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Ref lec t io n s o n th e

F in an c ia l C r is isan d In v es tm en t B an k in gB y Ro be r t J . Rh e e

THE FINANCIAL CRISIS OF 2008 HAS PERMANENTLY changed WallStreet. Conventional wisdom says that Wall Street-the "bad guy" inthe simple narrative---enabled the crisis by providing the financialtechnology, primarily securitization and derivatives, that brought theglobal financial system to its knees. I don't disagree, except to suggestthat there is nothing intrinsically wrong with these financial instru-ments. But I take aslightly different perspective on the relationshipbetween Wall Street and the crisis. With the caveat that in hindsightwe are all an Einstein or a Buffett, I posit that one of the root causesof the crisis (and there aremany) is the way Wall Street organized itselfduring the 1990s and beyond.

During this period, Wall Street was consolidating at an aggressivepace. The consumption of firms was startling. Consider these venerablenames from the not so distant past: Alex. Brown, Bankers Trust, SGWarburg, Donaldson Lufkin &Jenrette, Montgomery Securities,First Boston, JP Morgan, Salomon Brothers, Smth Barney, PaineWebber, just to name a few. Many of these firms were consumed bycommercial banks, which had enormous balance sheets but lackedthe intellectual capital and operational scale to break into the top-tierof investment banking. These banks included Deutche Bank, UBS,Credit Suisse, SwissBank, Barclays, Bank ofAmerica, ChaseManhattan,and the predecessors of Citigroup. These firms brought an enormousamount of new capital to the activity of investment banking.

Likemost financial executives, I accepted the idea that global financerequired intense concentration of capital and aglobal network ofintellectual capital and cross-selling capabilities within asingle firmstructure. I was wrong. And so too were the titans of Wall Street whoengineered this mega-catastrophe. The consolidation combined stablecommercial banking with volatile investment banking. The invest-ment banking business now had far more capital. During this time aswell, vast pools of private capital, private equity, and hedge funds alsocame into promnence and were searching for returns. With the con-vergence of these factors, Wall Street was primed to take larger risks.

In hindsight, as I try to make sense of what ishappening now, mymoment of insight should have been avaluation study I performedfor a large financial institution. The question concerned the value of alarge fixed income trading operation. There wereno comparable publiccompanies, and so no easy answer to the question. The work requiredan implied sum-of-the-parts analysis of bulge bracket (full service)investment banks. The study's essential conclusion was that propri-etary trading operations, the rype of activiry that isat the epicenter of

this crisis, areand should be lowly valued. Even then, this made intuitivesense: Such activity requires large amounts of capital and is highlyrisky, thus necessarily resulting in low valuations.

When investment banks were independent, capital was preciousand judiciously applied. True, Wall Street is littered with firms thatself-destructed as a result of poor risk management. But notableaccidents and malfeasances aside, the risks of proprietary tradingwere contained by an appreciation of risks that could blowout one'scapital. This fear instilled discipline. In the past, Wall Street hadfocused on high value, high return activities-some of which such asmergers and acquisitions advisory require little capital.

The balance radically changed when Wall Street consolidated inthe 1990s. Firms were getting larger, fueled by an occasional shot ofanti-regulatory steroids. A landmark event was the conversion ofGoldman Sachs from apartnership to apublic company. The logic is

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apparent: bigger meant more capital; more capital required greaterreturns; greater returns areachieved only with greater risk. There areonly so many highly profitable, lower risk opportunities to goaround. Where would the returns come from? The banks had to takebigger risks, and this meant that the focus would turn to trading-that lowly valued, highly risky business, which was "juiced up" withhigh leverage to yield greater profits. Just as there was aglobal creditbubble that fueled the housing bubble, there was aglut of capital onWall Street, with commercial banks, investment banks and privatecapital all searching for returns. The resulting financial pressurestransformed Wall Street from avalue-added, intermediation serviceprovider to an enormous hedge fund.

The organizational changes on Wall Street left it highly vulnerableto aseismc shift in market volatility, just the way adecade beforeLong- Term Capital Management was vulnerable to the abnormaldisturbance in the fixed income market triggered by the Russian debtdefault crisis. This time around, in the wake of the housing crash andcredit illiquidity, it is no surprise that the first casualties were theindependent investment banks that did not have the capital to with-stand acatastrophic shock: Bear Stearns, Merrill Lynch, and LehmanBrothers. These firms did not have the balance sheets to survive afinancial shock, or at least to delay an ultimate demse. I would neverhave thought that in one fell swoop, these firms would go the way ofthe dinosaur. Nor could wehave foreseen that Goldman Sachs andMorgan Stanley, the two surviving patricians of American investmentbanking, would be forced to convert to banking holding companies.

Sowhat is thefuture of invest-ment banking?Any answer isspeculative. Weknow that finan-cial institutionscannot be allowed to take the type of risks they took. In hindsight, itwas acontinuing game of Russian roulette and ultimately the oddscaught up. We do not know whether universal banks will voluntarilydivest their investment banking operations. My guess: probably not.Investment banking is an alluring activity, and there may still be anappeal of cross-selling financial products under aone-firm umbrella.In any event, it seems that the genie is out of the bottle. Investment

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banking isno longer the prime domain of American firms, and thefinancial market is truly globalized. We can only better regulate therisk-taking activities.

My hope is that, from the ashes of the 1990s and the financialcrisis of 2008 Wall Street, will come a different business model.Market forces have brought down an industry of titanic scale, andWall Street is certainly far smaller now than it was just ayear ago.There is no longer aglut of capital in search of returns (indeed wehavethe opposite problem in that capital is seeking shelter from risk). Inlife as in fashion, what was once old issometimes the "new" new. Apossible future of investment banking may be a return to the oldmodel of focusing on intermediation services, high profitabilityproducts, measured risk taking, and a renewed appreciation that

capital is the lifeblood of a firm and itcannot be so easily staked. In any event,the crisis does not mark the death of WallStreet, or capitalism for that matter, butonly its transformation into anew form.

MY HOPE IS THA T, f r o m th e as h es o f th e 1990San d th e f in an c ia l c r is is o f 2008W al l St reet , w il lc om e a d if fe r en t b us in es s m od el . Assistant ProfessorRobert Rhee'sscholarly

interestsinclude risk-focusedeconomc analysesof legal and social problems. He has served asa law clerk on the u.s.Court ofAppeals for the Third Circuit, and a trial attorney in theHonors Program of the u.s. Department ofJ ustice. Professor Rhee alsohas worked asa vicepresident infinancial institutions investmentbanking at Swiss Re, as an M&A investment banker at UBS Warburgin London, and as a real estate investment banker at DeutcheBancAlex. Brown in Baltimore.

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