Wall Street's winners and losers
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The collapse of Wall Street's investment banking giants has left many analysts wondering whether this is the end of the banking system as we know it. Amid the rubble, banks whose activities are more diversified are emerging as the winners of the day.
After four days of nose-diving world markets, there is renewed hope that the central banks’ concerted decision to pump billions of dollars into money markets to avoid a global shortage of liquidities may help restore stability to the financial world.
Of Wall Street’s flagship investment banks, only two – Morgan Stanley and Goldman Sachs – were left standing Thursday. But US media reports that the former had entered talks with US commercial bank Wachovia have left many analysts wondering whether this is the end of the banking system as we know it.
“The winners are those who have capital and liquidities,” says Philippe Dessertine, an economics professor at Nanterre University in Paris. “The losers are those who relied only on services and knowhow, but who had high labour costs and no possibility to raise funds.”
Investment banks vs commercial banks
“This crisis looks a lot like the 1929 crash because banks are once again caught in the middle,” explains Vincent Catillon, an expert on crises in the banking system from the French Clermont-Ferrand University. “After 1929, banks were divided into investment and commercial banks to limit the damage. In the current crisis, we thought commercial banks would be the most affected, but it is the other way round. The so-called ‘universal banks’ are comparatively better off because they can rely on their deposits.”
The main difference between a commercial bank and an investment bank is that the former earns revenue by issuing primary loans from its pool of deposits while an investment bank brings debt and equity offerings to market for a fee.
Because their assets are tied to mortgages whose value has been falling in a tight credit market, investment banks’ stocks started crumbling over the last few months. At the end of last week, Merrill Lynch was trading for $17.05, well below what it was worth at its peak in early 2007, when its shares traded above $98.
A couple days later, Lehman Brothers, one of its Wall Street competitors, was filing for bankruptcy for lack of a buyer. To avoid a similar fate, Merrill Lynch accepted a $50 billion buyout offer by Bank of America.
“Because of moral hazard, some banks like Lehman Brothers adopted irresponsible practices,” Catillon says. “By refusing to help them out, US financial authorities sent a strong message to financial institutions to try and make financial institutions behave more responsibly.”
Bank of America’s move was well received by analysts. Though the United States’ largest bank already has a small investment arm, it is too weak to compete with Merrill Lynch. At present, Bank of America customers will also be able to benefit from Merrill’s brokerage services.
Reshaping the banking landscape
But whatever changes are made to the system, they’re unlikely to lead to the complete disappearance of investment banks.
“It’s very unlikely that such a legal decision would be made,” says Philippe Dessertine. But the banking landscape is likely to evolve, he adds. “One can imagine that in four of five years, Barclays will bring together Lehman Brothers’ entities under a new specific one.”
Barclays announced Wednesday that it had acquired the investment banking and capital market businesses of the bankrupt Lehman Brothers for a bargain $1.75 billion.
In the short term, it is the way investment banking is carried out that could change. Activities like securitization or leveraged buyouts (LBO) could be phased out, Dessertine says.
Meanwhile, the call for regulatory action to address the crisis is being answered in part.
On Sunday, the Federal Reserve announced that it had eased restrictions preventing regulated companies from transferring money to less regulated and more risky affiliates, The New-York Time reported. This could enable the commercial arm of a bank to move money to another arm such as its investment unit.
The Securities and Exchange Commission (SEC), the Wall Street watchdog, also announced it was considering imposing new limits on short selling.
In short selling, an investor borrows an asset from another investor and then sells that asset hoping the price will fall. The aim is to buy back the asset at a lower price and return it to its owner, pocketing the difference.
The London Financial Services Authority (FSA) already declared a short selling ban as of Friday until January in order to steady the markets. Short selling has been blamed for the debacle experienced by Britain’s Halifax Bank of Scotland (HBOS).
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