Paying the price

Insider Philip Augars book on investment banking analyses how the financial sector functions, and is a damning indictment of the practices of financiers.

LIKE honeymoons, parties too tend to come to an end. And when they do, realism usually enters the scene, even if only briefly. The apparent ending of the stock-market party has focussed minds once again on the problems inherent in the functioning of capital markets and the risks for small investors. As long as the stock market continued its bullish streak, such concerns were ignored or swept aside by market analysts and media commentators alike. But now, with Indian and ot her stock markets in Asia and across the world in what could become a free fall, the need for honest and unbiased analysis has suddenly become apparent.

This is a good moment, then, to pick up a book that analyses how these financial markets actually function, and which is written by someone who is in a position to know because he has been very much a part of it (Philip Augars The Greed Merchants: How the Investment Banks Played the Free Market Game, Penguin Books, 2006).

It may not be news to many of us that inequality lies at the heart of the modern free market. But it is news to read these words coming from someone who worked for more than 20 years with two British securities firms as an international investment banker and who interacted closely with Wall Street. Augars fascinating book is full of all the detailed insights that only an insider can provide. While it confirms some of the suspicions we may have had about the problematic practices of financiers, it is a particularly damning indictment because it is based on his own experience as well as on frank discussions with colleagues and others who have been major players in the financial sector.

The book focusses on some inadequately discussed features the dark corners of recent investment banking history that include the very high returns that accrue to a small number of large banks despite the variable quality of their advice. Augar explains this in terms of the state of competition in the industry, which he sees as essentially oligopolistic, and the integrated model of investment banking that gives some large firms a strong competitive edge. In addition, flexible management and a ruthless approach to customers, competitors and regulations have allowed a few of the large banks to reap extraordinarily high profits, which are camouflaged to some extent because some part of the profits is shared out as excessively high employee compensation.

First, the nature of the market itself. The world of investment banking appears to be a crowded field, with more than 6,000 firms in the United States alone. But only 10 big companies (known as the bulge bracket) dominate the market. Of these, three companies Morgan Stanley, Goldman Sachs and Merrill Lynch are the clear market leaders, the super-bulge.

All of them obviously have to offer what are now seen as standard activities of investment banks such as bank loans, commodities and currency dealings, prime brokerage services, real estate financing and proprietary trading and investment in financial assets. But in addition, the top 10 firms all offer at least three other products: advice on debt and equity share issues, mergers and acquisitions and financial restructuring; research on equities and equity derivatives, sales and trading for institutional investors (including hedge funds); and the same for bonds and bond derivatives. It is this combination of services that makes up the integrated securities and investment banking model.

This model is an American invention, but it is rapidly spreading to the rest of the world through deregulation or takeover. The alternative models of financial system the debt-based companies of Germany, the Japanese state-determined system, the British equity finance system all appear to have been defeated by the U.S. approach, which according to Augar involves the relentless pursuit of shareholder value to the exclusion of all other objectives. Investment banks have been instrumental in exporting this model to the rest of the world, for instance, Latin America and now also Asia, including India and China.

At the heart of Augars argument is the issue of conflict of interest between the different functions that investment banks have taken on in recent times, between investment banks and regulators, between financial interests and the media, and so on. In terms of the activities of the banks, the integration of broking and underwriting, of proprietary and customer trading, of market research and investment advice, all give rise to huge conflicts of interest within the leviathan investment banks, and these conflicts are seldom or inadequately regulated.

He argues that this has enabled a few corporations and individuals not only to exert inordinate influence over both business and government but also to acquire immense wealth in the process. And this has essentially been at the cost of capital issuers and small investors, including workers who have saved for the future by putting their money into pension funds.

Augar calculates that as much as $180 billion was taken out of U.S. capital markets in two decades in the form of abnormally high profits and employee compensation (page 166). Where did this money come from? The answer: Ordinary people, pooling their resources into mutual funds, pension funds and other investment vehicles pay the fund managers fees and own the majority of shares in the companies that use the markets.

According to Augar, while there is no evident cartel, some of the results in the financial markets are similar. Thus, a few firms dominate the market; they make excess returns (even though these are cleverly disguised); risks have not been transformed as is claimed, but only spread; and prices have remained high. So, there has been implicit collusion or strategic pricing among the large investment banks.

And the conflicts of interest similarly have spread across the system, creating ethical grey areas where anything goes. The media are clearly implicated, especially in building up speculative bubbles through the incessant encouragement to buy. But the role of regulators is no less problematic and looks rather more dubious when the two-way street that ran between Wall Street and Washington is exposed. So, regulators tended to make top appointments from the group of senior bankers, and bankers tended to hire former regulators.

In one typical but especially striking example, the man who had been the head of the investor protection bureau for the high-profile New York regulator Eliot Spitzer was hired by Morgan Stanley in 2004 to oversee regulatory matters. In Britain, the former chairman of the Financial Services Authority was also hired by Morgan Stanley within three months of his stepping down from his regulatory position. Augar makes the point that the recent reforms driven by Spitzer and others, which were supposed to have cleaned up Wall Street after the financial scandals of the late 1990s, have not really addressed the problem. Instead of removing huge areas of conflict of interest, they have simply tried to manage them better. So future lapses and with them scams, scandals and crashes are only to be expected. Prophetically, he ends his book with the words: Heres to the next time.

Those of us who reside in countries with supposedly different systems of finance and regulation have no reason to be complacent about such tendencies. The current shocks may well portend losses that hit smaller investors hard, even as the big guys manage to retain their highly profitable bottom lines. As Augar points out in his Preface, If you look hard enough the games that are being played in American capital markets can be found wherever you live. And if you look hard enough you will find that you too are paying the price.