Tuesday, September 29, 2009

Nature Red in Tooth and Claw: Part IV

Westley: "Who are you? Are we enemies? Why am I on this wall? Where is Buttercup?"
Inigo Montoya: "Let me 'splain. ... [pause] ... No, there is too much. Let me sum up."

— The Princess Bride
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EDITOR'S NOTE: This is the fourth and final installment of a multi-post treatise on investment banking compensation. Previous entries include:

This post attempts to tie together the preceding entries and come to some sort of reasoned conclusions. Fasten your seatbelts.

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— Part IV: Darkness Calls —

We have covered a lot of territory already. Let me sum up.

Traditionally, investment banks acted as intermediaries or agents for wholesale capital markets transactions, not principals. As such, while they did perform services that exposed capital to risk, traditionally these risks were of short duration, relatively small, and very well contained. Risky activities such as these are concentrated on the capital markets (or sales and trading) side of the business, and consist of using the bank's capital on a temporary basis to facilitate securities issuance or securities trading by their institutional customers. Due to investment banks' privileged position at the nexus of market flows and information and their ability and inclination to trade rapidly in and out of positions, banks have historically been able to conduct such business pretty successfully using relatively small amounts of equity capital.

Because their business is designed to make money off the flow and volume of transactions in the marketplace, rather than off sustained price appreciation or direct investment, investment banks have a business model and a culture which focuses almost exclusively on chasing transaction fees, or revenues. Since markets are often volatile, and revenue opportunities are fleeting, there is an institutional bias within investment banks to chase and book revenue first and worry about consequences later. With its low fixed salary component and theoretically unlimited upside incentive bonus, compensation for revenue-producing investment bankers is explicitly designed to encourage this pursuit.

On the other hand, investment bankers historically were very good at managing their business risks. Capital markets risk used to be managed by senior partners who had been traders themselves, and who had complete visibility and understanding of the risks in the bank's trading book.1 Encouraging and supporting this hands-on supervision was the fact that senior trading partners typically had a major portion of their own personal wealth tied up in the equity capital of the firm, along with that of senior management and other partners. Accordingly, risk management was a very high priority for all of the firm's key decision makers, and it acted as a powerful and effective brake on the countervailing tendency for bankers to pursue revenues at all costs.

Using this time-tested model, traditional investment banks used to do pretty well for themselves. They ate what they killed, feasting in times of plenty and tightening their belts in times of famine. Because the bankers were the owners of the firm, they kept a pretty tight balance between revenue generation and capital preservation. Accordingly, firm-threatening or -ending mistakes were rare.

But this was not a model suited to rapid growth or global scale. And as the capital markets continued to grow, and the global economy became more connected, the old partnership model of investment banking began to disappear.

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In its place arose large, publicly-owned global investment banks and—with the gradual erosion of Glass-Steagall barriers between commercial and investment banking—large, integrated "universal" banks. Banks funded their expansion with increasing doses of outside capital—other people's money—and merged and acquired their way to greatness with their peers. Unfortunately, with increased scale many of the built-in checks and balances of the partnership model began to break down.

Large public banks did retain much of the partnership compensation model, which deferred ever more of a banker's pay the higher up he got and the more he made. But keeping risk management a central concern for every banker was never a principal reason for this. Instead, banks were much more concerned with preserving cash and attempting to lock up bankers with deferred equity so they could not leave for a competitor. More importantly, deferred pay lost its effectiveness as a distributed risk management tool. As investment banks grew ever larger and more complex, each banker had less and less impact on the overall results and health of his bank, almost no matter how much he made. A banker's deferred equity nut began to look more and more like a ball and chain, rather than a direct link and meaningful incentive to control the overall risk of his employer.

Exacerbating this was the professionalization of risk management at large investment banks. As banks got bigger, and their trading books swelled with ever more complex securities, grizzled old traders with big equity stakes in the firm no longer had the experience or the bandwidth to monitor their underlings' trading positions. Instead, professional, dedicated risk managers—who often came from a structuring or academic background, not sales and trading—took over the role of trying to say "enough" or "no" to the hotshot revenue producers. Given the revenue-worshipping culture embedded at the core of every investment bank, such a system was bound to fail, as the big swinging dicks with real skin in the game ignored, bullied, or coopted the sniveling little (equity-less) PhDs sent to rein them in.2

Adding to the problem, the only people with enough skin in the game and the power to do something about firm risk—senior executives—became increasingly beholden to outside public shareholders. Because most of these outsiders were big, diversified institutional investors, they had an even more aggressive risk posture than the investment bankers themselves.3 They pushed the bank CEOs and Boards for ever more growth and return on equity, and the senior executives, being investment bankers who worship at the altar of revenue anyway, complied.

Finally, the growth in investment bank balance sheets and the increasingly complex securities either demanded by customers or manufactured "on spec" by revenue hungry bankers led to increasing concentrations of opaque and badly understood risk in many banks' trading books. Market making shaded into speculative trading, which morphed into full-blown proprietary trading (and even internal hedge funds at some banks). Investment banks began to accumulate—apparently without their full knowledge—poorly understood contingent obligations that hinged upon their traditional market-making role as buyer of last resort for securities they underwrote. Risk seems to have been misunderstood and significantly underestimated by almost everybody in the financial markets, but when the shit hit the fan, investment banks were uniquely positioned to have most of it blow right back onto them.

Of course, increasing leverage and lax regulatory oversight played a role, too. But leverage acted as an accelerant and a conduit for contagion across market sectors, and sloppy supervision added to the general haze of ignorance and the thicket of unintended consequences. Neither was the ultimate source of the breakdown in the financial markets. Had they not been present, the fire might not have spread so quickly or so broadly. But make no mistake: the fire would have started anyway, and it still would have burned down a pretty big swath of the financial forest.

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So, what can we conclude from all this?

Well, for one thing, the need for traditional investment banking services—intermediating capital flows and financial transactions for all comers—is not going to go away any time soon. It is simply impractical to imagine a world without investment bankers, no matter how eagerly the torch and pitchfork crowd would love to do so. But it seems to be a somewhat paradoxical business, one best suited to entities which combine extremely aggressive pursuit of revenues with a highly developed aversion to risk. The old partnership system, where the revenue producing bankers were also the owners and providers of equity capital, seemed to work pretty well. The currently much-maligned system of investment banking compensation is a relic of that earlier time, but it does not seem to balance these tensions well in today's huge, publicly-owned global investment banks.

Instead of the old integrated risk model, we now seem to have one where outside investors have high risk tolerance, revenue producing employees have low risk tolerance but cannot effectively influence it, and professional risk managers tasked with controlling it are politically and economically disenfranchised. This is not an unavoidable outcome of the current model, but it certainly makes the whole system far more difficult to manage. Unfortunately, there is absolutely no way to recreate entities the size of Goldman Sachs or Citigroup with purely private partnership capital. Even if you could, I am not sure you could avoid the span of control, scale, and complexity issues bedeviling these enterprises.

One solution, of course, is to shrink investment banks down to a more "manageable" size, whatever that means. The immediate question this raises, however, is whether such smaller banks could perform their systemic function in today's highly integrated global financial system adequately. The next question, if we determine they cannot, is whether we would miss them. My crystal ball is too cloudy to offer an opinion on that one, although I can guess what Matt Taibbi would say.

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In any event, I hope I have convinced those hardy souls who have soldiered along with me this far that investment banking compensation was not the sole source of our current troubles. It is part of the puzzle, make no mistake, but it is not the only piece. Therefore, fixing it and nothing else will not right the ship.

Notwithstanding what legions of indignant and self-righteous commentators contend, the incentive system currently in place operates exactly as most of them propose: a large portion of banker pay is deferred for years and is tightly tied to the overall health and success of the firm. Bankers are not incentivized to print huge risky trades and run away as soon as they collect their bonus at the end of the year. In fact, they are more closely tied to the long-term health of the firm and its stock price than any other stakeholder. They just can't do anything about it. Unfortunately for them and for us, such a system does not seem to have prevented anything.

Perhaps a solution could be structured which balances all of the competing pressures and strains that the modern investment bank encounters. It would be complicated, involve multiple variables, and require constant monitoring, adjustment, and correction to adapt to ever changing market conditions. It sounds like a fun project for Larry Summers and crew.

Sadly, they never taught multivariate optimization techniques on the savannah when I was coming up in the business. I guess I'll just sit here, gnawing a wildebeest bone, until somebody tells me what to do.


1 Capital markets activities are the only significant source of firm-wide risk for the traditional pure investment bank.
2 This was made worse by the fact that the huge expansion in most banks' capital markets operations during the Great Moderation meant that Capital Markets grabbed the political reins of power from their partners in M&A and Corporate Finance. (Investment banks allocate power based on the Golden Rule: He who brings in the gold gets to make the rules.) Since M&A and Corp Fin bankers enjoy little direct upside from increasing sales and trading revenues but face a lot of downside if sales and trading blows up, they tend to be strong advocates for clear risk limits and controls in the trading book. But the traders were the ones bringing home most of the bacon, so M&A and Corp Fin bankers had no choice but to shut up and view the ballooning risk with increasing disquiet.
3 If Fidelity or another outside investor got worried about Lehman Brothers, they could (at least theoretically) sell all their shares. Dick Fuld and most of the other bankers at Lehman had to watch helplessly as a lifetime's worth of deferred compensation evaporated into thin air when the firm collapsed.

Photo credit for the series: Nathan Myhrvold's 2007 photo essay on lions in Botswana, Africa. Warning: blood, gore, and sex galore. Now do you see the connection?

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