A new paradigm for investment banks | Financial News

In the highly unlikely event that Goldman Sachs loses $500m in its fourth quarter, which closes this week, it is sobering to think that it would still make record profits this year. Despite mediocre market conditions, a mild slowdown in the fixed-income markets, and the failure of the equities and merger and acquisitions businesses to recover, Goldman Sachs made more money in the first nine months than in any previous year. Goldman"™s performance, likely record profits at Lehman Brothers and Bear Stearns, and the recent record quarters for Citigroup and Merrill Lynch, show that the traditional model for plotting the fortunes of investment banking has become inappropriate. It also shows how some, but by no means all, investment banks have decoupled from the traditional banking cycle. They are making abnormal returns, regardless of market conditions and despite decreasing margins. ankers, analysts and investors have traditionally seen investment banking in binary terms. Think of it like filling a bath with hot and cold taps. For the past few years, the fixed-income tap has been on full, while the equities and M&A one was closed with an annoying drip. This year was supposed to be the year when equities came back on stream as fixed income gradually turned off. That equities and M&A failed to stage a revival should, in theory, have dented the industry"™s profitability and stalled its recovery. However, the past 12 months have shown it is increasingly inappropriate to think of fixed income and equities with M&A as mutually exclusive taps. Indeed, fixed income has become an increasingly lazy description of a wide range of assets and activities. Take Goldman, which has been powered by its fixed-income and commodities and currency division. While fixed income has performed well, commodities and currencies have powered Goldman"™s growth and explain the rush into anything that can be traded "“ from oil and electricity to sports betting and gold. The discipline and mathematics are the same. Those banks with finely tuned engines and lots of different fuel lines are coasting. Those without continue to drive the bumpier road of relying on a recovery in equities and investment banking. At the same time, the development of hybrid products has further blurred the distinction between debt and equity, and the progress in the credit derivatives markets has reduced funding costs and risk. On the other hand, the higher profile equities and M&A businesses have become little more than a bonus. If, and when, mega-mergers and IPOs return, great. However, a growing number of banks don"™t need them any more. A storming year in investment banking would hardly dent the trading revenues of houses such as Goldman, Deutsche Bank or Citigroup. Goldman"™s revenues from fixed income, currencies and commodities are running at seven times those in investment banking. Investment banking clients can also be annoyingly hesitant, which has encouraged banks to put their own cheap capital on the line to co-invest, speed things along and make more money by applying the same engine room technology and risk management as they do to their trading businesses. Good league tables make for pretty pitch-books at beauty parades, but they are little more than superficial marketing. This move away from the traditional model sounds dangerously like a new paradigm. To succeed, it requires unusually sophisticated risk management and increased financial discipline. It is encouraging to see that more banks have applied this discipline and are walking away from markets such as block trades, where building market share can only be achieved at a loss. It is also encouraging that the market has so far seen only a handful of three-figure trading blow-ups. The obvious outcome from this new model is increased consolidation as investment banks buy the order flow and scale they need to feed their engines. The danger is that sooner or later everyone will think they can do it.

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