This is a timely book, given the out-sized attention heaped on highly compensated investment bankers and their role in society. It was published before the financial meltdown and was not intended to predict that event, but it provides great clarity about why and how we got to this point. In the authors’ findings lie the seeds for substantial reform within the banking industry, reform that need not come from the ever-reaching hand of government regulation.
Morrison and Wilhelm’s intent was to provide a rationale for the existence of investment banks and their role in society. The authors noted the “voluminous historical literature” on investment banks, the legal rules pertaining to investment banking, and the economics of investment banking; yet they found nothing that precisely explained why such banks exist.
Their book begins by examining the situation-specific information relevant for economic decision making, referencing Hayek’s famous observation that a central planner could never cope with the immense amount of information that would be required to make all decisions centrally (p. 37).
While institutions exist that can enforce real property rights, and even intellectual property rights associated with innovations and inventions, there
is no institution that enforces rights that may pertain to situation-specific information. Morrison and Wilhelm suggest that the “most efficient way to incentivize information production would be to create property rights over it” (70), but they realize the practical difficulty of enforcing such rights in a legal setting. An investment bank provides a way of establishing informal property rights over a very important kind of information — the information that people need when they decide to lend or borrow money. By gathering confidential information about lenders and borrowers, the returns they seek and the risks they are willing to take, the bank establishes informal property rights over price-relevant information.
Here’s an example. In March, a company named Calix, Inc., wanted to raise money to expand its research and its market opportunities for broadband communication systems. To raise those funds, Calix turned to the investment banking firm of Goldman Sachs, which led an initial public offering of Calix stock. Goldman acquired important information; it “knew” something valuable — about Calix and the broadband communication industry. It also knew where investors might be found. By acting as an informed intermediary, Goldman was able to create a competitive advantage for Calix and the investors in the initial public offering. It maximized the funds Calix could raise, and it created a ready market for the trading of securities bought by the initial investors.
The investment bank’s own competitive advantage is created by its expertise in specific investment areas and its proven ability to create and manage a network of ready buyers. Its good reputation is arguably its most valuable possession. The authors classify this asset, somewhat clumsily, as “human capital,” and provide ample evidence of the importance of this “capital” throughout the history of investment banking.
The origins of investment banking can be found in the early age of European exploration, in merchant banking activities carried on primarily by the Dutch. In trade across vast regions of the earth, the most important consideration was simply trust. People would do business only if they trusted other people to fulfill their obligations. Legal partnerships were created to formalize this trust.
Significant also was the “bill of exchange,” a legal IOU invented to deal with the inconvenience of carrying coins and goods for barter over long distances. By the early 1800s, merchants such as the Rothschild family and Baring Bros. & Co. had determined that they could leverage their good reputations, and their legal partnerships throughout the developing world, to earn substantial profits, simply by buy- ing, selling, and implicitly guarantee- ing bills of exchange.
Morrison and Wilhelm clearly outline the role of the early investment bank as a structure to safeguard property, manage information, and enhance profits. They show its importance for the development of the private partnership as a legally sanctioned organization. The authors continue for several chapters describing the rise of the modern investment bank in Europe and the United States, providing many colorful stories about the early days of capital formation and the adventurous characters involved in it.
By the beginning of the 20th century, investment bankers “looked like titans” — but “titan” was not usually a term of admiration. Their success was envied and feared. They were accused of amassing “an excessive degree of power, which they used to feather their own nests at the expense of the ordinary working people whom they had disenfranchised” (223). It’s a view that would not appear out of place on the editorial page of today’s news.
The result of fear and envy was a “protracted period of state interference” (224). In America the interference included the Securities Act of 1933, the Securities Exchange Act of 1934, and the provisions of the Glass-Steagall Act of 1933 that effectively separated investment banking and commercial banking activities. The period of heavy regulation had the unintended consequence of reducing the amount of capital available to investment bankers to support the issuance of new securities issues.
The next two significant changes in the industry did not occur until the 1960s, but these would strongly influence today’s environment. The first was the emergence of computer technology, which led to a huge increase in trading activities. But with technology comes an obvious corollary: automation meant more reliance on what the authors term “financial capital,” i.e., money, than on “human capital” (11). Trading volume soared, investment banks made huge bets on securities, and the knowledge base within the banks became more technology- than relationship-oriented.
And that led to the second, and probably the more underestimated, change. Given the need for an expansion of financial capital, the New York Stock Exchange changed its rules in 1970 to allow memberships by joint-stock corporations. For the first time since the advent of investment banks, partnership was no longer the primary choice among forms of legal organization.
To understand the importance of this change, one needs to understand the compensation structure of investment banking — an issue that the authors do not cover in-depth. When partners owned the investment banks, they would pay themselves salaries throughout the year that were significantly below the profits of the firm. At the end of the year, they would determine how much capital to reserve in order for the firm to accomplish its goals for the upcoming year, then divide profits after paying bonuses to employees.
The risk of loss was always borne personally by the partners, who relied upon their reputation, or human capital, to generate profits. The employees, in turn, rarely changed firms, because their compensation and bonus structure were based on the firm’s established human capital.
After investment banks became publicly traded, reliance on financial capital increased enormously. According to Morrison and Wilhelm, the average capitalization of the ten largest investment banks in 1980 (the first year for which they present precise figures) was approximately $600 million, with an average capitalization per employee of only about $65,000. By 2000, those figures had risen to an average firm capitalization of $20 billion and per- employee capitalization of about $1 million (13).
Even more important, the risk of loss shifted to shareholders, although the compensation and bonus structure remained largely unchanged. Those pushing for increased regulation often say that “we have privatized profits, but socialized risks.” Yet the real losers are not the taxpayers; they are the shareholders of publicly traded investment banks who have never been adequately compensated for their risk of loss.
The issue is tricky: if shareholders demand a percentage of profits more commensurate with their level of risk, they will risk losing the human capital element of their firms, and profits will probably be lower. The challenge is to provide greater compensation for the shareholders, while creating risk-reward structures that will keep knowledgeable employees loyal to the firm.
The simplest way to do this is for shareholders to demand significantly larger cash dividends, and for employees to be given most of their compensation in the form of restricted stock that cannot be cashed in for several years (at least five at first, but eventually longer). This would encourage management to be prudent in risk-taking, with a view to increasing the long-term value of the organization, not the immediate value of their bonuses.
Even now, however, we are seeing a marked increase in defections from the large investment banks to boutique investment banking firms of the old-fashioned type, where relationships and human capital are the primary assets. I’ll note that many of these firms are privately owned.