FIVE months ago accepted wisdom held that corporate and investment banking could achieve great economies of scale. Banks could get their foot in the door of a company by lending to it at generous rates, with the promise of profitable investment-banking business in the future. As proof that the strategy was paying off, the world's biggest full-service banks, Citigroup and J.P. Morgan Chase, were racing up the capital-markets league tables. The “pure” investment banks, such as Merrill Lynch, Morgan Stanley and Goldman Sachs, were under pressure to get out their cheque books and offer cut-price loans too—and so they did.
The collapse of Enron and WorldCom, and a general credit crunch, have changed the game. Lending has become more expensive, and rightly so, to reflect more closely the risks of companies' defaulting. Meanwhile, investment banking is under powerful public scrutiny: exactly how do these guys, especially not-so-humble research analysts, justify such huge pay cheques? Last week Jack Grubman, once Wall Street's most celebrated telecoms analyst, resigned from Salomon Smith Barney, part of Citigroup, taking $32m of severance pay with him.
New York state's district attorney, Eliot Spitzer, is leading investigations into individual firms—an exercise that is fast turning into a cross-examination of the entire industry. Why stop at research analysts? CalPERS, the pension fund for California's public employees, joined the hunt this week: its board voted to withhold business from bond and equity managers who could not clearly demonstrate their freedom, and that of their analysts, from conflicts of interest. It could cut deeply into the way some financial firms do business.
Citigroup's chairman, Sandy Weill, rushed earlier this month to be the first on Wall Street to embrace Mr Spitzer's proposals. He has also promised that his firm will no longer sell complex financial products to companies that do not fully disclose the effect on their balance sheet (ie, no more special-purpose vehicles to hide the true nature of a firm's indebtedness).
For a moment there seems to be convergence between Wall Street firms, anxious to appear squeaky clean, and regulators and investors demanding more transparency. But how long before this unusual alliance brings tears? Seeking out conflicts of interest in investment banking is like peeling an onion. It could go on and on until there is little or nothing left. Take equity trading. It does not require much digging to unearth potential conflicts of interest at firms with even the purest (that is, the simplest) business. Even that singular man, the so-called specialist on the New York Stock Exchange, trades both for himself and on behalf of clients.
In the wholesale markets for bonds, derivatives and other exotic products, few checks exist to ensure that prices are transparent and that privileged information is not abused. There is a question of perception: one person's synergy (the happy combination of abilities and information) is another person's conflict of interest (ruthless exploitation of privileged foreknowledge). What appeared to be synergy in a bull market, suddenly, in a bear market, looks more like conflict. If all this and more were drawn out into the daylight, precious little would be left of the fabulous returns investment banks and their staff are used to getting.
Yet there may be a reason, say investment bankers in their defence, why even the most militant of investors would be unwilling or unable to go so far. Bankers protest that unbundling or putting businesses and competencies into different compartments behind Chinese walls will not suit investors. Unbundling, they argue, is fundamentally uneconomic, and the investor will pay: in terms of the cost of fully independent research; and, still more, in a wider margin between selling and buying securities—because the traded market will be less liquid. Moreover, say investment bankers, most wholesale and investment-banking business is done among professionals able to look after themselves.
Proponents of the model of integrated banking are adamant that it has not been discredited by recent events. The subsidised lending was done largely to firms of good standing that were hardly expected at the time to be caught by a cyclical downturn. J.P. Morgan Chase was hit harder than was Citigroup by concentrated exposure to such firms, partly because it has merely half Citigroup's capital, and thus fewer chances for diversification. It is a blip that does not disqualify the model, these bankers insist. Big banks in general have survived remarkably well since the onset last year of a credit crunch, and have continued to make new loans to cash-strapped companies. Mr Weill said in the past that his bank should have the capital to survive all weathers, and so it has.
Yet a deep-seated problem in the sector must be the presence of too much capital chasing too high a return. Investment banks are still aiming at returns on equity of 20-25%. That might be more attainable if they had less capital, and indeed their falling share prices have done a good job of reducing the problem. But there may, and probably should, be much more slimming to come.
New lessons have been learned in the past few months about diversification and the management of credit risk. Reputation risk (in particular, the risk of being tainted by your customer's lack of honesty), litigation risk and conflicts of interest have moved high up the agenda. Will this lead to a leaner, cleaner financial-services sector?
In fact, one of two outcomes is likely. Either investment bankers and analysts will be back to their old tricks within six months. Or increasing attention will be paid to greater transparency in the raising and allocation of capital. Under the second, more desirable outcome, financial intermediation will aim to be more of a service, less of an ego-trip for the participants, and considerably less well paid. But no one should expect too much. Mr Spitzer and the board of CalPERS have thrown down the challenge. Yet financial markets follow cycles—and that probably goes for the contrition of investment bankers.