From the monthly archives:

July 2013

Earlier in July, Elizabeth Warren, the newly elected advocate Senator from Massachusetts, proposed splitting up banks’ commercial and investment banking businesses into two completely separate business units.  Her catchphrase for her desire is: “Banking should be boring.” Joined by senators McCain, King, and Cantwell, the bill states as its purpose: to reduce risks to the financial system by limiting banks’ ability to engage in certain risky activities and limiting conflicts of interest, to reinstate certain Glass-Steagall Act protections that were repealed by the Gramm-Leach-Biley Act and for other purposes …

Overall, the ideas behind the bill are simply rehashed complaints that are approaching a century in antiquity.  The complaints, as stated in the bill, include issues with deregulation and risk taking, the complexity of big banks’ balance sheets, concerns about derivatives and trading activities, and general disgust over lack of government oversight. The bill cites such reports as the Vickers Independent Commission on Banking (United Kingdom), the Financial Stability Oversight Council (United States), and the Liikanen Report (Euro area) as entities finding weaknesses associated with the current activities of investment banks.

The question here is: how much would splitting up the commercial and investment banking businesses of investment banks harm the economy?

In order to answer this question, one has to appreciate the relationship between risk and economic growth and the extra risk enabled by merging commercial and investment banking businesses.

As a general background, typically risk-taking is associated with increased economic growth. In fact, in all economic boom cycles, risk-taking was present, and generally an important contributor to healthy economic conditions. And why is risk-taking important for economic growth?  The simple answer is that risk-taking leads to innovation, new products, investment, and other economic activities essential to economic expansion.

In fact, as a matter of common understanding, a highly important factor contributing to the advantage the United States has in technological innovation (Silicon Valley) is partly due to the venture capital system, where investors make very risky bets on innovative start-up companies.  The ecosystem and connection between technological innovation and financial risk-taking is only the tip of the iceberg regarding the high importance of financial risk-taking.

Advocates for greater government regulation will simply reply that venture capital risk-taking is completely different than the risk-taking in which investment banks are engaged, which is true to a degree. Essentially, regulation advocates for the investment banking industry point to the broad effect big investment bank activities can have on the economy if they fail, compared to the relatively small effect on the economy when venture capital firms fail.  The example most commonly given is the recent recession and the associated bailouts of certain financial firms.

How could a person with an understanding of the importance of the free-market respond to the regulation proponents?  The easy answer is that the problem lies with government policy rather than the investment banking industry’s world class risk management experts. Essentially, having a government backstop encourages more risk-taking than what might happen if bankruptcy was always on the table.

With this brief background in mind, how might splitting up the commercial and investment banking businesses of big banks affect the economy? Empirical evidence does not provide an easy answer. For example, here’s what economic growth looked like before the Glass-Steagall Act of 1933, after the Glass-Steagall Act was implemented, and after the Gramm-Leach-Biley Act took effect in 1999.  The data behind the chart doesn’t give any more conclusions than the ambiguity introduced by the chart.

GS

In doing some further analysis by using input-output matrices, one could reasonably assume that splitting up investment banks may decrease employment in the economy by up to 10,000 people.  Not a lot, but then again, in a very competitive globalized economy, every job matters.

Overall, Senator Warren’s idea of breaking up the investment banking and commercial banking components of big investment banks would likely have some downside effects on the economy, including a potential of a significant drop in employment economy-wide.

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Asian bond issuance had investment banking firms quite happy through the first half of calendar year 2013. The fees on these transactions and issuances produced a significant stream of revenue that kept bankers quite busy. However, the winds seem to have changed, taking their signal from the U.S. Federal Reserve’s own stepping away from the bond market. Central banks and big institutions in foreign countries often tend to pay attention to international markets, so the U.S. move, scheduled to occur by 2014, may have already started a ripple effect across different markets.

Changes in Flow

The demand and movement of bond issuance that has occurred mid-year was not a gradual change. As of early June, bond issuance activity in the Asian market suddenly froze off and disappeared. Mergers subsequently died off as well. The last big movement was by China Huaneng Group in the first week of June, which generated a $400 million bond issuance.

The amount of revenue involved is no chump change either; fees in the first half of the year generated $3.6 billion for bankers, which is sizeable, but it is also the lowest level of fees collected since 2009. The various revenue charges that feed into this income includes debt arrangement fees, equity transactions, advice and assistance on mergers, and acquisitions.

From the technical perspective, the windows for new bond issuances in Asian markets are few and far between now. Much of this has to do with market volatility, which has increased dramatically since the chatter from the U.S. Federal Reserve. Prior to this point, Asian markets were seeing regular activity in government bond sales, mainly due to the extremely low interest rate environment that existed up until mid-year 2013. However, as soon as the Federal Reserve began speaking about “tapering” in June 2013, interest rates shot up. That, in turn, has likely triggered a cost freeze across global markets.

Impact on Opportunities

For investment bankers that heavily rely on Asian markets for work, clients, and revenue streams, it’s high time to start adding other options to the portfolio – if one hasn’t already. The current market shift situation is showing strong signals of a drawback by Asian bond customers until the global central bank directions clear up. Once markets have a better idea of what the U.S. Federal Reserve is doing, as well as Asian central banks, additional bond issuance decisions will come into line accordingly. However, until then, work could conceivably be dry, with little demand for new deals or bond projects for a while.

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There’s quite a bit of chatter in the mortgage and real estate world regarding rising property valuations and mortgage interest rates going in the same direction. Everyone’s focusing on buying property while it can still be financed relatively cheap, and rates are rising as the Federal Reserve has begun signaling it will begin to end its support of the U.S. economy via quantitative easing. However, an interesting thing has been occurring underneath the major headlines: investment banking has also been enjoying quite a successful run in the real estate recovery as well.

No one has to think back very far to remember the banking fiasco of 2008 when real estate investing literally destroyed entire brokerage houses as the mortgage-backed securities house of cards came apart quickly. That said, the industry and investment sector has not been shunned since that financial meltdown. Instead, real estate investing on a global level has triggered a fee revenue stream that has risen to $2 billion annually, a 54 percent increase since the drop and two thirds of the way to the high point of 2007 with $3.5 billion in banking fee revenues. The revenues coming in breakdown as follows for the first six months of 2013:

  • $2.3 billion from U.S. investing
  • $86 million in Latin America
  • $720 million in Asia

There is no question that the pursuit for more profitable yields has created the revenues. Most of the conservative tools available don’t produce anything viable, thanks to interest rates in banks being kept at all-time lows, forcing investment to go elsewhere. For years conventional bond yields haven’t been much help either. As a result, real estate trusts have become quite attractive. However, investment banking managers and experts looking for even bigger results have moved directly into real estate itself versus working through third party funds.

To make matters even more interesting, various trusts and real estate ventures are maturing now, again becoming ripe for market consolidation. This is the kind of buildup investment bankers want to see; it generates more mergers & acquisition activity, and that in turn generates more banker’s fees.

The one risk to this rising improvement in the real estate sector is, of course, the potential actions of the Federal Reserve over the next few years. Ben Bernanke’s comments have already underscored a desire by the Reserve to get out of buying mortgage-backed securities by mid-2014. If that actually occurs, the economy will be flying on its own completely and could suffer a serious retraction without a crutch to stand on anymore. The results could turn all those profitable real estate positions in sinking mud again very quickly.

For career impacts, those already in the investment banking field and considering specialization, the rise in real estate may be a good wave to catch while it is still swelling. However, for those just coming into the field, putting all of one’s eggs into real estate work would likely be a mistake. The market has the potential to swing wildly in the next year or so, and if the federal pullout in 2014 goes badly, real estate could fall as well as everything else if credit freezes up again. So new investment banking players cautiously consider this area as a primary career path just now.

As a result, while the real estate sector is once again making money, the real question for the investment banking community is, how solid is that area as a long-term risk?

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How Does the June Jobs Report Affect the Investment Banking Outlook

July 8, 2013

The Labor Department released its June employment report on Friday.  Overall, the net new jobs created was estimated at 195K. The June jobs figures put total jobs created at around 6 million based on the household survey and around 6.5 million based on the employer survey since bottoming out in late 2009/early 2010. The market […]

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Did Direct Access to the Treasury Bid System Affect Interest Rates?

July 1, 2013

In June 2011 the U.S. Treasury Department, for the first time, allowed direct access to its auction system to an entity outside the investment banking community.  The entity: the People’s Bank of China.  The deal involved giving the People’s Bank of China a direct computer link to the Treasury’s bidding system. Overall, this historical change […]

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