Banking: It’s Not the People, It’s the System

The one-stop-shop banking model has created unmanageable conflicts of interest that are driving destructive incentives that put profits ahead of cl...
Reuben Daniels and Craig OrchantApril 13, 2012

While everyone is talking about the open letter from a former employee of a global financial-services firm, most of the discussions are missing the bigger picture. The problems are not isolated to one person’s experience or the culture at a particular iconic Wall Street firm the real issue is the conflicted system global capital markets have become. The advent of the one-stop-shop universal banking model has created unmanageable conflicts of interest that are driving the destructive incentives of the system today.

As banks expand their product capabilities, almost every transaction creates an opportunity to profit on every side of a trade. Megabanks are regularly both an adviser and principal in transactions, whether the activity is loans or derivatives, underwriting or trading, cash management or asset management. The bank earns advisory fees, garners an advantaged principal position, and curries favor with preferred investors. The opportunity to profit is extreme and the temptation is too great for most to pass up.

Victory for the banks is to be on all sides of a deal: owning equity in a company that’s acquiring another, advising the target company, installing supportive management at the target company, providing bridge capital, executing transaction hedges, and underwriting the take-out financing. Which element of this fee pool would a rational firm give up? As in every business, bankers are rewarded for maximizing their contribution, and the common view is that there are few reasons to decline these revenues as long as the conflicts are “managed.”

The current state of the banking business was recently compared to that of a Wal-Mart or Costco, in that you can buy everything in one place. But banking was very different 30 years ago. Back then, the connections among trading, underwriting, advising, and financing were clearly distinct, with different institutions providing these specialized services. The inception of the derivatives market was the catalyst that led commercial banks to realize a new opportunity of enormous, not to mention opaque, profit potential. While these derivatives fees funded the growth of the commercial banks’ securities businesses in the beginning, financial institutions were still largely separated by the kinds of services they offered. In fact, prohibitions against tying (requiring a client to buy something it doesn’t want to get something it does want) restricted banks from demanding securities revenue in exchange for the provision of capital.

During the 1990s, however, bankers began to reverse the tying proposition by training their corporate clients to demand capital of their financial counterparties in order for those counterparties to be eligible for other securities revenues, such as cash-management fees. Thus, a new “quid pro quo” was born, wherein commercial banks increased their competitive advantage because they had access to inexpensive and regulated capital that they could lend out. The banks cemented their position with the passage of Gramm-Leach-Bliley, which ended restrictions and separations imposed by Glass-Steagall.

Then in 2000, it was no coincidence that many large banks began reporting that their derivatives revenue exceeded their lending revenue. The transformation to the universal banking model was largely complete. Any final attempts to resist collapsed along with the financial markets in 2008, as the remaining investment banks capitulated and converted to regulated banks.

The financial system today is highly industrialized, specialized, and commoditized. The presentations, the capabilities, the services, the approaches, and the conflicts of interest are virtually identical for every bank. Banks now are typically compensated in relation to their provision of capital and less frequently for the quality of their advice. Thus, there is limited incentive to invest in human capital. This is the root of the toxic environment that has permeated the entire industry, not just one firm.

The consolidation and concentration of banking is reversible without having to burn it down or wait for the unintended consequences of regulatory intervention. The industry can return to the advisory-oriented model of old by turning its attention back to clients and the objective advice that characterized the business years ago. While there may be value in buying paper towels at Costco, financial services shouldn’t come in bulk.

The authors are co-founders of EA Markets LLC, a corporate finance and capital markets advisory based in New York City.