Investment banks' future: smaller and cheaper: James Saft

-- James Saft is a Reuters columnist. The opinions expressed are his own --

LONDON, Sept 18 - The greatest financial upheaval since the Depression won't kill investment banking, but will make it smaller, less profitable and probably a heck of a lot less lucrative for its workers.

Bear Stearns and Lehman went out the hard way and Merrill Lynch sold itself to Bank of America, leaving only Morgan Stanley and Goldman Sachs as major independent investment banks. Shares and debt of both remaining banks were under severe pressure on Wednesday as investors questioned their business model.

Investment banking is in the midst of a major cyclical recession even without taking into account issues with how those banks fund themselves and problems with assets on their balance sheets.

The dollar value of completed global mergers and acquisitions is down 36 percent year on year, equity issuance is down 18 percent and debt underwriting down 46 percent.

More to the point, the industry is undergoing huge secular changes; the amount of leverage that firms use is on a very bumpy trip lower and regulators will almost certainly impose new costs and attempt to limit risk among the survivors.

More secure, longer-term funding and lower leverage is great and everything, but it does imply lower profits.

It is also very likely that, having picked up the tab for some of the fallout, the taxpayer decides to crack down on risk-taking in investment banks. This is a role investors should have played when times were good -- refusing to fund banks that paid employees too much for taking too many risks with their money -- but signally they did not.

"Do you need stand-alone investment banks that became hedge funds? No," said Peter Hahn, a former banker at Citigroup and fellow at Cass Business School in London.

The answer the market seems to be moving towards is housing investment banks within commercial banks. The reasoning is twofold; first, commercial banks have larger balance sheets and have a shot at absorbing the investment banks and secondly, they often enjoy lower costs and more diversified long-term funding.

So an investment bank within a commercial bank, the argument runs, will fund more cheaply and pose less of a systemic threat.

I'm not sure I buy that.

The best home for some of today's investment banks and their troubled balance sheets may well be in the arms of a big bank, but that is not the same as saying that is a sound business model.

The question that remains to be answered, especially in the United States, is whether this is just another form of regulatory arbitrage. Commercial banks in the U.S. enjoy government insurance on their deposits, and their superior cost of funding is in part a function of that.

The Federal Reserve, acting on Sunday as Lehman Brothers drew up its bankruptcy filing, actually relaxed limits in the U.S. on how commercial banks can provide funding to their brokerage affiliates.

"In the U.S. you have the issue of moral hazard when you've got the Federal Deposit Insurance Corporation subsidising far riskier investment banking activities," said Roger Ehrenberg, managing partner of IA Capital and the former CEO of DB Advisors.

BOUTIQUES IN VOGUE

The regulatory fate of investment banking will ultimately be settled politically, so in advance of the November presidential election it is very difficult to predict.

One thing that is likely is lower compensation. This would naturally be the case anyway given that the industry is not making as much money, but I think it might be a trend with strong legs.

While you can make a reasonable case that an M&A banker's contribution can be measured over a short period of time, it is much harder to assess for traders or others who depend more upon access to the firm's capital in order to generate profits. In many cases people were putting their bank's balance sheet at risk for deals where they got short term compensation but did not share in the medium and long term risks.

Investment banks, be they owned by commercial banks or not, can be expected to extract a bigger amount of the profit and to expose their employees to more of the long term risks. That spells lower pay, especially in combination with lower overall revenues.

I also think that, given the difficulties of operating within a big commercial bank, quite a few boutique investment banks will spring up during the coming years. They will be at a funding disadvantage so by definition will specialise, but they will be able to attract talent and, unlike commercial banks, respond nimbly to changes in the market.

Ehrenberg, who has been through a few cycles, thinks that investors and managers will forget caution once the profits start rolling again.

"Some time in the next 5-7 years they will be levering up 30 times again and the market will accept it," he said.

I hate to be the guy saying "this time it's different," but I really hope this time it is.