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Investment Banking: Technology and the Decline of Trust - Ideas for Leaders
Idea #325

Investment Banking: Technology and the Decline of Trust

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KEY CONCEPT

‘Up or out’ promotion policies and reward systems that encourage ‘star’ bankers to ‘shine’ by taking unacceptable risks were significant factors in the 2007-2009 financial crisis. But they need to be viewed in a broader context. The seeds of trouble were sown decades previously, when a trend towards ‘transactional’ models, powered by technology, began to transform investment banks.


IDEA SUMMARY

Investment banking was once regulated mainly by ‘reputational incentives’: bankers were motivated to act in the client’s best interests by concern for the bank’s good name. It was a system that owed as much to pragmatism as integrity. Contracts relied on the honest exchange of information (about, for example, the quality of securities) and the ‘tacit skills’ (knowledge and experience) of bankers. As such, they were difficult to codify in law or verify in court. Informal and extra-legal, they depended on trust.

Bankers, of whom there were relatively few, built close and long-term relationships with clients, and, as their remit broadened, it was in their interests to protect these relationships by acting honourably. The business model was ‘relational’ — and it was built on intangible assets such as reputation.

Further checks and balances were provided by the ownership structure. Senior bankers, partners with a stake in the firm, were motivated to mentor and pass on tacit skills to junior bankers. When bankers said ‘my word is my bond’ they generally meant it. How else were they going to get rich?

This model of ‘happy pragmatism’ lasted well into the 20th century but it is unrecognisable in much of the industry today. Concerns for institutional reputation have been replaced by concerns for individual reputation. A ‘star’ culture has emerged in which talented but unproven individuals, ‘incentivized’ by performance-related pay, have peddled complex products against the interests of clients — with sometimes disastrous results. Reputational incentives have been perverted: they’re now more about narrow self-interest than self-regulation.

This profound cultural shift has been examined in detail in recent years by Alan D. Morrison of Saïd Business School and William J. Wilhelm Jr. of the McIntire School of Commerce, University of Virginia, and others. The reasons for it are various and complicated but they can be summed up as a trend towards more transactional models and arm’s-length relationships. And in this, information technology has played a key role.

Computerisation has put more distance between banker and client — and between junior banker and employer. It’s meant, Morrison and Wilhelm point out, that activities once the preserve of the relationship banker have migrated to the trading room, and that skills such as option trading and valuation, once learned through lengthy on-the-job apprenticeships, can be acquired in the classroom.

It’s made trading more codifiable and, consequently, more subject to formal contracting. The importance of trust-based, extra-legal contracting and tacit skills has declined as powerful desktop computers have enabled banks to measure and to record data and to introduce formal financial modelling techniques.

The impact on the nature of client relationships has been matched by the impact ‘in-house’. The arrival of IT both coincided with and facilitated fundamental change to the institutional framework.

In 1971, rules preventing member firms from floating on the New York Stock Exchange were relaxed. The banks that chose to raise capital on the market in the decades that followed did so partly in the knowledge that IT was helping to make the partnership an anachronism.

The move to the joint-stock form and computerisation contributed to increased emphasis on ‘personal capital’. ‘Star’ bankers, easier to spot in the computer age, were lured by outsiders and, no longer motivated by a ‘job for life’, they happily moved between banks.

Computerisation, then, has been a powerful force for cultural and structural change, transforming the way business is done and relationships inside and outside banks.


BUSINESS APPLICATION

The changes of the 20th century have not all been bad. A business that was once controlled by ‘dynastic’ firms — for example, the Rothschilds and the Morgans — is now more open, its employees more diverse.

Codification, what’s more, can work in the interests of clients and investors. The ability to spot a concentration of stars might be valuable in some markets, allowing resources to be placed in the most efficient hands.

Nonetheless, there can be little doubt that the decline of relational banking and changing reputational concerns have increased risks.

How can these risks be managed? Monitoring the activities of every talented but unproven individual can be impractical and expensive. Banks might need, instead, to take ‘softer’ measures. In the 2013 paper ‘Investment Bank Reputations and “Star” Cultures’, Morrison and Wilhelm and Zhaohui Chen suggest:

  • Developing a culture that emphasizes team rather than individual accomplishment.
  • Trying to make sure the average quality of the bank’s employees is high. (If you employ talented people in the first place you won’t have the problem of people trying to prove themselves.)

The corollary is that companies might need to do a bit more research on the ethos and culture of their bankers.

For those in need of the tacit skill of knowledge and information, meanwhile, there’s the option of ‘advisory boutiques’. A reaction, in part, to the rise of the full-service investment bank, these are smaller specialist institutions, and many of them are constituted as partnerships.


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