There are many financial institutions that are actively involved in financial markets. When we think about the financial system, we can think of financial markets and financial institutions as two distinct parts or channels of the system. For instance, commercial banks are financial intermediaries associated with the indirect channel of finance. However, there are other types of financial institutions whose business model is closely tied to financial markets. Two categories for these types of financial institutions are — investment banks and investment funds. These types of institutions play an important role in financial markets, which can put them at risk in periods of crisis.
Investment Banks
Investment banks are designed to support financial markets. While commercial banks provide funding to their clients, investment banks help their clients access funding. Commercial banks are balance sheet lenders that fund their investments on their balance sheet. Investment banks do not need such a large balance sheet because they are connecting their clients to other sources of funding.
Investment banking in its purest form is a fee based business. Investment banks make money by helping clients issue securities and serving as broker-dealers in capital markets. An example of their role in securities issuance would be an investment bank serving as the lead arranger in a company’s initial public offering (IPO). In this role, the investment bank does “book building” (or book running) to help line up investors for a security issuance and determine the appropriate listing price. The broker-dealer role is the sales and trading business of investment banking. An investment bank can have a “trading desk” in any financial market. Examples of trading desks include equity, fixed income, currencies, and commodities.
Goldman Sachs (GS) and Morgan Stanley (MS) are the two largest U.S. investment banks. Goldman is the quintessential U.S. investment bank, because their performance is closely tied to financial markets. During periods of volatility, Goldman can earn significant revenue by servicing their clients’ demands for buying and selling securities. For instance, Goldman managed to increase their share price during the COVID pandemic based on sales and trading.
The history of financial regulation in the United States has shaped the role of investment banking in financial markets. Prior to the 1930s in the U.S., investment banks and commercial banks were allowed to operate under one roof (as one company). Universal banking describes a bank that provides both investment banking and commercial banking to its clients. During the early 1930s, there was significant financial distress in the U.S. caused by market downturns that then caused distress in the commercial banking sector. To address this spillover effect, the Glass-Steagall Act of 1933 separated investment banking from commercial banking by law. This period in U.S. history was the origin of stand-alone investment banks as we know them now. However, in the 1990s, many bankers and policymakers argued that this law was outdated. “Gramm-Leach-Bliley” (the Financial Modernization Act of 1999) effectively repealed Glass-Steagal and allowed the combination of investment banking and commercial banking again.
Universal banking has grown in the U.S. since the 1990s. Citigroup (C) was one of the first modern universal banks in an effort to be a “one stop shop.” Today, J.P. Morgan (JPM) and Bank of America (BAC) are the two largest universal banks. A ranking of the world’s largest banks by market capitalization shows that J.P. Morgan and Bank of America are the two largest banks in the world. Morgan Stanley and Goldman Sachs are ranked 15 and 17, respectively.
Investment Banks and the Financial Crisis
Investment banks played a central role in the global financial crisis of 2008-2009. This is particularly true in the use of the term “bail outs.”
Bear Stearns was an investment bank that was bailed out in March 2008. At this early stage of the crisis, Bear Stearns was particularly exposed to subprime mortgage-backed securities. Investment banks had made significant returns on the creation of mortgage-backed securities for their clients. However, Bear Stearns was brought to the point of failure due to its holdings of these securities. At the brink of bankruptcy, Bear Stearns was acquired by J.P. Morgan with the assistance of government funds and guarantees. This is what we mean when we say that Bear Stearns was “bailed out.” Notably, this was also a significant expansion of J.P. Morgan’s investment banking operations. This was the first expansion of universal banking in the financial crisis.
In contrast, Lehman Brothers was an investment bank that was allowed to fail in September 2008. The decision to let Lehman fail illustrates the tension in government about whether to bail out or not. The Lehman decision reflects the hands off approach to market discipline. However, the failure of Lehman was the event that marks the epicenter (depth) of the financial crisis. When Lehman failed, other financial institutions connected to Lehman suffered losses, and soon the global financial system was spiraling downward. The Reserve Primary Fund, a money market fund, “broke the buck” due to their holdings of Lehman liabilities. This led to a call for government intervention.
Merrill Lynch was one of the largest U.S. investment banks prior to the global financial crisis. However, Merrill Lynch was also brought to brink of failure in November 2008. Merrill was ultimately bought by Bank of America in a government-assisted acquisition that folded the investment banking operations into Bank of America. This is the merger that produced Bank of America Merrill Lynch (“BAML”). This was the second expansion of universal banking in the financial crisis.
J.P. Morgan and Bank of America are now the two largest banks in the world. This is a consequence of universal banking and the resolution of the financial crisis. Is this a good outcome? Some would argue that the problem of “Too Big to Fail” has only gotten worse. The systemic risk of these two banks is so large that any distress would result in widespread contagion.
The “Volcker Rule” in the Dodd-Frank Act of 2010 was an effort to reduce proprietary trading by large financial institutions. The hope was that this would reduce the exposure of these institutions to market swings and would mitigate the amount of systemic risk. The “Volcker Rule” was ultimately dismantled due to the legal challenge of distinguishing proprietary trading from market making.
Goldman Sachs and Morgan Stanley survived the financial crisis, but they have both been changed by it. Goldman Sachs and Morgan Stanley are now official bank holding companies like J.P. Morgan and Bank of America. This designation was changed during the crisis so that these two investment banks could access the liquidity facilities offered by the Federal Reserve. This access to the “lender of last resort” was a lifeline that kept them afloat.
Goldman Sachs and Morgan Stanley have also altered their business models over time. Since the crisis, Morgan Stanley has emphasized wealth management as a more stable source of income to offset market risk. Goldman Sachs recently introduced “Marcus” as a brand of consumer-focused financial products. It is interesting to see how these institutions are evolving from their origins.
Investment Funds
Investment funds are the other key “financial institution” involved in financial markets. We sometimes do not think of funds as institutions, but investment funds do function as a form of financial intermediary. To the extent that a fund receives money from investors and then chooses how to invest those funds, it it operating as an intermediary in the flow of funds.
A mutual fund is one of the most basic forms of investment fund. A mutual fund issues shares to investors and then uses the money to invest in securities. Traditionally, mutual funds invested in a range of stocks and bonds. For instance, some mutual funds focus on growth stocks and others focus on value stocks. The goal of a mutual fund is to offer diversification to the investor. Rather than buying a stock of single company, an investor can buy the share of a mutual fund whose performance will be determined by the wider range of underlying securities.
Fidelity is one of the largest mutual fund families. The company offers hundreds of different funds that have their own fund manager and offer a unique investment prospectus. Peter Lynch was one of the well-known Fidelity fund managers of the past who was known as a smart money manager. Over time, Fidelity established a reputation in active management by offering funds that made investment decisions to “beat the market.”
Vanguard is also one of the largest mutual fund families, but its origins are very different than Fidelity. Its founder, Jack Bogle, created Vanguard based on the premise of efficient markets. The main value proposition of Vanguard is passive management based on index investing and low fees. Vanguard funds do not attempt to beat the market, but rather simply to track the market. Vanguard funds have seen record investor inflows with the growing popularity of passive, index investing.
Exchange Traded Funds (ETFs) are the evolution of mutual funds. ETFs trade on stock exchanges, so their price is more transparent and they are considered to be more liquid. It is very easy to buy and sell shares in an ETF. ETFs are also closely associated with index investing, because the largest ETFs track market indexes just like index mutual funds. One of the lingering concerns with ETFs is the potential liquidity mismatch between the actual shares and the underlying assets. A liquidity mismatch could cause a significant dislocation in the tracking ability of an ETF.
Beyond mutual funds and ETFs is the world of hedge funds. A hedge fund is an investment fund that invests in assets beyond the traditional domain of stocks and bonds. Hedge funds often take short positions and invest in alternative assets. A good example is Melvin Capital short selling shares of GME. Hedge funds take greater risks and charge higher fees based on the potential for higher returns. The goal is again to “beat the market” or offer uncorrelated returns. However, beating the stock market can be very difficult during good years for the stock market, so hedge funds have seen a significant compression in their fees. Regulation requires that investors in hedge funds be “qualified investors,” based on income or assets, so hedge fund investors tend to be high- or ultra-high net worth individuals. This is part of what drives the tension between hedge funds and retail investors.
Investment funds also include other forms of institutional asset management. Pension funds are investment funds that operate on behalf of a government entity or firm for the purpose of defined retirement benefits. The pension funds in Chicago and Illinois, such as firefighters and police, are currently underfunded. This means that they do not have sufficient assets to cover their liabilities. The temptation in this situation is to increase asset risk in an effort to increase returns. This history of underfunding has resulted in a pension crisis. Another form of institutional asset manager is insurance companies. Life insurers have long-dated liabilities so they tend to invest in long-dated assets. It is critical that asset growth meets or exceeds future insurance claims.
Trends in Investment Banking and Investment Management
There are many new and interesting trends in the investment banking and investment management space. Here are a few examples:
- Direct listing and SPACs
- High-frequency quantitative trading. Spoofing.
- Commission free trading. Low advisory frees.
What is the future of investment banking and investment management. Is it bright?