Where Investment Banking Came From

Investment banking may seem like a modern innovation, but that’s not the case at all. Many of the financial products and services pitched by investment banks today trace their history back to the days of maritime commerce during the age of the Renaissance.

This appendix gives you a greater appreciation for the role investment banking has had during the ages. You see how investment banking has changed and how that evolution explains the role it plays to this day. You also get a sense of the complicated relationship between investment banks and traditional banks over time, and see why that interaction is so important.

The Roots of Investment Banking

Investment banking has somewhat of a tortured past, rising out of what was originally traditional banking services. And although investment banking serves the same primary role as traditional banks, getting money from those who have it to those who need it, the route by which investment banks make this happen creates a distinctly unique industry with its own culture, characteristics, and dynamics.

Evolving out of traditional banks

The development of banking remains one of the greatest accomplishments in history, and one critical for accelerating the rate of progress through the ages. Banks were the first real institutions that had the job of getting money into the hands that needed it most.

Scholars figure there was some semblance of banking going on in Ancient Greece, the Roman Empire, and even before. Most of these banks were essentially lenders to businessmen and leaders of commerce. There is evidence that these early bankers took deposits and stored the valuables in temples. Some of these early bankers are also believed to have verified the value of currency and converted monies into different currencies.

The Renaissance of banking

Banking really got cooking during the age of the Renaissance, spanning from the 14th to the 17th centuries in Europe. After the world was shaking off the funk that was the Middle Ages, the globe was alight with new ideas.

The innovation of banking is widely thought to trace its roots to the Italian cities of Florence and Genoa. Two wealthy families, the Bardi and Peruzzi families, quickly set up banks to finance the burgeoning activity at the time, including maritime commerce and other business activities. This practice of private lenders offering loans to customers, usually businesses, gave rise to the concept of a merchant banker, which is still in existence today.

The lenders of the Renaissance financed all sort of ventures, including wars. It’s believed Italian bankers floated loans to kings and princes of the period. The Medici bank, created by the powerful Medici family in the 14th century, was even the banker to the pope. Being a lender to royalty proved a difficult task, because it was hard to force a monarch to repay loans and equally hard to decline lending to a deadbeat king. Making such bum loans along with a string of other complicated events resulted in the failure of the Medici bank in the late 15th century.

Technical stuff The role of the Catholic Church in high finance isn’t as obscure and academic as it may seem. The church played an unintentional but significant role in finance, one that partially explains some of the more convoluted financial instruments today, including particular bonds. The Catholic Church considered usury (the collection of interest in exchange for a loan) to be immoral. The pope’s ban on usury made collecting interest a sin. Bankers, therefore, had to cook up some crafty financial instruments that allowed them to get paid for their loans, without looking like they were collecting interest payments. These ancient rules explain why some financial instruments, even today, are so darned complicated. A classic example of usury-ducking investments are zero-coupon bonds. With zero-coupon bonds, investors pay below the face value of a bond (say, $90) but then get the full face value (say, $100) back when it matures. Investors got interest, but it was disguised. (For more information on bonds, turn to Chapter 11.)

Banking starts to spread to Britain

Although the Medici bank didn’t survive, the ideas of banking and finance caught on. As economic prosperity and expansion spread throughout Europe, banking needs grew and radiated through the continent as well. Italian banking practices made their way to England in the 17th century.

The rise of the bill of exchange

One of the financial instruments to make its way to England is the bill of exchange, which was a breakthrough in the financial world. A bill of exchange was a document that allowed the holder to hold a promise that a certain amount of money would be paid in the future. These documents would be critical in fueling the rampant international expansion taking place. It was a boom for banks in Europe, as young nations hungry for cash were eager to borrow.

IOUs turn into a medium of monetary exchange

Another significant development in Europe was also a breakthrough. Goldsmiths in London were artisans that held gold on deposit. They would give people who deposited gold with them a deposit receipt. The goldsmiths found that they could start lending out gold and hold IOUs in exchange, which would be repaid with interest. But in a major development, it turned out that these deposit receipts, could be exchanged between people in exchange for goods and services instead of commodities, like gold itself. This development opened brand-new ways for money to be exchanged.

The rise of key British banking powerhouses

Some of the iconic British banks arose in the 1800s. Barings Bank, founded in 1762, was created to work in the import and export business and later evolved into a merchant bank. The bank was heavily involved in financing some of Britain’s biggest military engagements; it also handled the financing of the Louisiana Purchase. Ultimately, Barings yielded its influence to the institution of Rothschild & Son, founded in 1811, as the latter firm helped create an international bond market.

Banking Catches On in the United States

Up until 1863, the Europeans had dominated the global banking system. That changed, though, with the passage of the National Bank Act in the United States. All of a sudden, the federal government had the power to allow the creation of banks. Demand for banking erupted, first to finance the costly Civil War and the railroads. By the turn of the 20th century, major banking powerhouses were in full swing. It was around this period that some of the most well-known investment banking powerhouses were consolidating their influence, including J.P. Morgan; Bear Stearns; Kidder, Peabody; Goldman Sachs; Lazard Frères; and Lehman Brothers. These investment banks were financing the Industrial Revolution, one of the more progressive and capital-intensive periods the United States has ever seen.

The development of modern investment banking

Investment banking as we know it today is in large part the result of the banking system’s failure in the 1930s. Widespread speculation and aggressive lending was the norm in the early 20th century. Following the stock market’s crash in October 1929, rampant runs on the banks sparked a record-breaking period of bank failures. At the height of the crisis, a number of pieces of legislation were passed that forged the modern investment banking era. Perhaps most important, the Banking Act of 1933, known as the Glass–Steagall Act, banned commercial banks, which took deposits, from engaging in investment banking.

The ban precluded banks from selling stocks or bonds. Similarly, the investment banks were banned from owning banks. Banks and investment banks couldn’t have it both ways — they had to choose banking or investment banking. This was a pivotal moment in financial services.

The new rules were designed to rope off the risky business of investment banking from banking, preventing a collapse in an investment bank’s bets from causing a financial panic on Main Street with bank depositors. One of the best examples: J.P. Morgan remained in the commercial banking business, but a former member of the bank left to form the investment bank Morgan Stanley.

Tip The passage and ultimate repeal of Glass–Steagall remains one of the most definitive shifts in modern investment banking. The safeguards created during the Depression, and repealed in 1999 created a perfect environment for problems that lead to the financial crisis of 2007, some say. With Glass–Steagall out of the way, large super-sized banks were able to engage in increasingly risky businesses that were usually the domain of investment bankers. Some academics, of course, disagree and think that banks and investment banks would have engaged in similar behavior even if Glass–Steagall were in force. The debate will take years to sort out. But the financial crisis, no matter the cause, served up a reminder of why government plays such a strong role in overseeing and supervising banks and investment banks. Investment banking, even today, is considered a risky business. Keeping it separate from the savings of widows and orphans was a goal of early lawmakers.

How investment banks were threatened by banks

Investment banks blossomed during the 1950s and 1960s. Even big companies outside the finance game wanted to get into the lucrative business. The 1980s was a time of some strange mergers, including the Sears purchase of Dean Witter Reynolds, the Shearson/American Express purchase of Lehman Brothers, and the General Electric purchase of Kidder, Peabody. Each of these deals ended in disaster and eventually dissolved through spinoffs and sales.

Investment banks then went into their next phase of being stand-alone, often publicly held companies. The behemoths Bear Stearns, Morgan Stanley, and Goldman Sachs all sold shares of themselves to the public in the mid and late 1990s. But just as investment banks were able to stand on their own two feet, the commercial banks were grabbing more of their business as they found ways to provide more investment banking services themselves.

That would change in 1999. The Gramm–Leach–Bliley Act, also known as the Financial Services Modernization Act of 1999, turned banking and investment banking upside down. The Gramm–Leach–Bliley Act repealed a big chunk of Glass–Steagall, allowing banking companies to encroach on the turf of investment banks by selling securities. Banks were so eager to jump into the investment banking business that one, Citicorp, bought Travelers Group (which owned Smith Barney) even before the Gramm–Leach–Bliley Act was signed.

The financial crisis of 2007 changes everything

Facing stiffer competition from the traditional banks, who largely encroached on the lucrative business of selling stock and bonds for companies, the investment banks were pushed into riskier ventures. Large investment banks got heavily involved with a number of exotic and highly complicated financial instruments, including many tied to the housing market. Some of the most infamous financial tools that investment banks got wrapped up with included mortgage-backed securities (debt instruments tied to mortgages) and collateralized debt obligations (financial instruments that allowed financial institutions to buy and sell pieces of loans).

Meanwhile, investment banks — which were pushing for profit in an age in which banks were soaking up much of the high-end business — searched for ways to make money. And that meant taking on more risk. Investment banks found what they were looking for in the subprime housing market, where they financed loans to homebuyers with low credit ratings and little or no down payments.

The fall of Bear Stearns and Lehman Brothers

These bad bets started to haunt the investment banks when the housing market collapsed, bringing the value of the financial instruments down with it. In March 2008, the first major investment bank to fall was Bear Stearns. The failed institution, swamped in losses from bum bets, was sold to JPMorgan Chase for $10 a share.

Lehman Brothers was the next major investment bank to be claimed by the financial crisis. Large amounts of subprime loans and related investments soured, and Lehman couldn’t stay afloat. The company filed for Chapter 11 bankruptcy protection in 2008.

More shotgun weddings in finance

The crisis only widened from that point to historic proportions. In another defining moment, Merrill Lynch, one of the best known investment banks, dating back to 1914, was choking on its own massive portfolio of investments tied to bad housing bets. As trading partners lost faith in Merrill Lynch, that choked off the company’s access to capital, which is the oxygen to investment banks. With its options dropping off, Merrill Lynch agreed to be bought by Bank of America for about $50 billion.

Hoping to fend off another Great Depression, the federal government agreed in 2008 to buy troubled assets from the banks and remaining investment banks to prevent the financial system from collapsing. This historic bailout, called the Troubled Asset Relief Program (TARP) turned into a defining moment of the financial crisis, as taxpayers found themselves in the position of saving some of the nation’s most powerful financial institutions.

Investment banks stay alive by becoming … banks

The wake of the financial crisis marks the end of the standalone American investment bank. In September 2008, both Goldman Sachs and Morgan Stanley, the two last independent investment banks, turned into bank holding companies. This move allowed the companies to accept deposits, which they needed to do, because they were no longer able to get enough cash by selling securities. But they also had to adhere to banking standards, which, in theory, would rein in their ability to chase after any risky ventures in the name of profit.

Not only did Goldman Sachs have to tap TARP to get adequate operating capital (to the tune of $10 billion), but it also sold $5 billion in preferred stock (a unique type of shares that gives its owners typically oversized dividends) to Warren Buffett’s Berkshire Hathaway.

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