Death of Bulge Bracket Investment Banking operations?
There is a lot of noise being made about tightening Investment Banking regulations worldwide post credit-crisis, but what does it all really mean?
Sometimes the world of finance seems so interesting but difficult to understand, in this article I will try to simplify a lot of things. For starters, all of this regulation being imposed is only necessary because of the credit crisis that occurred in 2008.
The Credit Crisis
The Credit Crisis was a point in time (2008-2009) when the availability of capital was minimal, availability of capital is also referred to as the availability of credit, hence the name, credit crisis. One of the main triggers of the credit crisis was that banks found a way to make a lot of money off sub-prime (riskier than usual) mortgages without having to take on the risk themselves, by simply repackaging and selling these sub-prime mortgages to investors.
This is how it works, the bank goes out to literally anyone, does not matter how terrible your credit history is, and they issue mortgages, so now you have all these people who are incapable of paying back these mortgages sitting in houses. Then banks will take those mortgages, add a premium on top, and sell them to investors. The only reason investors would buy these mortgages is because rating agencies were giving these mortgages a high credit rating, which meant they were good for the money, or in other words, “safe” investments. However, these credit rating agencies were not exactly “independent” to say the least, and their ratings were biased because they were being paid by the banks.
Anyway, so these banks were making ridiculous amounts of money off the sub-prime mortgages and it was the investors that were taking the financial loss when these people who had the mortgages could not pay the mortgage. There are a lot more details to the credit crisis, and if interested in looking deeper, I strongly suggest further research on “Credit Default Swaps” and “Collaterized Debt Obligations”, these are two terms you will come across a lot when reading up on the credit crisis, but those are more the details, the bigger picture is that risky mortgages were being sold to investors without them knowing any better because they trusted the credit rating agencies. Needless to say, those investors stopped buying these risky mortgages when they started to default, and the banks were left with a lot of bad mortgages on hand, overall investor confidence lowered and banks needed to be bailed out, and voila, credit crisis.
But… Canadian banks are doing pretty good, eh?
True, in the midst of all the chaos, Canadian banks remained very conservative and did not take the same risks as their American counter parts. As a matter of fact, the World Economic Forum ranked Canadian banks as the safest banks in the world… for six years in a row! Which does raise the question of many, are all these new regulations even necessary for Canadian banks?, but that is a debate I won’t get into.
Overall, things looked pretty ugly during the credit crisis as a whole and a lot needs to be fixed, this is where these new regulations come into play. Generally, they are trying to increase the amount of capital that a bank needs to hold prior to taking a certain risk and they are dictating certain levels of liquidity that the bank must maintain. This is all being done so that the banks cannot take unreasonable risks as they did before, and then just come crying for tax payer money when things got ugly.
Basel III
One very common term that you will hear being tossed around when talking about tightening of regulations is “Basel III”, which is just a regulation that is being rolled out that will dictate that amount of capital that a bank must hold relative to it’s risk-weighted assets. This regulation was written up in 2010 after the credit crisis and is still being rolled out in phases, it is expected to be fully rolled out by 2019.
That’s great, but so what?
Well, this means that banks cannot take the same risks that they used to, which means they cannot generate the same returns that they used to. Overall, this means a shrinking Investment Banking industry as a whole, and yes, for all of you finance majors out there, that does mean there are not as many Investment Banking jobs out there as there once was pre-credit crisis, and the ones that are still there don’t pay the same amounts they used to. A “dying” investment banking industry for bulge brackets (big banks) might be a little extreme, but it is shrinking for sure. That being said, worry not all of you finance majors, because although the investment banking industry is shrinking, there are other areas in finance which are gaining more and more traction.
So… What is the “next big thing”?
Private Equity, Risk Management, Hedge Funds, Real Estate. Each area has it’s own reasons for being the “next big thing”. Low Interest rates, lack of capital availability (during the credit crisis, not anymore), and increasing income inequality are some of the reasons.
Private Equity
During the credit crisis, when there was a lack of capital availability, Private Equity was (and still is) a very big deal. See, simply put, everything melts down to supply and demand, there will always be brilliant projects out there that will make insane amounts of money, and they all need financing. That did not change during the credit crisis, but what did was the supply of money, less people were willing to provide the capital that these very profitable ideas of businesses needed to capitalize on that profitability. With a low supply of capital, the few guys out there that will provide the capital, can now charge higher required rates of return. This made Private Equity a very profitable business due to the lack of capital availability on the public markets. Essentially, low investor confidence makes Private Equity a very profitable area to be in.
Risk Management
Ever since the credit crisis, managing the amount of risk that any financial institution is exposed to has become increasingly important. This caused the field of risk management to take off - ideal for those quants heavy finance majors/actuaries/engineers. A lot of what is involved with risk management is financial modelling and stress testing. “Stress Testing” is just creating hypothetical situations and testing how bad things would have to get to make the bank default. “Financial Modelling” could be used to for multiple things, but it is essentially just creating excel models that replicate a hypothetical situation/deal. Stress Testing is a form of Financial Modelling, and financial modelling in general is becoming a highly demanded skill amongst employers, so definitely plenty of jobs in this field.
Hedge Funds
This area is definitely a personal favourite. As a result of the credit crisis, the economy needed to be stimulated, a common method of doing so, is lowering interest rates. Since the credit crisis hit the economy hard, interest rates hit very low levels, making capital very cheap to borrow. Often times, borrowed capital is used for investment purposes, this low interest rate environment made it an amazing time for hedge funds to leverage (take on debt) themselves and invest that money in the public markets. Hedge funds are interesting because they are not subject to the same level of regulation as mutual funds, they can take on very high amounts of risk since the investors involved are all very wealthy and can afford those levels of risk. Also, with growing income inequality, there are more and more extremely wealthy individuals that qualify for hedge fund investments, providing hedge funds with even more capital on top of the cheap capital being provided through public markets. All in all, cheap capital, increasing income inequality, and protection from tightening regulations provide an economic environment perfect for hedge funds to grow in and we can expect to see more hedge funds and bigger hedge funds in the future.
Real Estate/Infrastructure
This one seems a bit ironic, since risky mortgages were exactly what caused the credit crisis to begin with. However, during the crisis, one of the least affected asset classes was Infrastructure, and that is because it is a necessity, things like toll roads are still used even during tough economic times and are used even more with growing density of population, making more conjusted public roads, which makes toll roads even more attractive. Toll roads are only one example of infrastructure investments. Since this asset class was able to remain relatively strong even through the credit crisis, and more and more people were afraid of risk, more and more money was pumped into infrastructure. Canadian real estate in specific has been performing very well, which has caused a lot of foreign capital to flow into Canadian real estate, only pumping the market even more. There are a lot of practical examples which show that institutions recognize how strong the Canadian real estate market is. For example, Loblaws recently issued a Real Estate Investment Trust (REIT) which is simply ownership of the real estate they own, companies usually issue securities when they are “overvalued”, which means they know that they can get a lot of money from issuing them. Low interest rates is also the driving factor in the real estate market, since real estate is a “real” asset, which just means it’s a physical asset, it is seen as a safe investment, so more and more people are leveraging themselves to purchase more and more real estate.
