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Investment banking: why do we need a financial sector?

Charles Goodhart

As protestors occupy Wall Street and financial centres around the world, among the grievances are "socially useless" investment banks. But investment banking is critical to any effective economy, and the idea that policymakers can safeguard retail banking alone is not only tragically mistaken but also horribly dangerous.

By Professor Charles Goodhart
First posted on the VoxEU debate 'Why do we need a financial sector?'|

Investment banking has attracted much vilification in recent years, being frequently described as "socially useless", or a "casino". Yet if its functions are not properly appreciated, the 'reforms' that are now being proposed could lead to further problems down the road ahead

The historical roots of universal banking

Universal banking came into being on the continent of Europe in the late 19th century and in Japan in the early 20th century in order to connect banking with large-scale industry (steel, chemicals, pharmaceutical, electrical, cars, etc). With weak capital markets then, there was a need to channel retail savings into large-scale industry in order to promote industrialisation and growth.

The 'haus-bank' in Germany and Zaibatsu in Japan had close links with a stable of associated firms at the advisory, managerial, and equity ownership levels, as well as in the provision of loan finance. The contrast with the Anglo-Saxon tradition of "arms-length" banking, with no close involvement with associated firms, and bank lending supposed to be for temporary purposes, was often noted, frequently on the back of accusation that the British (retail-type) banks were not doing enough to support industrial development.

The other main root of investment banking was merchant banking. The growth of international trade, and the globalisation of supply chains, again largely carried out by large firms, rather than SMEs (small and medium-sized enterprises), led to a concomitant need for the provision of trade finance; and with that to a need for the development of an international information network on financial, especially foreign exchange, commercial, industrial, legal, and political conditions in all the major countries involved. While bits of such information could be provided by specialist boutiques, there were obvious advantages of scale and scope in having large information networks in large financial institutions.

Banking in a world with sophisticated financial markets

The (often implicit) argument is made that such roles, in supporting large industry and international trade, have been superseded by the growth of efficient capital markets. These allow (big) industry, and other big borrowers, often in the public sector (eg subsidiary governmental bodies as well as sovereigns) to finance themselves directly, allowing banks to concentrate on lending to households and SMEs. Similarly trade finance can rely on efficient markets for foreign exchange, and various hedging derivatives. This judgement would be wrong (if made). The informational requirements needed to navigate oneself around the complexities of the current financial scene, especially international, are vast, and most corporations, local governments, large charities, and even central governments know that they do not have that ability.

On the other (buy-) side of financial intermediation, most household savings are now channelled through institutional investors, pension funds, and insurance companies. Many people probably think that these institutional investors do all their investment analysis in-house, simply sending instructions to complete deals (at the best available price) to whichever broker offers the best immediate price. The reality is different. Most institutional investors have close relationships with one or more investment banks that provide analytical, financial, administrative, and deal-execution support. Besides their contact with (real money) institutional investors, investment banks provide a crucial link between all the major buy-side institutions and the financial/capital markets.

Thus the investment banks provide the key intermediation role both for the big sell-side borrowers and big buy-side borrowers. Much of this can, and is, done without the need to use such banks' own balance sheet, eg analytical advice on mergers and acquisitions, etc, but much requires the need for at least temporary use of the balance sheet. Clients often want assured access to finance, and so investment banks have to be able to make markets without necessarily knowing in advance to whom and at what price they can offload such positions.

For more from Charles Goodhart on Investment banks as intermediaries between big borrowers and big lenders |and The temptation of knowledge |and other articles posted for the debate Why do we need a financial sector? on VoxEU website, click here  |

Posted on 31 October 2011

The opinions expressed in this commentary are solely those of Charles Goodhart. This article on Investment Banking| was first published on the VoxEU debate 'Why do we need a financial sector?'| website.

Charles Goodhart is Norman Sosnow Professor of Banking and Finance at the London School of Economics.