Investment Banking

INVESTMENT BANKING

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Investment Banking:

Institutions, Politics,

and Law

ALAN D. MORRISON AND WILLIAM J. WILHELM, JR.

1

Great Clarendon Street, Oxford ox2 6

3 DP

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c Alan D. Morrison and William J. Wilhelm Jr., 2007

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First published 2007

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Typeset by SPI Publisher Services, Pondicherry, India

Printed in Great Britain

on acid-free paper by

Biddles Ltd., King’s Lynn, Norfolk

ISBN 0-19-929657-X 978-0-19-929657-6

1 3 5 7 9 10 8 6 4 2

Contents

Prologue vii

List of Figures xi

List of Tables xiii

1. Introduction 1

Market trends 7

Industry structure 15

Investment bank activities 21

The growing dichotomy between specialists and

generalists 30

Conclusion 35

2. Institutional Theory 37

Property rights, institutions, and the state 38

Non-state institutions 45

State decision-making, the law, and extra-legal

contracting 59

Conclusion 62

3. An Institutional Theory of Investment Banking 65

Information, innovation, and property rights 67

Information marketplaces and investment banking 71

Internal organization 88

Industrial organization 92

Conclusion 95

4. Investment Banking Origins 97

Information exchange 98

Institutions and the law 101

Mercantile networks 107

Early capital markets 117

Conclusion 120

5. The Rise of the Investment Bank 121

Merchant banking 123

vi Contents

The legal and political environment 126

The evolution of investment banking 136

Conclusion 153

6. Investment Banking in the Age of Laissez-Faire 155

Legal and political environment 156

Technological advances 157

The Civil War and retail investment banking 160

Investment bankers after 1873 162

Investment banking after 1873 170

Conclusion 184

7. Leviathan and the Investment Banks 187

Changes to the legal and political environment 188

Legislation, regulation, and investment banking 196

Industry evolution 215

United States versus Morgan Stanley 220

Conclusion 223

8. The Modern Industrial Revolution 225

Early computer advances 227

Early changes to market structure 231

Real-time computation 238

The revolution in financial economics 242

New human capital businesses 249

Conclusion 263

9. Inside the Investment Bank 265

Investment bank partnerships 267

The joint-stock investment bank 280

Conclusion 291

10. What Next? 293

Large, complex banking organizations 294

Small, focused investment banks 300

Conclusion 309

Bibliography 311

Index 333

Prologue

The Securities Act [of 1933] will be fully justified if it drives the government

into the investment banking business. (William O. Douglas)1

Justice Harold R. Medina stated in 1954 that ‘it would be difficult to

exaggerate the importance of investment banking to the national econ￾omy.’2 This remark remains true today. Investment banks lie at the

heart of the capital allocation process in both America and England,

and they are of increasing importance elsewhere. Their actions are

sometimes controversial, and their business activities have attracted

press and government scrutiny for over a century.

Although it sometimes seems that everyone has an opinion on the

investment banking industry, we lack a coherent theory to explain

its existence. A voluminous historical literature examines the history

of investment banks, both individually and in the aggregate, a legal

literature analyzes the rules under which shares are issued and traded,

and a financial and economic literature describes the incentives facing

investment bankers and their clients, and uses this to explain the

mechanisms that they use when trading. But there is very little to

explain precisely what it is that investment bankers add to economic

life. This is the goal that we have set ourselves in this book.

It is not enough to answer this question in purely financial terms.

Much economic power is exercised through investment banks, and to

a varying extent, politicians have assumed that some of this power has

been devolved to the banks. The quotation at the top of this page is an

excellent illustration of this point. William Douglas was a graduate of

Columbia Law School, worked briefly as a newly minted attorney for

the Cravath firm, the dominant member of the Wall Street bar, and

was for six years a professor at the Yale Law School. He rose to fame

during the New Deal, and later would be the longest-serving Supreme

Court Justice ever. His comment reflected a widely held contemporary

1 In correspondence to Felix Frankfurter on February 19, 1934, quoted in Skeel

(2001: 123). 2 Medina ([1954] 1975: 15): see chapter seven for the context in which this remark

was made.

viii Prologue

opinion that Wall Street banks were over-powerful, and that they

should be ‘superseded’ in their security market dealings by a system

that allowed for more rational governmental allocation of resources.

One of the defining features of the New Deal was an increased level

of financial market regulation.

As we shall see in the course of the book, New Deal controls

over financial markets started to erode almost as soon as they were

introduced. The final stage in this erosion was the 1999 repeal of

the Glass–Steagall Banking Act. At the end of the twentieth century,

investment banks collectively had attained a level of power, visibility,

and freedom of action which was in many respects comparable with

that enjoyed by JP Morgan & Co. at the beginning of the century. But

like Morgan, investment banks were soon the target of a regulatory

and political backlash of the type witnessed repeatedly throughout

the industry’s history. Once again, investment bankers were accused

of exercising excessive power in an irresponsible fashion. The conse￾quence was further regulatory intervention in the industry.

We cannot understand investment banks without understanding

what brought Douglas and people like him to their point of view.

For this, we need a deep understanding of the institutional environ￾ment within which investment banks work, and we need to under￾stand precisely what it is about their activities that attracts the atten￾tion of politicians. The activities of legislators, and the actions taken

in response by the investment bankers, have shaped the contours

of today’s investment banking industry, and thus have affected the

development of Anglo-American capitalism.

We address these issues by developing an economic rationale for

investment bankers, and attempting to situate it in a broader social

and legal context. We hope that this ‘institutional’ perspective on

investment banking sheds some light on the evolution of the modern

investment bank, and helps to explain the legal and political aspects

of investment banking. But it comes at a price: although we are not

lawyers or historians, writing this book has forced us to confront legal

and historical questions. We are not attempting to create fresh schol￾arship in either field; we hope instead to use the legal and historical

literatures to shed some light upon the operation of a central economic

institution.

We are grateful to the many people who helped us while we were

writing this book. We received excellent support from our research

assistants, Thomas Knull, Qiao Ma, Mary Weisskopf and David

Wilhelm. Special thanks are due to Brendan Abrams for doggedly

Prologue ix

tracking down a good deal of the historical data, as well as for com￾piling bank capitalization data. Paul Bennett, Steve Wheeler and the

staff at NYSE archives were extremely helpful with the compilation

of twentieth century investment bank partnership data, and we are

also happy to acknowledge assistance with data from Sang Lee of

Aite Research and Marc Greene of Greenwich Associates, the staff at

the Mudd Library, Princeton University, for providing access to the

Harold R. Medina Papers, and the Securities Industry Association.

For informative and instructive conversations about the practice of

investment banking we are particularly grateful to Don Chew, Peter

Engel, Jim Harris, Shaw Joseph, Mike Millette, Bill Schnoor and Vic

Simone. Ed Perkins and Alexander Ljungqvist were particularly help￾ful in checking academic facts. Our early thoughts regarding partner￾ships were shaped in conversations with Bruno Biais, Zhaohui Chen,

Steven Tadelis, Bharat Anand, Oren Sussman and Colin Mayer; David

Smith made some very helpful comments upon early drafts of the

historical material in the book.

Finally, our families suffered almost as much as we did while we

worked on this book, and we are deeply appreciative of the sacrifices

that they made. We hope that they think it was worth it.

Alan D. Morrison and William J. Wilhelm, Jr

Oxford and Charlottesville, 2006

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List of Figures

1.1 US and global securities market activity (billions of US

dollars, CPI-adjusted: 1983 dollars) 2

1.2 Equity market capitalization as a percentage of GDP for

major industrialized countries 2

1.3 New York Stock Exchange average daily trading

volume, 1960–2004 (millions of shares) 8

1.4 The US investment banking industry, 1955–2000 13

1.5 Investment bank employees and capitalization,

1979–2000 (top five banks by capitalization) 14

1.6 Income producer revenue and compensation (ten

largest banks by capitalization) 14

1.7 Equity underwriting fees as a percentage of gross

proceeds 24

1.8 Debt underwriting fees as a percentage of gross proceeds 25

1.9 Morgan Stanley daily 99 percent per one-day trading VaR 27

1.10 Investment bank revenues (percent of total revenue, ten

largest banks) 31

3.1 The investment bank’s information marketplace 72

3.2 Relative importance of tacit and technical skill for

investment bank activities 89

5.1 Foreign trade using Bills of Exchange 125

5.2 US net capital inflows, 1790–1900 144

8.1 Advances in processing power, 1950–2001 227

8.2 Holdings of outstanding US equities, 1945–2000 232

8.3 Merrill Lynch revenue sources, 1961–70 233

8.4 Cost of computing, 1950–2001 239

8.5 Underwritten debt and equity (common and preferred)

as a percentage of GNP 250

8.6 Public and private securities issuance, 1935–63 253

10.1 Origins and precursors of leading investment banks 298

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List of Tables

1.1 Global derivatives market 10

1.2 Markets for derivative financial instruments: notional

principal amounts outstanding, 1986–96 (billions of US

dollars) 11

1.3 Notional principal value of outstanding interest rate and

currency swaps of the members of the International

Swaps and Derivatives Association, 1987–June 1996

(billions of US dollars) 12

1.4 Underwritten common stock (thousands of US dollars)

US transactions 17

1.5 Mergers and acquisitions (thousands of US dollars) US

transactions announced during year 18

1.6 Morgan Stanley business lines 32

1.7 Percentage of net revenue by functional area for Lazard

Freres and Morgan Stanley 33

4.1 Ratio of stock turnover to nominal capital, 1704–55

(currency amounts in sterling) 119

5.1 Capitalization and partnership size for leading

investment houses, 1815–18 143

5.2 Capitalization and partnership size for leading

investment houses, 1850–5 153

6.1 Dollar increase in stocks and bonds issued by US

Railroads, 1875–95 176

6.2 Consolidations per year in the US manufacturing sector 183

7.1 Corporate issues, by class of security, 1919–29 (millions) 218

8.1 Client underwriting relationships in the 1950s and 1960s 256

9.1 Average partner tenure in 17 prominent investment banks 282

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