American Financial Crisis Series (1)
The True Nature of the Investment Banking Crisis and Directions for the Future
‐ Towards a model involving de-leveraging and going back to basics ‐
October 22, 2008
One background factor in the crisis that became apparent with the collapse of Bear Stearns in March 2008 is a change in the business model used by investment banks. In the past, the core business of investment banks consisted of bringing together borrowers with a wide variety of fund procurement needs and investors with a wide variety of asset management needs, by means of high value-added solutions and wide-ranging networks. However, since the 1990s, changing competitive conditions and financial deregulation have led investment banks to switch to a model in which the emphasis was on earning revenue by expanding their own balance sheets.
Against the backdrop of an expanding global money supply, there being no market so large as America to serve as the final recipient of investment, the world's financial assets continued to gravitate towards the United States. The beneficiaries of this financial and asset bubble were America's investment banks. Data surveys reveal that the balance of financial assets held by investment banks has risen sharply since 1980. In 2007, against a backdrop of economic growth and asset bubbles in housing and equity, the financial assets held by investment banks reached nearly 1,000 times their 1952 level.
Against a backdrop of excess liquidity, investment banks generated high revenues through a combination of short-term fund procurement at low cost and investment in securities, etc., with high leverage. While macroeconomic conditions remained steady, this was no problem, but as economic growth slowed, the weaknesses of the investment bank business model were exposed.
The first was the potential for rapid growth of losses. Once the prices of subprime mortgage-related securitized products and other negotiable securities started to fall, a vicious circle was established whereby efforts to reduce leverage led to more assets being sold, prices fell still further and losses mushroomed. This rapid expansion of losses is typical of investment banks as opposed to commercial banks.
The second weakness was liquidity risk. The fatal flaw was that because investment banks did not have access to a stable supply of short-term funding from outside the markets, i.e. deposits, they depended on the markets for the bulk of their fund procurement.
The third weakness was undercapitalization. Taking on high leverage is equivalent to having too little equity capital. Accordingly, the investment banks' ability to withstand losses was small and as their losses mounted, they were quick to fall into insolvency.
Further, the investment banks' increasing dependence on security-collateralized loans for fund procurement amplified the instability of fund procurement due to falling market prices.
The present crisis, caused by the investment banks, suggests the possibility of a fresh crisis in the financial system. In contrast to a "classic liquidity crisis", which would be caused by an outflow of deposits and difficulty in procuring funds on the markets, this is the risk of a new kind of crisis in which fire sales through de-leveraging cause the fall in the prices of assets held to accelerate, and eventually, by exacerbating the lack of liquidity, lead to solvency problems.
What does the future hold for investment banks? High leverage and complex financial products will probably vanish in the short term. It is highly likely that investment banks will focus on businesses that take advantage of their areas of expertise, such as asset management (fund management on behalf of institutional investors, rich individuals, etc., investment advice, composition and management of managed funds, etc.) and mediation in corporate mergers & acquisitions, and will work to secure revenue without over-expanding their assets. In addition to strengthening their risk management systems and making use of their outstanding expertise, they are also increasingly likely to go back to basics in their core business by focusing on business more closely related to the real economy.
For more information on the content of this report, please contact Lirong Li, the Japan Research Institute, Limited.