End of the 'Investment Banking' era on Wall Street

The memories of the 'Great Depression' of 1930's have returned to haunt Wall Street in 2008. It's an end to the 'Era of Investment Banking', with the last two surving Investment Banks viz. Goldman Sachs and Morgan Stanley opting for transformation into ordinary banks. The total bailout package announced by US authorities this year amounts to US$ 1.8 trillion, which is equivalent to 13% of US GDP. For academic interest this figure stacks up to 180% of India's GDP. Why was there a need for such a massive bailout? Are there any lessons to be learnt?

The 'Great Depression' of 1930's resulted in passing of the "Glass Steagall Act" in the US to promote stability of the Commercial Banks. It separated the business of traditional Commercial Banks from the more risk taking, glamorous banks known as 'Investment Banks'. The act provided for close regulation of the Commercial banks, but allowed more freedom and more leverage to the Investment banks. The Investment banks came under the purview of Securities Exchange Commisions (SEC's). The SEC's were deregulated in 1970's and in 1990's Glass Steagall restrictions on separating commercial banking from investment banking were relaxed. In this scenario Investment banks were forced to enter new businesses such as distribution of complex derivative securities to protect their profitability. The 2001 recession in US saw Federal Reserve cut interest rates drastically, leading to a negative savings rate and gave rise to a illusionary credit boom.

The US regulators failed to tighten the Capital inflows and Lending mechanism at that time leading to a runaway boom in US spending. The regulators failed to gauge the quantum of disproportionate risk taken by these investment banks. Investment banks like Bear Sterns and Lehman Brothers were leveraging their equity to the extent of 30 to 40 times. In this case even a 5% drop in valuation of assets would neccessarily lead to the company going 'bankrupt'. And that is exactly what has happened to these investment banks as a fallout of the sub prime crises. The credit rating agencies, unfortunately all the major credit rating agencies are US firms, failed to gauge the risk and continued to rate these investment banks higher than what they desreved. Whatever has happenned in US is more in nature of a 'Regulatory failure' rather than a 'Systemic failure'.

The US continues to be the most powerful economy despite the crises. Threfore, the tremors of this crises will continue to rock the financial markets world over. India may not be impacted directly by the crises, but the failed institutions have substantial investments in our markets. It will take some time before the crises blows over. Long term investors in the equity markets are advised to grab the opportunity to build a long term portfolio on steep market declines, preferably by investing in blue chip stocks or equity oriented mutual funds.