World needs stand-alone investment banks: Experts

While the acquisition and restructuring of the U.S. investment banking system seems to have helped head off a massive crisis in the U.S. financial system, merging commercial banks with investment banks could have negative implications for worldwide consumer lending, says a panel of experts from research firm TowerGroup.

TowerGroup expects many of the investment banks that have been acquired to be spun out again within the next 12 to 24 months since they perform a necessary role of higher-risk investing that deposit-taking institutions like commercial banks cannot really afford to bring onto their balance sheets.

“The risk profile doesn’t and never will fit. It’s made clear by several of the banks, including Bank of America [which purchased Merrill Lynch last week], that the investment banking business is a difficult business to manage. Their risk profile just doesn’t fit that of investment banks,” says Robert Hegarty, TowerGroup’s practice leader for securities, investments and insurance.

Hegarty was one of three practice leaders on a conference call to TowerGroup clients about the unprecedented set of events happening in the capital markets. He believes the commercial banks have bought the investment banks as investments to be resold rather than as new operating divisions.

The primary reason for this is the vital role the investment banks have played in parcelling out and managing credit risk. Granted, their mismanagement of mortgage-backed securities is what got them into this mess in the first place; nevertheless, credit remains a vital driver for world economy, and TowerGroup says investment banks create a vital global market for credit, thereby allowing lending to continue.

“They bought these assets on the cheap in a distressed market, and they will be able to sell them later on when this market recovers,” he says, “because when this market recovers, the need for a large-scale, independent non-risk-averse investment bank becomes apparent.”

Kathleen Khirallah, TowerGroup’s practice leader for banking, notes the push right now is for “balance sheet” lending, which is lending derived from deposits as opposed to using assets or derivatives of assets as collateral. Right now, regulators and industry observers are hoping that the investment banks can get involved in the credit markets using the deposits of the commercial banking units as the basis for lending.

Khirallah says the two are somewhat incompatible and that there are already signs of undue pressure on the Federal Deposit Insurance Corporation to cover deposit insurance.

“There are persistent consumer worries concerning the global banking system. We’ve seen the NAV on some money market funds drop bellow a dollar,” she says. “That question of what is insured and what is not insured is really in a state of flux. Consumers are going to be worried about that. There are going to be continued threats to deposit insurance funds by troubled institutions. The number of troubled institutions on the FDIC’s troubled list is at 117. The number of names on the troubled list that fall into failure is relatively small. I think the issue is we really don’t know what’s going to happen there, and we will see some continued threats.”

According to Ted Iacobuzio, TowerGroup’s practice leader for payments, having lending tied to commercial bank deposits would tighten credit conditions on sectors not affected by defaults to the same extent of the mortgage lending industry — such as the credit card industry.

Credit cards still by and large cover off their risk through the asset-backed securities market because it also has a high degree of sub-prime lending that commercial banks don’t want to bring onto their balance sheets. However, this risk has been managed much more effectively than it was in the housing market.

“The natural funding mechanism of the credit card business has been asset-backed securities. It’s been developed with the risk profile of the consumers in the portfolio in mind,” he says. “If a different portion of the bank is going to be used as a source of funding, that risk falls back on them and becomes a very volatile situation again. There is a significant portion of sub-prime lending in any credit card portfolio, so what we may see happen is a move by U.S. banks towards a universal banking system like they have in Europe.”

Iacobuzio says that model of banking, in which large commercial banks are the central providers of credit-lending, has created a much more “inert” consumer lending environment, because those banks refuse to take on the additional sub-prime consumer loans. These consumers remain vital to the survival of merchants and retailers, so they have had to bring back the archaic system of offering in-store credit in order to continue to sell products and services.

Effectively, what happens then is risk is taken out of the financial system and placed squarely on the shoulders of merchants and retailers.

“This amounts to turning the clock back 50 years. The universal acceptance model of credit cards is replaced by store paper. If the bank level of consumer credit dries up, in fact, what is going to happen is the retailers are going to supply it. Rather than a relatively complex and market-sensitive structure for managing risk in consumer lending that exists today, there will be a relatively static one incumbent on the retailers themselves,” he says.

Iacobuzio predicts eventually the vital need for consumer credit will necessitate reviving the stand-alone investment banking system. In the meantime, he expects consumer lending to dry up.

“Right now retailers move the merchandise, and the banks hold the risk. That would be unwise to desert at this point in the economy. Nobody wants to see the U.S. credit market dry up — not banks and not merchants,” he says. “It could be that we will have to go through a dry period if we go through the sequence of investment bank/commercial bank together, balance sheet lending and finally a divorce. We have to go through that cycle before there is a resumption of lending services.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(09/23/08)

Mark Noble