are still mid-mar- few years. 90%. Goldman and Morgan Stanley have ket rms needing to raise capital. China’s A strategy for Asia is more complex to abandoned their Indian joint ventures be- vast corporate underbelly contains lots of design than for Europe or America. The - cause regulations have eased, believing growing companies that are not yet ready nancial systems across the region are at they can do better on their own there. Citi- for public markets but are prepared to o er vastly di erent stages of maturity and group and UBS, among others, have suc- bold investors long-term stakes through there is a bewildering array of regulations, private placements. Such issues are han- legal systems and compliance require- dled quietly, but a banker says hedge ments. In Hong Kong and Singapore, for Coming on nicely 9 funds in Hong Kong are mopping them up. example, investment banks trade every- Investment banking fees in Asia Some bankers believe that the keenest thing from foreign-exchange futures to By sub-region, $bn foreign rms may have got a little ahead of credit derivatives and structured products. Australasia Japan themselves. It’s like kids going to the South Korea has become one of the China & north Asia South-East Asia sweet shop for the rst time, says a long- world’s biggest markets for warrants in the India & subcontinent time Hong Kong banker. Others are play- few years since it started trading in equity 15 ing a waiting game. JPMorgan Chase, for derivatives. India has a vibrant local stock- example, appears to believe that at a 12 market and sophisticated retail investors, weaker point in the economic cycle it will but currency and other controls make it a 9 nd opportunities to make a decisive frustrating place for international brokers. move into China. Not all are wholly sym- China, as ever, blows hot and cold. Cu- 6 pathetic to Mr Paulson who, in response to riously, at present more investment-bank- 3 mounting congressional pressure against ing revenues come from Taiwan than from China’s trade surplus, is urging the country the mainland, though China’s are growing 0 to free up the capital markets. Some, such 2001 02 03 04 05 06 faster, says Lehman Brothers. The value of as Robert Morrice, chief executive of Bar- the Chinese stockmarket tops $1 trillion, Source: Freeman & Co clays Capital in Asia, note a lack of reci- but after a huge run-up at the start of this procity in the West in granting access to year the market fell when o cials sought cessfully entered alone. All want to book a emerging-market banks. to calm down overexcited retail investors. bigger share of investment-banking reve- Clearly there will be setbacks in Asia. The regulatory environment in Beijing is nues that have risen tenfold since 2002. Last year Merrill led the underwriting of a hard to gauge and enforcement of securi- The spoils have not been divided evenly, bond issue for a government-owned Thai ties law is haphazard. Bankers say local however: local brokers have dropped bank launched hours before the military brokers have often misused clients’ funds. down the league tables. None of them ad- coup. After a debate about whether to ex- vised on Tata Steel’s takeover last year of ercise the bond’s force majeure clause, the Watch it grow Corus, an Anglo-Dutch steel company. issue was repriced and relaunched. But there are plenty of reasons for risk-tak- China is likely to keep a careful eye on Getting the risk management right is ers to salivate over the region. Australia the experience of India’s domestic bro- one of the reasons why banks like UBS provides the second-largest source of fees kers. As the head of a top global invest- prefer to have full control of operations in in the region after Japan, according to Leh- ment bank in China puts it, the authorities the region. But Peter Wu i, the bank’s man Brothers. It is also replete with priv- are prepared to see a securities market that chief executive, argues that diversi cation ate-equity money (much of it on the re- is less than fully Chinese, just not a pre- matters most and can improve stability bound after a rebu from China). Hong dominantly foreign one . They want to re- over time. When regulators express con- Kong and Singapore compete to attract tain control to stop markets becoming too cern about the bank’s growing exposure to hedge funds. Some banks have made for- volatile and threatening domestic stabil- far- ung places, he has the perfect riposte. tunes from pouring private-equity-style ity. A compliant domestic brokerage base What business has lost UBS the most capital into the region. Goldman earned is easier to steer than the thundering herd money in recent history? Not emerging $5.2 billion from a small stake in the Indus- from Wall Street and Europe. markets, he says, but lending on property trial and Commercial Bank of China, Many instruments still cannot be in Switzerland in the late 1980s. 7 The Economist May 19th 2007 A special report on international banking 13
Comeback kid
After two decades in the wilderness, Japan is slowly returning to the international nancial scene
HEN Yuji Yamamoto, Japan’s minis- Wter for nancial services, recently an- nounced his intention to revive Tokyo as a world nancial centre, expatriate bankers could hardly suppress a smile. It has been almost 20 years since Japanese nancial institutions ashed their capital around New York and London, and since then the balance of power has shifted dramatically. Sumitomo Bank, which in 1986 rattled Wall Street by buying a slice of Goldman Sachs, is now part of a bigger group, Sumi- tomo Mitsui Banking Corp (SMBC), in which the surippa is on the other foot: Goldman is a big investor. Bankers in Ja- pan complain that the locals have become their business customers. As he puts it: that lesson, says Katsuyuki Hasegawa, se- insular in nancial matters the legacy of Cheap credit has been the dead hand on nior economist at the Mizuho Research In- years when cash-strapped banks stopped the capital market. stitute. His gures show that in 2005 Japa- sending their sta abroad and teaching The banking crisis and economic nese companies for the rst time in a them English. The country is a regulatory slump of the 1990s may have erased some decade borrowed more than they repaid. quagmire. Japanese authorities require of the most familiar names of Japan’s However, last year two-thirds of their bor- more paperwork than does the rest of Asia glory days of banking, but they have not rowing needs were met by bank loans, put together, says a banker. wiped out all the old habits. Three mega- compared with just 19% in America, where Most poignantly, while Japan was ab- banks have emerged from a wave of merg- the capital markets are much more liquid. sorbed with its economic slump and bad- ers and takeovers: Mizuho, formed in The market for syndicated loans is loan problems in the 1990s, Hong Kong 2000, SMBC, hatched a year later, and the growing by about 15% a year, says Mr Ha- and Singapore emerged as English-speak- biggest, Mitsubishi-UFJ, created in 2005. segawa. The securitisation market is ex- ing Asian trading hubs with light regula- But they have retained some of their old panding almost twice as fast; Wall Street tion, lower taxes and, peripatetic bankers practices of relationship lending, and are rms such as Morgan Stanley and Lehman note, a less gruelling journey between air- only just beginning to make use of capital- Brothers have bought regional banks to port and o ce. These are brave words, markets products. gain access to their mortgage loans. Yet the one foreign banker says of Mr Yamamoto’s The lesson we learned in the past de- debt markets remain backward, and Mr plans. But Tokyo has lost a lot of time. cade was that our loan books were very Hasegawa says they operate ine ciently: International investment banks have concentrated on property. We need more changing jobs, for example, can make it not sat idly by. The recovery of Japan’s diversi cation, which means developing a much harder for an applicant to get a mort- equity markets, the pro ts from converting syndicated-loan market and a risk-hedg- gage, even if he is going to a more senior non-performing loans into investments ing market. We paid a high price to learn and better-paid post. such as golf courses and property, and Another problem is the requirement for trading in the oceanic government-bond strict rewalls between corporate and in- 10 market have made it a good place to do Back in the swim vestment banks. This dates back to the per- business in recent years, but a frustrating Takeovers of foreign targets by Japanese companies: iod after the second world war when Ja- one nonetheless. Value, $bn Number of deals pan imported rules from America, includ- 50 500 ing a version of the 1933 Glass-Steagall act, The bane of cheap credit separating the activities of commercial Last year capital-market fees paid to invest- 40 400 banks and securities rms. America ment banks as a proportion of GDP were scrapped Glass-Steagall in 1999, but Article only one-third the level in America and 30 300 65, as the Japanese law is known, remains half the level in Europe, bankers say. Ja- 20 200 on the books. Lenders and investment pan’s share of the global equity market has bankers are unable to share information shrunk from over a third in 1990 to a puny 10 100 on a client unless the client gives permis- one-tenth. One of the main reasons, says sion. This adds another layer of cost to in- Mark Branson, chief executive of UBS Se- 0 0 vestment banking in Japan. And regula- 1986 90 95 2000 06 curities Japan, is that the local commercial tion is unpredictable. You’re always Source: Thomson Financial banks continue to lend at very low rates to feeling your way, says one banker. 1 14 A special report on international banking The Economist May 19th 2007
2 Given the cheaper and easier opportu- are shaking up corporate governance. In vour of a more liquid market for capital in nities elsewhere in Asia, there are plenty of 2000 Ripplewood faced strong opposition which local as well as international rms reasons not to allocate more investment- when it rescued what became Shinsei can thrive, but he is up against powerful banking resources to Japan. But there are bank, but the deal proved hugely pro t- vested interests. So bankers were im- quite a few encouraging signs too. Japan able and other private-equity groups have pressed when regulators did nothing to Tobacco’s acquisition of Gallaher, its Brit- managed to elbow their way into deals. stop Citigroup’s $7.7 billion acquisition of ish equivalent, was one of many recent And league-table rankings last year were Nikko Cordial, owner of the third-largest overseas conquests: last year the value of fairly evenly shared between the top three Japanese broker by revenue (even though outbound M&A from Japan exceeded that global investment banks, Citigroup, UBS Nikko had been tainted by a recent admin- of the bubble years of 1990 and 2000 (see and Goldman Sachs, and the local brokers, istrative scandal). That was a sign of open- chart 10, previous page). Foreign investors Nomura, Daiwa and Mizuho. ness that anyone, Japanese- or English- now hold a quarter of Japanese shares and Mr Yamamoto is thought to be in fa- speaking, could understand. 7 The wobble factor
Regulators are doing their best to ensure nancial stability, but they don’t have all the answers
N 2005 participants at the Kansas City such as hedge funds, intermediated by a dox, as Malcolm Knight, general manager IFed’s annual shindig in Jackson Hole, small number of large global investment of the BIS, put it in a speech in February to Wyoming, were reminded of a sunny day banks, poses new questions about nan- the Global Association of Risk Profes- in London in June 2000 when the queen cial stability. The professional pessi- sionals, is that nancial markets may be opened the new Millennium Bridge. Thou- mists , as some bankers call regulators, vulnerable to the same forces that trig- sands of people ocked to take part in the concede that under benign economic con- gered old-fashioned bank runs. And if spectacle, but no sooner had they stepped ditions everything appears to be working there is a run, hedge funds, whose assets on to the bridge than it started shaking vio- remarkably well. But how bad will the under management have tripled this de- lently, forcing them to hold on to the hand- wobble be when conditions get worse? cade to about $1.5 trillion, may drain li- rails. The bridge was immediately closed It is clear that new forces are at work. quidity rather than provide it. again and remained so for 18 months. The big investment banks’ exposure to pri- The speaker at Jackson Hole, Hyun vately arranged credit derivatives is esti- Safety catches Song Shin, a professor of economics at mated to be nearly as large as to their more The industry has tried to deal with these Princeton University, used that embarrass- traditional forms of lending. Hedge funds concerns. In 2005 some of the world’s ing wobble as a metaphor for potential in- early last year accounted for more than most senior bankers, led by Gerald Corri- stability in nancial markets. He was dis- half of all credit-derivative transactions. gan, a former head of the New York Fed cussing a paper entitled Has Financial Commercial banks have sold o loans and now at Goldman Sachs, issued a compre- Development Made the World Riskier? , bought structured credit products instead. hensive report that looked at nancial sta- and he equated the pedestrians on the These three factors have fed more li- bility from a private-sector perspective. bridge to people in nancial markets, and quidity into the capital markets, and credit This di erentiated between distur- the bridge itself to movements in prices. spreads have fallen dramatically. The para- bances (isolated problems) and shocks As Mr Shin observed, soldiers are (systemic ones). It identi ed three red trained to break step before crossing zone shocks: the emerging-markets debt bridges. The footfall of thousands of indi- crisis of the mid-1980s; the stockmarket viduals should be entirely random in the crash of 1987; and the Asian and Russian rst place. Here is the catch, he said. crises culminating in the near-collapse of When the bridge moves, everyone ad- Long-Term Capital Management, a hugely justs his or her stance at the same time. over-leveraged hedge fund, in 1998. This synchronised movement pushes the To help prevent further shocks, the bridge that the people are standing on, and group produced guidelines on which regu- makes it move even more. This, in turn, lators are still chewing today. The most im- makes the people adjust their stance more portant of these include identifying credit drastically, and so on. In other words, the risk, liquidity risk, crowded trades, embed- wobble of the bridge feeds on itself. ded leverage in complex instruments, the Fears of a self-reinforcing downward shortcomings of nancial modelling tech- spiral in prices have been around for as niques and unexpected tail risks . long as nancial markets have, but regula- The most basic rule, say regulators, is tors and central bankers are becoming know your counterparty . Banks are be- more vocal about the danger. The prolifer- ing discouraged from doing business with ation of new instruments, such as credit hedge funds that reveal little about their derivatives, and new market participants, exposures or risk-management systems,1 The Economist May 19th 2007 A special report on international banking 15
2 and to strengthen collateral requirements respect of new instruments and trading where there are doubts. This is especially partners. The accord updates the one-size- important when hedge funds have expo- ts-all framework of Basel 1, dating back to sure to many banks, so lenders are not sure 1988, when capital requirements were set where they stand in the repayment queue. on parameters now considered unsatisfac- But even with the best checks and bal- tory. For example, banks had to post the ances in place, collateral can be a double- same amount of capital against lending to edged sword. As Mr Geithner of the New IBM as to an internet start-up. Under Basel York Fed puts it, in periods of stress, as 2, capital requirements will depend on the rms move to hedge against future losses rating of a borrower and the type of loan. and to raise money for margin calls, the Sometimes banks will also be able to use brake becomes the accelerator. It can ex- their own assessments of capital needs. acerbate the wobble. Some aspects of the new regime re- Banks should not be complacent about quire extensive discussion between banks their nancial models, either. Prices of and their supervisors on how to assess new instruments, by de nition, have short risks, though there is room for further im- complex credit exposures. Capital also has histories, which makes it hard to predict provement. Annette Nazareth, a commis- to be set aside against operating losses, how they will react in a crisis. At the height sioner at America’s Securities and Ex- which for large investment banks exposed of the troubles with subprime mortgages change Commission (which supervises to complex transactions may be onerous. earlier this year the price of indices based investment banks), says there are rum- Not everybody agrees that Basel 2 has on tranches of subprime loans went into blings that non-American banks trying to all the answers. Sheila Bair, chairman of free fall. Regulators are now asking build up their prime-brokerage arms, America’s Federal Deposit Insurance Cor- whether that was modelled for. through which they supply hedge funds poration, which provides a safety net for Sorting out a crisis once it has occurred with credit and other facilities, may be of- bank depositors, worries that the models it will also present new headaches. With risk fering lenient credit terms. John Dugan, uses to assess risk-weighted capital have held by so many new market participants, head of the O ce of the Comptroller of been designed in a period of unprece- it is not clear how easily they could be cor- the Currency, which oversees the largest dented prosperity for the banks. That may ralled to deal with a large default. And commercial banks in America, says there lead to insu cient levels of capital when even where banks know there are short- has been some slippage in the collateral the credit cycle deteriorates. I’d rather comings in the market infrastructure for demanded from hedge funds. But, he maintain a constant cushion of capital in new assets, they may not do anything notes, our banks owe them more money good times and bad, she says. about it individually for fear of losing busi- than they owe us. This is a function of - The accord does maintain minimum ness to rivals. For example, the industry nancial-market conditions and credit capital requirements and allows plenty of used to take a long time to settle CDS terms, and because both of these variables scope for ne-tuning. But, as Ms Bair trades. It was only after regulators in New can change we have to remain vigilant. points out, with banks potentially holding York and London twisted its arm that, col- Many hope that when the Basel 2 capi- much less capital during business expan- lectively, it agreed to mend its ways. tal accord is introduced in Europe and sions under the new rules, raising the capi- Regulators say the investment banks (eventually) in America, it will further tal they will need to withstand a recession have got much better at dealing with the strengthen risk-management systems in could be painful and risk a credit crunch. 7 Eggheads and long tails
Investment banks are a high-wire act. How good are the safety nets?
ANKERS can be surprisingly colourful butter on toast. With luck, he says, the but- balance sheets, they now carry more com- B when describing the risks that keep ter will not be rancid. plex exposures, such as collateralised lend- them, their shareholders and their super- Mr Isaacs at Lehman Brothers in Lon- ing to hedge funds. visors awake at night. One Spaniard likens don notes that over the past century of Risk, though spread far more widely, the nancial system to a spider’s web world wars and cold wars the nancial has not disappeared. In a crisis such expo- over which central banks have less control system has proved more resilient than sures may surface in ways that are hard to than they did in the past; another talks might have been expected. Like many predict, especially because so many banks about a constellation of risks and ap- bankers, he thinks that the biggest danger are exposed to the same counterparties. proaching asteroids. A French banker re- to the nancial system at present is avian The risk is disseminated, but trying to re- fers to a sou é of o -balance-sheet ex- u. But he agrees that there are new di - aggregate it becomes an almost impossible posures, whipped up by leverage. A British culties in managing a system where risk is task, says one senior investment banker. counterpart, speaking over breakfast, com- transferred from banks to investors. Other Banks are not helpless in the face of pares the process of transferring risk bankers point out that although invest- such uncertainty. One of the landmark around the nancial system to spreading ment banks may have fewer loans on their changes of the past 20 years has been the1 16 A special report on international banking The Economist May 19th 2007
2 development of risk-management sys- fascinating mixture of risk-management to hedge or sell positions and must hold tems that estimate potential market, credit, methodologies which provide a rare them from peak to trough. One of its xed- liquidity and operational losses and seek glimpse into the internal culture of these income tests is a replay of the 1998 LTCM to impose appropriate limits. Investment secretive organisations. and bond-market meltdown. In its equity banks, because of the complexity of their In a report last year Moody’s looked at division it uses a supercrash test that as- exposures, have been at the forefront of ef- Goldman Sachs, the most pro table in- sumes an instantaneous fall in the price of forts to measure and manage risks, encour- vestment bank and, in many respects, the equities of 50%. The Armageddon experi- aged further by the approach of Basel 2. envy of its peers. Describing its risk philo- ment combines the worst that has hap- They have employed mathematicians and sophy, Moody’s said Goldman saw risk pened in both xed-income and equity spent billions of dollars on computer sys- not only as the counterpart to revenues or markets over the past 30 years. Besides tems. Barclays Capital has turned whole pro t, but as the source of pro t . Accord- market risks, Goldman also assesses credit walls into whiteboards to accommodate ing to Moody’s, most rms might ask risks, based on whether a counterparty the hugely complex formulas involved. themselves if they are taking too much might default on a loan or fail to honour a But the results of all this e ort are not quite risk; Goldman Sachs’s most senior man- derivative contract, and liquidity risk. But as brilliant as might have been hoped. agement more aggressively than others the rm does not disclose much detail on The bond-market turmoil leading to the constantly asks the question, ‘are we tak- any of its simulations, nor do most other liquidation of Long-Term Capital Manage- ing too little?’ and ‘are we taking the right banks. France’s Société Générale is an hon- ment (LTCM) in the summer of 1998 not kind of risks?’ ourable exception. only exposed the risk-management negli- In its annual report Goldman says that Moody’s is impressed by many of gence of that institution, sta ed by Nobel all risk-control functions ultimately report Goldman’s techniques. Although the risks laureates and storied traders; many invest- to the management committee (though, in have increased, the ability to generate ment banks were caught out too. The les- earnings has gone up even more. But the son, learned at an exorbitant cost, was that rating agency also has concerns, both models are only as good as what is fed into Who dares, wins 11 about Goldman and about its Wall Street them. So risk management is as much For top ten investment banks peers. It worries about the opacity, the ex- about human judgment as about math- Equity value at risk Equity-trading revenues posure to illiquid investments and the fail- ematical genius. $m $bn ure to spell out worst-case scenarios. Gold- And there is always the million-to-one 600 18 man has large, illiquid o -balance-sheet chance, far along one tail of the bell curve, exposures, too, known as Variable Interest 500 15 that something will go disastrously wrong. Entities. These include pools of debt se- There is a parallel here with climate 400 12 curities such as mortgages. Last year these change, where many previous sceptics are 300 9 assets surged to $72.5 billion from $54.1 bil- now in favour of taking preventive ac- lion, and Goldman’s maximum exposure tion not so much because they think the 200 6 to loss from them doubled to $20 billion. world could not cope with the most 100 3 Mr Viniar, the rm’s chief nancial o - widely expected rise in temperature, but cer, acknowledges that the models cannot because they fear that things might just 0 0 be perfect: We know with 100% certainty possibly turn out very much worse. 2002 03 04 05 06 that we can’t know everything. But the Source: Boston Consulting Group main backstop, what he calls the life- Thinking the unthinkable blood of Goldman Sachs , is liquidity. He An assessment of the investment banks’ common with other Wall Street rms, not thinks that liquidity problems are the risk-management systems must start from to the board of directors). The checks and main source of risk in investment banking. the premise that as they have grown, and balances then cascade down to the level of They brought down Drexel Burnham Lam- diversi ed their sources of revenue, they each trading-desk head, the front-line bert in 1990 and Barings ve years later. should be less exposed to losses capable of where decisions to buy and sell are made Goldman keeps $50 billion-60 billion of wiping out the rm. That, after all, is the almost instantly. The main tool for assess- government securities ready to be de- point of diversi cation. ing the short-term losses traders are ex- ployed if a liquidity crisis strikes. The Also, trading oors now pay much posed to is value at risk (VAR). Goldman, amount increases in proportion to the more attention to risk management than for example, would expect to lose more rm’s assets and capital. And Goldman - they used to, and although there are inev- than its VAR in the course of a single day nances all its long-term illiquid assets with itable tensions between risk-takers and about once a month. Last year its daily long-term debt and equity. risk-controllers, almost everyone appears VAR averaged $101m, against $70m in to take the issue seriously. 2005. But VAR is clumsy, relies on histori- Simmering pots But because risk management has be- cal data and works best when markets are The universal banks conduct their risk come so complex, understanding the sys- stable. It does not capture the e ects of management along similar lines to Wall tems in place even in one bank could take highly stressed markets, nor what would Street. But there are di erences in method- days. Those who have tried, such as happen if assets could not be quickly ology, and in each rm’s risk appetite. Moody’s Investors Service, are impressed hedged or liquidated. Credit Suisse and UBS, two Swiss banks, with the progress made by Wall Street What bankers use for those things are are among the most forthcoming with banks, though they think that levels of dis- stress tests. According to Moody’s, the their risk-management assessments. closure are higher among some of the big overall assumption behind Goldman’s Wilson Ervin, Credit Suisse’s chief risk European banks. They have also found a scenario planning is that the rm is unable o cer, appropriately works in a building1 The Economist May 19th 2007 A special report on international banking 17
2 that is a living testament to risk. Credit Suisse’s New York headquarters, at 11 Madison Avenue, was intended to be the world’s tallest building when Metropoli- tan Life started work on it in the 1920s. But the 1929 stockmarket crash put an end to that ambition and construction stopped at 28 oors. That is how the tower has re- mained to this day, stubby but stunning. Mr Ervin is ready to clamp down on ex- posures that might dent the bank’s balance sheet or earnings, but most of his job in- volves watching the pots simmering . He says it is important to concentrate on good ited; and never be hostage to a single trans- tain a partnership culture even after they information and clear rules, not to micro- action or client. UBS sets its overall risk ca- have gone public. Goldman, for example, manage the decisions of traders and credit pacity on the basis that it wants to be able has a partnership pool into which a large o cers. However, he notes that risk appe- to pay dividends out of current earnings, share of its pro ts go. tites are changing across the industry, es- not retained ones. But thanks to earnings Given the rapid sta turnover at invest- pecially in the use of investment banks’ growth and the divestment of its private- ment banks, keeping the rms’ culture own capital to support private-equity equity portfolio, its ability to take risks has carriers on board is a perennial problem. transactions. Things we used to say were grown much faster than its actual risk ex- The best way is to pay them generously. verboten are now considered an acceptable posure. Indeed, it is sometimes criticised But success is also a powerful incentive, so risk-return trade-o as liquidity and hedg- for not taking large enough punts. Earlier employees need to be allowed to take risks ing markets have developed. this year Ken Moelis, an investment and not be sti ed with controls. That may Credit Suisse’s rival, UBS, can hardly banker prominent on Wall Street, left the mean giving ambitious twenty-some- forget the risk-management failure of its rm, reportedly because he felt it was too things their heads. Mr Blankfein at Gold- predecessor, Union Bank of Switzerland. It conservative in using its own capital in man acknowledges that some of the made disastrous investments in the late private-equity deals. young traders at the rm have no memory 1990s, including in LTCM, and was taken of a business cycle. Clearly he does, but he over, in tatters, by Swiss Bank Corp. Now, A question of culture says he respects their views and has not as at Credit Suisse, risk is managed at the In the end, for all the fancy technologies, it been disappointed so far. top of the bank. Responsibility is dele- is culture that counts. This boils down to Above those traders are wiser heads gated by the board of directors to Walter the people a rm employs, the responsibil- who should be prepared to extend a re- Stuerzinger, group chief risk o cer. ities it gives them and the way it rewards straining hand. Between them, the 21 Mr Stuerzinger describes UBS’s ap- them for putting the company’s interests members of Goldman’s management proach to risk in stark terms: zero tolerance above their own. One well-established committee have 300 years of experience for efs; beware of tail risks, risk concentra- technique is to give them shares in the within the rm. Yet even that massed ex- tions, illiquid risks and legacies; avoid risks company, which can make up a large part perience cannot guarantee that they will that cannot be properly assessed or lim- of their pay. Some Wall Street rms main- always be able to keep trouble at bay. 7 Spreading the muck
Is risk ending up in the right places?
ONEY is like muck, wrote Francis allows banks to hold less capital if they nely spun web of global nance? This MBacon in 1625. Not good except it lend to sound and diverse borrowers, so special report has sought to test the nuts be spread. Today’s pin-striped philoso- better to sell o the dodgier stu if they and bolts of their risk-management ma- phers might swap the word money for can. The more of their lumpish loans that chinery to see how solid they are. What it risk . Hold credit risk too long, Wall Street are converted into liquid securities, the has found is partially reassuring. The top wisdom has it, and it may eventually reek higher the pro ts that accrue to the mid- rms trade in such a large number of pro- to high heaven. Spread it about, and a hun- dlemen, the investment banks. And regu- ducts, markets and countries that they ap- dred owers of nance will bloom. lators too are happier if the banks whose pear to be better cushioned than ever It is at least 20 years since such theories depositors they are meant to be safeguard- against problems arising in any one part of began to take root in the world of banking, ing have less toxic matter on their books. their business. Competition whether and there are good reasons why commer- But where does that risk end up? And caused by the demise of Glass-Steagall in cial banks that make loans, and invest- might some of it be sitting undetected on America, the emergence of strong univer- ment banks that transform them into se- the books of investment banks, the most sal banks in Europe or boutique rms such curities, have embraced them. Regulation complex institutions at the centre of the as hedge funds poaching their best peo-1 18 A special report on international banking The Economist May 19th 2007
2 ple has sharpened their wits. They are they go after liquid assets: most of their li- the proliferation of new instruments, such taking more risk, but then risk is their busi- abilities are long-term, and therefore bet- as (back then) junk bonds and swaps. At ness. Earnings and capital have risen even ter suited to higher-yielding illiquid ones. the time, Alexandre Lamfalussy, one of Mr faster. And they are trying to expect the un- He believes such concerns have be- Knight’s predecessors at the BIS, aired con- expected, aware of the inherent aws in come more serious now that pension pro- cerns that now sound eerily familiar. It’s the models they use to measure their viders and governments are increasingly not the risk to individual banks I’m wor- increasingly complex exposures. transferring responsibility for risk-taking ried about but macro-prudential risk it is to individuals, through de ned-contribu- much harder to tell who is bearing what Good times can’t last for ever tion pension schemes rather than de ned- risk and where it is ending up. He contin- But with money so cheap and liquidity so bene t ones in which companies suppos- ued: Transparency is diminishing. Some plentiful, the investment banks have inev- edly bear the risk. Jaime Caruana, head of risk-takers simply do not know the risk. itably become a little complacent. Their capital markets at the International Mone- It is encouraging that in the intervening willingness to rush headlong into sub- tary Fund, strikes a pessimistic note. It is two decades, when the capital markets prime mortgage lending in America is a not easy to know where all the risks are have increased hugely in size, scope and case in point. As one European central distributed. But some of them are ending sophistication, only two big shocks, one in banker puts it: With all the sophistication up with the consumer who is taking on the 1987 (proving Mr Lamfalussy right) and of their risk-management systems, a role of shock absorber of last resort. We one in 1998, have put the system to the test. whole series of the most powerful institu- need to increase his level of nancial edu- For much of that period the markets have tions in nance went ahead and made the cation so that the consumer better under- enjoyed easy money and lashings of li- classic errors of not watching credit qual- stands what he is taking on. quidity. When those halcyon days come to ity and overshooting. And their air for When The Economist published a re- an end, it will be not just the bright young creating complex instruments in which le- port similar to this one exactly 20 years things in Wall Street and Canary Wharf verage and collateral are nely balanced ago, much of the argument concentrated who will feel the e ects, but widows, or- may back re on them as well as on the in- on the risks posed by securitisation and phans, pensioners and everybody else. 7 dustry at large when big risks resurface and they rush for safe haven products. As the BIS’s Mr Knight deftly puts it, the trouble with risk is that now you see it, now you don’t. Regulators also judge the soundness of the nancial system in terms of the safety of individual banks. For all their misgiv- ings, they generally applaud the improve- ments they have seen in investment banks and in risk management across the nan- cial system as a whole. But what of the end-users the pension funds managing the accounts of individ- uals, who are often beyond the regulators’ remit yet may be increasingly exposed to these tail risks? Are they expert enough to assess the soundness of the loans they in- vest in? Are they as savvy as banks, whose Future special reports core business is managing risk, and which O er to readers Reprints of this special report are available at a Countries and regions have close and possibly long-standing price of £3.50 plus postage and packing. Hong Kong June 30th relationships with the borrowers? A minimum order of ve copies is required. Iran July 14th Avinash Persaud, head of Intelligence Corporate o er Business, nance, economics and ideas Capital, a rm of nancial advisers, and an Business and climate change June 2nd expert on systemic risk, says a new culture Customisation options on corporate orders of 100 Air travel June 16th has grown up in which risk has become a or more are available. Please contact us to discuss Financial centres September 15th hot potato, to be passed on as rapidly as your requirements. possible. Increasingly it is ending up in ob- Send all orders to: scure and unregulated corners. The nan- The Rights and Syndication Department cial system, he says, has become better at 26 Red Lion Square trading risk and pricing it, but maybe London WC1r 4HQ worse at holding it . Pension funds, for ex- Tel +44 (0)20 7576 8000 ample, currently have an appetite for com- Fax +44 (0)20 7576 8492 pany loans and bonds. Is that a good e-mail: [email protected] Previous special reports and a list of thing? Mr Persaud thinks not, because they forthcoming ones can be found online are long-term investors and the longer an investor holds a bond, the higher the www.economist.com/specialreports chance that it will default. Neither should