Boring Banker Syndrome

Bear Stearns, Lehman Brothers, and Merrill Lynch are no longer. Citigroup and Bank of America are on life support. Goldman Sachs and Morgan Stanley have become boring bank holding companies. Risk and leverage have gone from instruments of wealth creation to weapons of mass financial destruction seemingly overnight. The financial system has become a shambolic locus of mistrust and multibillion-dollar losses, and the consequences will be enormous.

Wall Street is embarking on one of the biggest changes it has ever seen. Boutique M&A banks and other mammals are likely to usurp the Goldman Sachs-Morgan Stanley-JP Morgan dinosaurs that are presently dying; investors will stop trusting highly levered financial institutions to survive in perpetuity; and the U.S. government is likely to have to nationalize a number of household-name banks.

For the time being, if 2008 was the year that Wall Street died, we’re now entering the era of the zombie banks: institutions too big to close, but too insolvent to survive.

The only two investment banks to have survived 2008—Goldman Sachs and Morgan Stanley—are now bank holding companies: a decision that marks the end of decades of careful cultivation of their investment-banking profiles. They are now swarmed by regulators who no longer trust the risk models of the highly paid quants that once helped Wall Street balance its appetite for risk with its desire for some assurance of an upside. Going forward, these new banks will be forced to concentrate on de-leveraging: selling off assets, downsizing their balance sheets. They might live, but they won’t grow—and growth was always their main reason for living in the first place.

Even in a best-case scenario, where the government’s TARP funds start getting repaid with interest, banks won’t find themselves freed up at all: The main lesson of the past couple of decades is that steady profitability, if it comes from taking a small risk of a major blow-up, is a recipe for disaster. And so everybody is going to get significantly smaller. Even during the boom years it never made a lot of sense for Goldman Sachs to have a trillion-dollar balance sheet; today, that balance sheet is little more than a monster contingent liability which the storied firm’s managers and regulators would dearly like to go away.

In any case, investment banks don’t need huge balance sheets any more, since they’re no longer competing with cash-rich commercial banks willing to finance deals of just about any size at the drop of a hat. The most prized M&A advisory shops won’t be the ones with the deepest pockets, they’ll be the ones that give the best advice—and these days, the best advice is often to simply sit and wait for things to get even cheaper still. For investment bankers who really believe their own hype about the best deals being the ones you never do, 2009 will be a great year to build up a reputation for caring about long-term relationships more than short-term deal flow. They won’t make much money that way, but surely they will have squirreled enough away during the boom years to last them through the present drought.

But when things start picking up again, the profits won’t be anywhere near the levels they reached during the boom years. A pure advisory shop like Rothschild, Greenhill, or Evercore will never make billions of dollars a year, as Goldman Sachs and Morgan Stanley did.

And in general, the financial sector will continue to shrink in the years to come. Banks are no more than intermediaries, and as such they should never constitute 20 percent of the market capitalization of the S&P 500, as they did for most of this decade. Without abundant international liquidity fuelling their deals and trades, and with a new consumer-minded administration genuinely caring about protecting individuals from predatory loans and fees, the days of outsized profits are a thing of the past.

The truth is, we’re nearly settled on the new banking landscape. We’re not likely to see any more outright collapses, à la Washington Mutual, of the huge financial supermarkets: The systemic consequences of that much debt going to zero are more than even the most financially feebleminded of our politicians could ignore. But nationalization, as happened to the similarly sized RBS in the U.K., is a distinct possibility, and much tougher government regulation is a certainty. Treasury officials, for the foreseeable future, will oversee to the point of micromanagement the kind of decisions which were formerly delegated by even low-level executives: Where should these debt instruments be marked? How much counterparty risk should we account for in our CDS portfolio? Exactly which models should we use when we structure securitizations?

It will be a long time before anybody in government forgets the massive amounts of economic damage that under-regulated banks can cause—which in turn means that we’ll see less leverage, less risk, lower profits, and lower remuneration for the foreseeable future. Now that the financial system has spectacularly failed a decades-long test of whether or not it’s capable of regulating itself, the public won’t allow it to get to that point again. Big banks will get smaller, laid-off bankers will get funding to start new banks with conscientious underwriting, and the industry will move from a culture of risk-taking to a much more conservative culture of professionals. Bankers, in other words, will be boring white-collar workers like lawyers or doctors—not the masters of the universe they fancied themselves to be in recent years.

Banks, and bankers, are entering a new age of modest expectations and diminished returns. Which is no bad thing at all.