It is hard to identify a single rationale for investment banks. Like most economic institutions, they were not designed for a specific purpose, but evolved in response to prevailing technological and economic forces. Hence, if we wish to understand the role of the investment bank in today’s economy, and to make sensible statements about its likely future development, we must first understand the historic economic, legal, and political forces that shaped investment banking.
Alan D. Morrison
This article, based on our book, Investment Banking: Institutions, Politics and Law, addresses these questions by tracing the evolution of the modern investment bank from its origins in 18th-century Atlantic trade between England and the US to the present day.
The activities of the earliest investment houses were very different to those of the modern capital-rich and technologically-advanced institutions of today. However, at every stage in its development, investment banking has relied upon a central competence: The enforcement of commercial agreements that would be impossible to document and to enforce using only the formal “black-letter” law. The arenas in which investment banks have created and enforced so-called “private laws” have altered over time in response to political, technological, and legal changes. But the assets that investment banks rely upon have changed far less: Investment bankers have always relied upon close relationships, repeat dealings, trust, and reputation. These have always been more important, and harder to replace, than financial capital. Investment banks that lose their reputations tend to lose their businesses, too.
Rise of investment banking
Although securities markets were already quite extensive at start of the 19th century, it was the technological and legal changes of that century that precipitated the emergence of fully fledged investment banking. Contract law matured and, hence, confidence in the courts to enforce predictable standards of damage after breach increased. At the same time, the development of the American railroads heralded a new era of big business; the capital that they, and later the industrial firms, required was largely raised through bond issues.
Capital accumulation in the US was insufficient to cover industrialization. As a result, American bond issues were marketed in England and continental Europe, as well as at home. As a result, transatlantic traders who had previously concentrated upon the commodities businesses started to turn their attention to the financial markets: by the middle of the 19th century, household names such as the Barings, Rothschilds and Browns specialized solely in finance. These institutions operated in a world of incomplete contracts, in which reputation and trust were of paramount importance. During the second part of the century they used their names to underwrite complex businesses that could not easily have been performed using court-enforced contracts. They adopted the advisory role that remains central to modern investment banks, and they developed the modern syndicate. By the end of the century, investment bankers were at the heart of American economic life.
Modern investment banks
Investment bankers grappled with the unwelcome attention of the regulatory state in the first half of the 20th century. Once the danger from this source had subsided, investment banking was shaped by dual revolutions in computer technology and in financial economics. Many traditional investment banking activities were transformed, as algorithms and technical prowess were substituted for old-fashioned, people-based, qualitative investment banking skills. These changes had an effect upon business schools: more and more investment banker skills can now be acquired in professional schools; and because banking skills are being more widely disseminated and because computers create economies of scale in their application, competition in investment banking has reached unprecedented levels.
Computers have therefore transformed the structure of the investment banking market. They have also transformed some activities that previously were regarded as very specialized and hard-to-teach. For example, company analysis that previously relied upon close contact with the firm and long-term relationships is increasingly separated into a relationship-management activity, and a technical, codifiable activity that can increasingly be performed anywhere. This shift is transforming the investment banking industry: technical skills that can be learned in professional schools can be applied anywhere in the world. So, for example, while JPMorgan Chase and Co. has been outsourcing basic operational jobs such as deal settlement to India for some time, it now performs a very wide range of processing, risk management, research, and analysis in India. Similarly, Goldman Sachs Group Inc. and Morgan Stanley both have significant presences in the South Asian country. Increasingly, the role of the local analysts is that of project coordinator, sending specific technical tasks to experts who could be anywhere in the world.
Information technology has transformed securities businesses, but its impact in other areas has been less pronounced. As a result, investment banking today is a rather bipolar activity. At one extreme, investment banks continue to provide the type of relationship-intensive services that they have always sold, in both advisory work and in complex security underwriting. At the other, they are engaged in capital-intensive business that is high-volume, low-margin and largely commoditized.
Arguably, the hi-tech, high-volume parts of investment banking do not sit happily with traditional relationship-intensive businesses. Certainly, we see more and more boutique operations concentrating upon relationship businesses. Investment banking will always rely upon human agency, relationships and reputation. The challenge for investment banks in the future will be to create within very large companies the smallness that these qualities require.
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Alan D. Morrison is director of MSc in financial economics programme and professor of finance at the Saïd Business School, University of Oxford. He co-authored Investment Banking: Institutions, Politics and Lawwith William J. Wilhelm Jr of the University of Virginia. The book was published by the Oxford University Press in February 2007.