Commercial and Investment Banking and the International Credit and Capital Markets

If the ‘man in the street’ were asked ‘What is finance?’, some of the possible answers might be: ‘It’s to do with money’; ‘It’s about getting a mortgage’; ‘It’s what banks do’; ‘It’s about saving for retirement’. All of these answers would be correct. But what they all omit is two important words: risk and price. Finance is about assessing risk, pricing it and then transferring it through credit and capital markets. A new issue of shares, for example, is about pricing the riskiness of the company concerned and then transferring that risk to new investors through the capital markets. If that company subsequently goes to a bank to raise a loan for expansion, the bank manager’s job is to assess the risk of a loan to that particular company, price that risk as an interest rate to be charged and then transfer that risk on to the bank’s own balance sheet.

‘Intermediation’ means standing between. There are two ways of standing between. The first involves simply acting as a means of bringing two people together after which the intermediary drops out and the two sides then conduct their business. For example, a dating agency which brings together people of the opposite sex drops out as soon as they have been introduced. Similarly a stockbroker introduces a buyer and a seller of a security then drops out as they transact with each other. This kind of intermediation does not require that the intermediary has a balance sheet. I discuss this kind of intermediation, known as broker or agency intermediation, in more detail later.

An intermediary stands between the two sides in a transaction and thus creates an indirect relationship between them. In order to survive and prosper, intermediaries need to provide some service that is of sufficient value that those on either side are willing to pay for it. But before we can understand intermediation or disintermediation we need to understand the two basic types of intermediaries that we introduced in the previous chapter.

In medieval times, merchants who traded between regions of a country or between countries needed to be able to change one currency in the form of gold or silver coins into other currencies. Merchants also needed to be able to keep their wealth somewhere they believed to be safe (gold and silver are very heavy to carry and ‘keeping it under a mattress’ was not safe). They grew to trust particular moneychangers with whom they would deposit their money, i.e. their gold and silver coinage, for safekeeping. The moneychanger would then make a book entry in his accounts showing who had deposited money and would give them a receipt. When merchants wanted to pay each other large sums, this could then happen across the books of a moneychanger rather than in coinage. If the person being paid did not have an account with that moneychanger, he could either open an account with him or the transaction could be settled between his moneychanger and that of the seller. This settlement could easily be undertaken physically between moneychangers if they worked in the same area. All that was required would be a short walk at the end of the day to settle any outstanding balances amongst the competing moneychangers. Similar services could also be provided by goldsmiths and even by monasteries and innkeepers — if they were trusted. The receipt that a moneychanger issued when a merchant deposited money was in effect a debt, i.e. a liability of the issuer (the moneychanger) and an asset to the holder (the merchant).

Liquidity is a much used word yet it has various meanings which are often not distinguished. The financial crisis which commenced in 2007 was, in considerable part, and by any definition of the term, a liquidity crisis, though it quickly became apparent that it was also a bank solvency crisis.

Financing involves two stages:

Commercial banks are the key type of financial intermediary in any economy. They are central to the functioning of the economic system in contrast to many other financial businesses which are of lesser centrality. Most commercial banks have a retail and a wholesale banking operation. In their retail operations as high street or main street banks, they offer deposit, lending and money transfer services (cheques, debit card, e-transfers) to households and to small and medium sized enterprises (SMEs). Included under loans would be consumer loans, mortgage loans, credit card loans and business development loans. The retail part of a commercial bank may have some thousands of branch offices. The wholesale part, on the other hand, is likely to be a single office on Wall Street (in the case of the US), in the City of London (the UK financial district), in Shanghai (in the case of mainland China) or Hong Kong. The wholesale part is likely to be involved in large scale lending, including cross-border lending, normally as part of a lending syndicate with other banks.

The City of Glasgow Bank collapsed in 1878, and Northern Rock would have collapsed by 2008 without government intervention. In both cases, when too many depositors came to the bank and demanded the return of their deposits, as fractional reserve banks they were unable to meet the full amount of their customer demand. It is the fractional reserve nature of banking, i.e. the small proportion of liquid assets relative to total assets, that is the principal cause of the fragility of the banking system and which consequently makes it subject to crises. Another way of putt ing this is that it is the highly leveraged nature of banks which makes them risky.

In the chapter on credit intermediation by banks we looked at financial institutions (financial companies) which accepted deposits and made loans and we classified these institutions as banks. We identify a financial institution as a ‘bank’ if it is a company which has a banking licence and is therefore permitted to accept deposits. The function of this type of company is credit intermediation, i.e. intermediation between lenders and borrowers through the use of a balance sheet in order to provide lenders with attractive savings vehicles and borrowers with loans. However, there are other institutions that also perform credit intermediation but which, in law, are not banks. They are not banks for the simple reason that they are not permitted to accept what in law is defined as a deposit. They therefore do not hold a banking licence and are not regulated as banks.

Capital markets are much more impersonal than bank lending, and the investor in such markets is unlikely to have any personal knowledge of the management of the firm to whom he or she is providing financing, unlike a bank manager who is likely to have met a corporate borrower. As a result, there have to be other mechanisms to try to ensure that the potential investor is not investing in an excessively risky company, has the necessary information to enable an effective evaluation of risk and that he or she is kept informed regularly of developments in the company. Essentially, therefore, for capital markets to function effectively, there have to be mechanisms to overcome asymmetric information problems.

Any asset — real or financial — whether a motor car, a house, shares or an item on eBay, can be traded, i.e. bought or sold in exchange for cash. Motor cars can be bought and sold, relatively slowly, through newspaper ‘small adverts’ or eBay or an immediate sale can be achieved through sale to a motor dealer; a house by advertising in the property section of a newspaper or through an estate agent (realtor). Any of these means of sale are, in effect, ‘search engines’, i.e. a means by which those who wish to buy or sell something can search for each other and, having found each other, agree a price for sale then execute the sale by the exchange of the asset for cash. There are two problems with such transactions. The first is how to agree on the price, which is difficult when an advertisement in the newspaper is used and only one person may respond but which is relatively easy on eBay if an auction is used and many people bid. The second problem is credit risk, i.e. handing over goods before receiving money, or handing over money before receiving goods. Systems like PayPal, as used by eBay, aim to minimise such problems in web-based transactions. In securities markets, mechanisms such as payment against delivery (see Chapter 14) are used try to minimise this risk.

Global bank and sovereign debt together comprise by far the largest sector of the investment market. By comparison the global equity market is smaller. The relative importance of each sector can be seen Figure 1.1. Sovereign debt has also, the eurozone excepted, been the asset class which has given by far the highest return to investors since 2000. In contrast equities have been a great disappointment to almost all investors over that period as has bank debt. Any investor, therefore, has to consider these two large asset classes — sovereign debt and bank debt — as potentially important components of any portfolio. Though I have noted that sovereign debt has been the best performing asset class, within that class clearly urozone debt has proved to be very risky, quite the opposite of what traditional finance assumes about developed market sovereign debt, i.e. being the riskless asset. Equally, bank debt or at least senior debt, has been assumed to be almost riskless due to the ‘too large to fail’ doctrine employed by governments. However, that doctrine is in the course of being modified in ways that may in future lead to losses even on senior debt but certainly on junior debt. Any investor, therefore, has to know how to assess risk on individual instruments within these two asset classes and to know when it may be appropriate to disinvest from them and, equally, to spot opportunities when they arise for highly profitable trades.

If asked: what is the purpose of investment management?, the average man in the street would probably say that it is to ‘beat the market’ i.e. to select shares that will outperform the market as a whole. Self-directed investors (households) generally operate on the basis that this is what they are trying to achieve for themselves and will read magazines such as Investors Chronicle in order to pick up ‘stock tips’ which they hope will lead to investment success — outperformance relative to some benchmark they have chosen. Households which do not want to do this themselves will employ a professional investment manager — a wealth manager — often because they believe a professional can achieve ‘outperformance’ on their behalf. Certainly the ability to generate outperformance is the marketing claim that many professional investment managers make. But despite this belief in outperformance being what investment management is about, generating outperformance is not in fact the purpose of investment management and indeed is also very seldom achieved consistently. The purpose of investment management is risk management, which in this case means creating portfolios which give the highest expected return for any given level of risk chosen by the underlying investors. The major types of risk facing the equity investor are the following.

The word fund is used with two meanings:

I include wealth management in Part IV since, at its core, it is simply the use of an agent to manage risk for an individual or a family. Wealth managers make use of collective investment funds, as described in the previous chapter, to achieve the risk management objectives of their clients; or they may create their own portfolios in-house.

Part I of this book covered the credit and ‘external‘ capital markets. The governance mechanism for the external capital market revolves around the need for the company to persuade potential investors in an IPO that they will, in fact, earn not less than the required market return for a project or company in its particular risk class. However, the main source of financing for new investment projects in companies subsequent to an IPO is not the external capital markets but the so-called internal capital market. The reason is that after undertaking an IPO on the primary capital market most companies never again raise equity on the public markets. Secondary offerings, i.e. an offering of additional shares sometime after the initial offering (meaning a second, primary offering and nothing to do with the secondary market), are relatively rare. In fact, most equity financing for new projects or expansion of existing ones comes from retained profits. Only banks which have eaten through their equity capital have had to access the equity market for additional funds. Companies may of course access the debt markets on a continuing basis both to re-finance their maturing debt (rollover) and to maintain the debt/equity ratio as equity increases due to retained earnings.

We noted in the last chapter that many investors will sell their shareholding in a company rather than trying to change the management if they believe it is not employing the company’s assets in the most productive way. Sales by large investors are likely to drive down the price of a company’s shares. As more people become aware of the problem another company may come to the conclusion that it could manage the assets better and make them more productive (profitable). It thus may make a bid in the stock market for all the shares (or at least 51%) to give it control of the company and will hope to profit from the changes it believes it can make.

All companies need to undertake risk management in order to minimise the possibility of unexpected events having catastrophic outcomes. Banks and investment banks are in the business of dealing in risk – it is their ‘stock-in-trade’ – through their activities in securities and derivatives markets. If they are to be able to provide risk management services to clients they need to manage their own risks in order to ensure that they stay in business. Also, banks are much more highly leveraged than any other type of company and thus a relatively small fall in the value of their assets can easily wipe out their capital.

A director of a company owes the company a duty of care and a duty of loyaty. In general, under the ‘business judgement rule’, if a board of directors exercises these duties appropriately, the members of the board will be protected from liability (to shareholders) for their actions. In effect, there is a presumption that, in making business decisions, directors act on an informed basis. However, this presumption can be overcome by showing that the board was grossly negligent in its decision-making. The directors and officers of a bank thus have the responsibility of, amongst other things, minimising the chance of their company failing due to liquidity or solvency problems which they could have anticipated. This responsibility arises from general company law. However, because of the importance of banks to the economic stability and growth of an economy, governments generally do not just rely on company law. Instead they have set up a regulatory framework which banks must follow. This framework is designed not only to minimise the risk of a bank collapsing and the cost of rescue should it collapse, but also to try to ensure that it does not act against the interests of its customers. That banks may do this, even with regulation, is emphasised in a statement by the Governor of the Bank of England in an interview in 2011:

Since ‘Big Bang’ in financial services in the 1980s, Mr King goes on, too many in financial services have thought if it's possible to make money out of gullible or unsuspecting customers, particularly institutional customers, that is perfectly acceptable. Interview with Charles Moore, The Daily Telegraph, 5 March 2011.

Optimal use of society's scarce resources requires that financial intermediaries, as well as corporates, employ the resources available to them, including human resources, in their most productive configuration. Corporate strategy is one important aspect of this. Without appropriate strategy and its eff ective implementation, resources will not be appropriately allocated by public capital markets or ‘internal’ capital market allocation.

Keeping investment banks alive in difficult times is challenging. Many have failed to survive. Bear Stearns and Lehman are only the latest in a long line of investment banks which have failed over the past decades. Royal Bank of Scotland and Citigroup are examples of those which survive, but in a much weakened state and only through temporary state ownership. Indeed the failure rate of investment banks over decades has made some rating agencies view them as not being eligible for ‘investment grade status’ in their company ratings. JP Morgan Chase is one which came through the financial crisis strengthened relative to its competitors. Even harder is the creation of a new ‘bulge bracket’ investment bank able to challenge the other major houses. I will now off er a contrast between a successful challenger and an unsuccessful one, before looking at some of the walking wounded from the war of att rition of 2007–12.

The following quotation from Henry Kaufman, one of the best known bankers of the last 30 years (he was on the board of Salomon Brothers which is now part of Citigroup and latt erly Lehman Brothers) suggests that the conglomerate structure of the financial services industry that has developed since the 1990s has led to the creation of companies which have a risk incentive structure that is inappropriate for society's needs:

Meanwhile, top managers at many financial institutions will find themselves in unfamiliar territory. Their mode of operating, their business culture, has been to pursue aggressive growth targets for profits and market share by diversifying operations into new financial domains and by swallowing up competitors. Wielding generous compensation incentives, managers of leading banks encouraged employees to take big risks. As institutions grew and diversified, their activities became too wide-ranging and complex for senior managers to oversee effectively. At the same time, risk-taking came to rely more and more on quantitative risk-modelling, which tended to marginalize qualitative investment judgment. As we now know, econometric risk-modelling failed when it was most needed. Henry Kaufman, ‘Prepare for Change on Wall Street‘, Financial Times, 2 June 2010.

We have examined the problems to which individual financial firms became subject during the financial crisis. But we also need to consider wider factors that were driving the industry as a whole in the direction that it was taking over a long period of time. To understand this narrative it is necessary to think in terms of how firms compete over time and what happens when the regulatory framework results in the rules of competition being changed — not just in the current period of regulatory change but stretching back to the first steps towards deregulation.

The English language has an expression ‘20/20 vision’ which means perfect vision. The year 2020 may be the end of the current decade but the surest way for an economist to lose his or her reputation is by making forecasts particularly as far out as that. Economists can no more predict the future than can anyone else. Thus I will not try to predict the financial or economic world in 2020. What economists can do, however, is to point to developing trends, inconsistencies in policy, changes in underlying fundamentals and other factors that might impact on the firms whose activities they help to finance and hence impact on the providers of financial services. But the outcome of these factors will remain uncertain and will not be subject to statistical risk analysis. Nonetheless, for politicians, regulators and bankers it is necessary to try to make sense of developments and take steps to try to protect countries, financial firms and financial assets, respectively, from these uncertainties.