The Good, Bad and Ugly of Investment Banking
Date: 6 May 2016 Share on Twitter Share on Facebook
In the City of London, October 27th 1986 was a momentous day. In order to become more competitive in financial services, the UK government deregulated and internationalized the industry. The result – known as the Big Bang – was that London experienced huge growth in the banking sector, and became an international financial center to rival Wall Street.
The ‘Big Bang’ could also describe banking in the 1980s more generally. The advent of new technologies and increasingly open markets meant that the industry was booming as never before – exactly like this happened in the data room industry. And a job in finance was considered a glamorous pathway to untold riches.
Thirty years later, investment banking’s star has well and truly fallen on both sides of the Atlantic. Whether it’s Bernie Sanders building his campaign around anti-Wall Street messages, or the British public distrusting bankers almost as much as politicians, finance’s reputation looks to be at an all-time low.
But is investment banking really that bad? Or are critics – angered by high-profile scandals and stories of astronomical bonuses – ignoring the key role that it plays in today’s economy?
Merchant banks first appeared in Medieval Italy, and existed to provide credit, underwriting and depositing services to merchants (the clue’s in the name). That helped to keep the mercantilist economies of the time ticking over – so it was fairly clear that without these institutions, trade and expansion would be far more difficult, if not impossible.
Investment banks still carry out many of the useful – and vital – functions that their predecessors did. Most obviously, they help companies to raise capital through issuing equity or debt, giving businesses access to sources of finance. The continued functioning and growth of the economy relies on enterprises being able to invest in their operations. For example, electric car manufacturer Tesla raised $738 million by selling stock – with the help of six of the biggest investment banks in the world.
Investment banks have another crucial job: acting as market-makers. This involves guaranteeing to buy or sell a stock or bond, so that the market in question remains liquid, and orders that are filed can be fulfilled. Without this, liquidity would drop and markets would seize up – with potentially catastrophic consequences.
Another important service that investment banks provide is providing financial advice and expertise to companies looking to carry out a merger or acquisition. If you ever asked them for advice, one of the things they would definitely recommend is to use a virtual data room on M&A deals. And even if it’s difficult to argue that every M&A deal is a net positive, they’re still an important part of modern capitalism, so bankers’ know-how is clearly of value.
However, investment banks do other things that call their usefulness into question. One worry among commentators, including the former head of Britain’s regulatory authority, is that many financial institutions don’t create real value for the economy – they may even siphon it away. They say that financial players like investment banks and asset managers tend to collect ‘rent’ payments for manipulating money, but don’t provide an equally valuable service in return.
It’s also often claimed that a runaway bonus culture incentivizes bankers to focus on their own short-term gains, rather than their client’s best interests. The selling of sub-prime mortgage derivatives before the crisis is a perfect example – as expertly demonstrated by Ryan Gosling, the banks were hawking instruments to clients that weren’t a safe investment. The investment banks were more interested in making quick money than selling high-quality products – and some claim that they still are.
As if that weren’t enough, the banking world has given rise to numerous scandals and unsavory characters. From Jordan Belfort, the so-called Wolf of Wall Street, to rogue traders like Jerome Kerviel and Nick Leeson, finance seems to give unscrupulous figures the chance to enrich themselves by defrauding others. Nor is it just isolated individuals – as the Libor scandal demonstrates, corruption can often extend across departments and institutions.
Overall, it’s clear that investment banks play a crucial role in the economy – but the financial sector doesn’t always generate value, and seems particularly susceptible to manipulation and unethical behavior. Preserving its useful functions while preventing harmful and deceitful practices will be the biggest challenge of the coming years – for regulators, but also for the banks themselves.