Investment banking challenges
Risk in investment banking comes primarily from prop book trading. Generally, such trading involves leveraging—ratio of trading assets to owner’s equity—on capital. When a firm takes on very high leverage and the trade turns out to be a loss, it can wipe out a bank’s entire profits and capital very quickly. During the sub-prime crisis, the collapse of Lehman Brothers—the largest bankruptcy filing in U.S. history—was due to leveraged trading.
Some banks with poor internal control processes may also face problems from employees who are able to circumvent the system and gamble on the firm’s capital. This can lead to large losses. In some extreme cases it might lead to the collapse of a bank. Barings Bank, one of the oldest investment banks in the world, collapsed due to a rogue trader called Nick Lesson.
Many investment banks also sell options to their clients. They earn premium income from selling options. However, it also exposes a firm to potentially huge liabilities which can be more than bank’s profits and capital.
Investment banks that focus solely on the advisory fee as a revenue stream and avoid leveraged trading are largely playing on markets and the economy doing well. However, when things go downhill they can face a substantial decrease in revenue. While such banks don’t carry high risks, their revenue might be irregular depending on the strength of the capital market and the economy.
The failure of large and respected banks like Lehman Brothers, Bear Stearns, Merrill Lynch, and Wachovia during the sub-prime crisis should serve as a timely reminder of the risks in investment banking. As a result, it’s essential for an investment bank to have excellent internal audit systems and superior risk management. It also needs prudent leverage. Then an investment bank can only hope to have sustainable future growth. All investment banks like Goldman Sachs (GS), Lazard (LAZ), Morgan Stanley (MS), Legg Mason (LM), or investment banks in an exchange-traded fund (or ETF) like the Financial Select Sector SPDR FD (XLF) face one or more of the risks discussed above.
We’ll focus on custodian banks in the next part in this series.