Dreams and Nightmares of Merchant Banking Performance

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Dreams and Nightmares of Merchant Banking Performance

COMMERCIAL BANKS have rediscovered investment banking and created a unique blend of activities that are usually called merchant banking. Both money center and regional banks are embracing this "new age' concept to adjust to today's reality of corporate lending. Corporate clients frequently defect to the public debt markets to raise growing amounts at borrowing costs below or near the banks' cost of funds.

Another attraction of merchant banking is the allure of high returns in investment banking. As investment banks go public to obtain needed capital to compete in the global marketplace, the publicized returns on equity of the Salomon Brothers of the world dwarf many other lines of business. Commercial bankers covet these returns, often without adequately assessing the risks.

A surge of financial innovation provides yet another market opportunity. Inflation-disinflation, interest rate volatility related to the Federal Reserve's inflation medicine, and telecommunications technology have sparked financial innovation. Think back 10 years. Swaps, futures, options, collateralized mortgage obligations, loan sales, or even money market funds were hardly a familiar part of the financial landscape.

Securitization is transforming wholesale banking as money market funds altered retail banking. With loan sales, investor/depositors gain access to loan yields, thereby eliminating the spread obtained from intermediation.

Similarly, money market funds provided a way for investor/depositors to access money market yields that banks were loath to pass through from the investment portfolio. Banks met the challenge of money market funds with the Garn-St Germain Act's money market deposit account and reclaimed some of those funds.

On the commercial loan side, the growth of high yield or junk bond, Eurobond, Euro and domestic commercial paper offerings, and the advent of shelf registration for domestic bond offerings have stunted loan volume and caused wafer-thin margins. The relationship orientation that once ruled in both investment and commercial banking has largely given way to transactional finance where price dictates who does the deal. Moreover, corporate finance executives are growing more sophisticated and occasionally are raising capital without the use of either an investment or commercial bank.

Financial innovations, burgeoning loan alternatives, attendant hypercompetition, and greater economic uncertainty carry the implicit message that wholesale banking is in a new era. Numerous strategic options exist, but many banks are adopting cloned strategies based on swaps or public finance due in part to Glass-Steagall.

Moreover, some more imaginative strategies, such as merger arbitrage, have encountered institutional resistance. While these strategic choices are necessary, risk management dictates that a thoughtful assessment of the risk-return trade-offs should precede any headlong rush to embrace merchant banking products or strategies. Without a fine appreciation of the risk-return aspects, some will find a tough downside facing them in the future.

Investment Banking Fast Lane

As the capital markets grow more efficient in allocating capital due to improvements in information technology and the packaging of securities, commercial and investment banks must scramble to find remaining imperfections from which to profit. As banks eradicate market imperfections and put themselves out of heretofore profitable businesses, they must utilize innovations to spawn new businesses.

Take, for example, the origination of mortgages. Imaginative financial engineers have created a host of unique instruments that changed the risk-return aspects of mortgage originations. Given the plethora of mortgages available to borrowers, financial institutions could develop mortgage brokerage as a innovation to provide fee income. …