Universal Banks, Customer Service, and the Subprime Crisis

Posted in Blog at 11:35 pm

—April 7th 2008

I have long felt that the marriage of investment bankers with stockbrokers was an unholy alliance, and that whatever its commercial justifications, it served the investment community very poorly. Now we discover that the promiscuous fusion of commercial banks, investment banks, and investment managers serves the general public and the broader economy even more poorly. I wish I could take more satisfaction from the fact I am able to say that I have told other investors so, for twenty years.

In 1987 or 1988 I received a visit from representatives of the Zurich Stock Exchange who wanted to ask me, as a fund manager at CREF, for my opinions regarding proposed changes in Switzerland, following upon the de-regulation of the London market. After a brief discussion of what the exchange hoped to accomplish, my questioner opened with what he assumed was a rhetorical question: “After all, the most important thing investors want is low transaction costs, is it not?” The poor man must have thought there was something wrong with his English when I answered, “No.” So he rephrased his question, and I had to explain to him that the most important thing for us as foreign investors was to receive good information, particularly from the local ‘Street,’ so that we knew what we were buying, and were buying and selling at appropriate price levels. Compared to the cost of making mistakes, transaction costs were a small part of the cost of doing business. He protested, “Everyone else is telling me that the most important thing is the lowest possible cost of transactions.” I had to tell him that in my opinion they were either kidding themselves or lying to him. “None of us have enough resources to evaluate foreign shares on our own as critically as we can evaluate shares in our own market. Moreover, we don’t have the same access to market news and market sentiment as do the local stockbrokers.” I am sure he must have placed my comments in the ‘Nut’ file.

In retrospect, I probably misrepresented the case—by understating it. Experience has shown me that most investors don’t have the internal resources to evaluate any shares as thoroughly as their counterparts on the sell side. The logical conclusion would seem to have been that investors should have favored anything which promoted the integrity and independence of brokers’ analysts. Instead, investors’ steady downward pressure on commissions and fees advanced the invasion of investment banking salesmanship ever further into brokerage research, and investment funds have had no choice but to invest heavily in their own research staffs in order to offset the heavily biased and frequently dishonest recommendations they now receive from American-style unified investment banks. That in-house research still leaves a great deal to be desired is shown by the number of times I have seen senior investment officers listen carefully to extensive internal analysts’ presentations, and then stroll off to consult surreptitiously with favorite sell-side analysts before making up their minds.

In the brave new world of integrated investment banks, when a sell-side analyst does dare to speak out against a banking transaction or any other favored client, retribution is usually swift. As traditional relationship business has gone out the window both on the brokerage and the investment banking sides, the commercial bankers themselves have become increasingly transaction-oriented, and thus the universal bank has become an industrial organization, dedicated to selling a product by volume and marketing power, rather than a service provider, dedicated to attracting and growing the dependency of clients through the quality and reliability of its services. Conflicts of interest, an ever-present danger to a service organization, are much less critical to an industrial producer, whose priority—maximizing sales—is usually clear. In such an organization, it becomes increasingly difficult for the dispensers of sage and sometimes cautious advice to be heard, whether they are advising some clients of the firm, or their own senior executives.

How does this pertain to the current crisis in the banking sector? Very simply, investment bankers, as innovators of products to be sold, have created (not for the first time, either) a defective product, and sold it, not only to the bank’s investing customers, but also to the bank’s senior executives themselves. Dealmakers, long adept at selling their dazzling visions to target boards, became more accustomed to selling them to both sides of a transaction as relationship banking waned. From there it was but a brief jump to practicing their salesmanship on their own corporate managements. That careless use of the Structured Investment Vehicle, with its fundamentally risky marginal quality loans at its base, might be dangerous to its owner, was never a part of their sales presentation. It may never have occurred to the bankers themselves that they were selling a dangerous product: star salesmen are seldom engineers. Salesmen sold, traders traded, and the profits rolled in, until the risks of having many times one’s net worth in assets all levered to the same thing—house prices—suddenly became apparent when the underlying market did what it was never supposed to do, and stopped rising. The markets in these hugely derivative instruments became discontinuous, prices gapped downwards, inventory became less than worthless, and huge banks, the central institutions of the financial system, became technically insolvent.

Increasingly, the universal bank has become a matter of its best employees acting in their own interests only, and not infrequently in opposition to the interests of the bank. The compensation schema of the old, risk-taking financial services intermediary, with small fixed compensation and large cash bonuses, has not mated well with large, diffuse organizations whose long-term survival is a precondition of economic stability. The universal bank became what the incorporated investment bank had already been, a stable of independent contractors, temporarily housed under one roof. Should the markets trust such an agglomeration to evaluate the risks inherent in its increasingly complex innovations, and to use those innovations responsibly?

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