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The Role of Investment Banking in US Financial System

The roots of investment banks are varied. Some are bankers or merchants who started guaranteeing other merchants’ bills, others are outgrown brokerages, but most are products of the Glass-Steagall Act. Originally, the term “investment bank” comes from the United States of America, while some other variations include ‘merchant bank’ in the United Kingdom and ‘securities house’ in Japan. With the globalization of US investment banking, the term has become a generic concept, nonetheless, while in the USA merchant bank has come to mean a bank which risks its own capital in bridge loans and position taking.

Small, limited-function investment banks are called ‘boutiques’. They thrive on relationships and the quality of work rather than committing their own capital, and necessarily lose the attached income. From today’s perspective, the Glass-Steagall Act may appear a deplorable market imperfection. For the investment banks, it was a godsend for the reason that it protected their independence from the money-center banks for decades. Moreover, it also gave them the first-comer advantage internationally.

They were free to underwrite equity and debt issues, trade them, arrange mergers and acquisitions, provide bridge loans for buyouts (LBOs and MBOs), develop products, hone skills and gain strength domestically. By the time international capital markets opened, they were the best and, backed by a home market which still generates two-thirds of investment bank revenue worldwide, went from victory to victory. Entrenched domestic banks, often much smaller but with all possible connections, could not outsmart the American banks which were selective and expensive, but got deals done.

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While the letter of the law separated commercial and investment banks, the profound difference was and is cultural. A typical commercial bank thinks nationally, has an extensive branch network supported by largely captive customers, staffed by armies of low-paid clerks in a slow-moving bureaucracy. A world-class investment bank, by contrast, thinks globally, has branches only in major finance centers, seldom employs more than 10,000 people, has a steeply differentiated pay scale and mobile employees, may still a partnership rather than a corporation, and cherishes its flat and entrepreneurial organization.

The bulk of business comes from the Fortune 500 or corresponding, and the activity is advising, organizing, underwriting, trading, broking and possibly fund management rather than borrowing and lending. Its greatest weakness used to be the limited capital base, even though this has changed with their acquisition by large commercial and universal banks. The entry of commercial and universal banks into the field by opening subsidiaries or acquiring investment banks has led to a difficult learning and acculturalization process.

Many have failed with the leaving of disgruntled bankers who only too often take the choicest customers with them. Great flexibility and tact are needed in integrating operations. When the merging and co-existence of two cultures succeeds, the synergy effects can be considerable. Investment bankers get protection from volatile markets, they can use the placing power of the commercial banking arm, benefit from its asset base and high credit standing, and contribute with a ROE which is easily double that of the commercial part of 25-40 percent against 10-20 percent in the USA.

Risks in Investment Banking Where universal banks have been split into commercial and investment halves, the identifiable reason has been the worry that investment banking is inherently more risky than commercial banking, and the depositor money should not be put at excessive risk. The idea gained popular acceptance in the USA during the banking crisis of the early 1930s and gained legal representation with the Glass-Steagall Act in 1933. Existing banks had to choose between the commercial banking and investment banking formats.

Most opted for the first alternative and a few split into two, the best-known example being the House of Morgan which was spun into JP Morgan (commercial) and Morgan Stanley (investment). The Glass-Steagall Act The Glass-Steagall Act had its roots in the buoyant 1920s. Companies could finance investments from profits and banks had to find other income sources. One was speculation in stock and money markets and many small investors followed suit, often on a 10 percent initial margin.

The frenzy was intense and bankers exploited it by packaging un-performing Latin American loans into bonds and selling them through their securities affiliates. When the stock market plummeted and the country moved into depression, the matter came to light, ruining many small investors. It was a major reason to separate banking from securities business. From a wider perspective, the securities industry hardly deserved its tainted image. Reckless lending to real estate, farming, leveraged acquisitions, developing countries, and so on has been equally disastrous as uncontrolled securities underwriting and trading.

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