The ownership structure of investment banks: a case for private partnerships?

Schellhorn, Carolin

INTRODUCTION

The subprime mortgage crisis and its fallout have caused losses for households, businesses and government in the U.S. as well as abroad. Among the crisis' more prominent victims are the five largest U.S. investment banks, which, by the end of 2008, had ceased to exist as stand-alone publicly traded firms. Lehman Brothers filed for bankruptcy protection in September 2008, while Bear Stearns and Merrill Lunch were sold to bank holding companies that same year. Also during 2008, Morgan Stanley and Goldman Sachs yielded to government pressure to change to bank holding company status in order to weather threats to their solvency. Clearly, investment banks, as originators and distributors of asset-backed securities, were at the very heart of the financial crisis. What caused this dramatic failure of all of the top investment banks? Was it a failure of managerial judgment, complacency on the part of investors, or a failure of regulators and credit rating agencies? Was the main culprit the 'Originate to Distribute" model of commercial banking, which facilitated the creation of toxic assets? In hindsight, it appears that several factors conspired to produce the crisis that ensued.

This paper suggests that the organization of the major U.S. investment banks as publicly traded corporations may have been an important factor in creating the incentive structure for prolonged and excessive risk-taking, which ultimately precipitated the near failure of the financial system. While publicly traded corporations enjoy important advantages, as will be discussed below, this form of ownership may not be desirable for investment banks, if the safety and soundness of the financial system are at stake.

In the next section, we summarize possible reasons why the major U.S. investment banks went public after operating as private partnerships for decades. We then discuss the agency problems that arise from the separation of ownership and control in publicly traded corporations, and the ways in which executive compensation packages have been used to mitigate these problems. Executive compensation in the form of large bonuses, stock and stock options, in turn, may have encouraged investment bank managers to take ever higher risks, a behavior that has remained unchecked by the arms-length owners of publicly traded firms.

One way to control excessive risk-taking is to strengthen and expand the government's supervision and regulation to include the investment banks. Similar to commercial banks, investment banks could be subjected to risk-adjusted capital requirements, asset quality standards, and frequent regulatory audits. Executive compensation packages could be scrutinized by the government. One drawback of this approach is that a potential failure of the government's supervision increases the likelihood that the government will be forced to bail out institutions that have become "too big to fail," thus putting taxpayers at risk.

This paper makes a case for a possible alternative: The requirement, or incentive, for investment banks to operate as private partnerships. The private partnership form of organization naturally reduces risk-taking incentives due to the fact that partners face unlimited liability. In addition, the private partnership, due to its limited access to financial markets, curtails firms' ability to grow to sizes that make them "too big to fail."

The paper further argues that, due to the nature of the investment banking business, firms in this industry are more likely to be successful when they operate as private partnerships. The corporate form of ownership may be well suited for firms in industries, like manufacturing, where performance is driven by "explicit knowledge." Explicit knowledge can be expressed, documented and passed on with the help of the media. However, the incentive structure of a public corporation may not be well suited for the investment banking business, which relies on personal relationships and the ability to price hard-to-value assets. This ability requires "tacit knowledge" and "tacit human capital," i.e., relevant experience, good business relationships, and a solid reputation for responsible underwriting (Polanyi, 1966). The investment banking industry, similar to other service industries, may work better when senior partners pass their experience, their relationships and their judgment on to junior partners in organizations that make it possible to preserve tacit knowledge and tacit human capital.

CONVERSION TO PUBLIC CORPORATIONS

Until the rules were changed in 1970, public corporations were not allowed to become members of the New York Stock Exchange. Member firms operated as partnerships or as closely held private corporations, and many continued to do so even after the rules restricting ownership structure were relaxed. While some investment banks, like Donaldson, Lufkin and Jenrette and Merrill Lynch, converted to stock ownership in the early 1970s, others waited several years, if not decades. Goldman Sachs floated its IPO in 1999.

Morrison and Wilhelm (2008) analyze the reasons why some investment banks found it advantageous to continue operating as private partnerships for years before converting to stock ownership. Their research builds on earlier work (Morrison and Wilhelm, 2004), which highlights the advantages of private partnerships especially in industries that rely heavily on trust, reputation, and tacit human capital. Investment banking, like management consulting and other service-oriented professions, requires skills that are difficult to teach in a classroom setting and are best learned on the job under the guidance of an experienced and successful mentor. Successful investment banking leads to a good reputation, which is necessary because the quality of the service cannot be observed by the client until well after the service has been provided. Arguably, one of the most important skills of an investment banker is to recognize when a risk should not be taken and a deal should not be done. This skill, as good judgment in other areas, is very difficult to teach in theory. It may have to be observed first hand in order to be learned.

Due to the fact that partners in investment banking organizations have difficulty transferring their ownership and, typically, face unlimited liability, their careers and lives are intertwined with the fate of their firms. They have strong incentives to spend the time required for mentoring junior colleagues. Without this, the partnership would lose its reputation and fail along with its partners. The partnership form of ownership, therefore, improves on-the-job training and facilitates the intergenerational transfer of tacit skills, such as good judgment and understanding the limits of risk-taking.

If the partnership form of organization is so well suited to the business of investment banking, then why did so many investment banks convert to public corporations during the decades following 1970? Morrison and Wilhelm (2008) argue that innovation in both information technology and finance gradually reduced the significance of tacit human capital. First, batch-processing and, later, the microcomputer allowed investment banks to replace human capital with physical capital. The development of quantitative financial models codified knowledge so that much of it could be learned in the classroom. This reduced the need for mentoring and facilitated access to trading markets. Reduced barriers to entry combined with reduced profit margins created the need for large-scale trading. The importance of access to financial and physical capital increased relative to the importance of human capital. The corporate form of ownership became more attractive than the private partnership because it was better able to finance expansion and growth.

Lost in the process was the tacit human capital, which could not be codified, even after the introduction of computers and financial modeling. In the investment banking business, it is this tacit human capital, which is required for judicious risk-taking. And that, in turn, is necessary to sustain a high-quality reputation and clients' trust in the long run. Lewis (2008) characterizes the transformation of Salomon Brothers from a private partnership to a public corporation as a transfer of risk from the partners to the shareholders: "The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith." (Lewis, December 2008, Portfolio.com, Conde Nast Inc.)

REGULATING THE CORPORATE FORM OF OWNERSHIP

Ever since Berle and Means (1932) and Jensen and Meckling (1976), the agency costs associated with the corporate form of ownership have been well understood and empirically documented. Inefficiencies in the use of assets, waste, shirking, and the consumption of perquisites by managers are observed in publicly traded firms, where ownership of the assets is separated from control over how they are used. These agency costs have been found to increase with the dispersion of ownership among non-manager owners and decrease with increases in managers' ownership share (Ang, Cole, and Lin, 2000).

To reduce these agency costs, executive compensation packages have been designed to increase managerial ownership and align the incentives of managers with those of the owners. Maher (1992) sheds light on the types of compensation packages offered by publicly traded investment banks in the early 1990s in efforts to re-create incentives that existed when the firms operated as private partnerships. Bonuses that are tied to short-term performance, stock and stock options, as solutions to the agency problems of public corporations, however, have created their own set of problems. In fact, the reduction of agency conflicts between managers and owners has exacerbated the agency conflicts between owner-managers and the holders and guarantors of bank debt. Bebchuk and Spamann (2009) analyze the role that pay packages have played in creating incentives for bank managers to take excessive risks at the expense of debt holders and the safety of our financial system. When the value of bank equity declines in times of crisis, the authors point out that the incentives to take excessive risks are reinforced, because equity ownership represents an ever increasing levered bet. This causes the interests of shareholders/managers to diverge even more from the interests of debt holders and the government guarantor.

In order to address these problems, the authors argue for more informed and more ophisticated regulation of compensation packages for bank executives. Beyond that, other traditional types of government regulation, such as higher capital requirements, minimum standards for asset quality, and frequent regulatory audits, could be employed to contain risk. Admati et. al. (2010) make a strong case for significantly increased capital requirements for financial institutions. The authors find that bank equity is not as expensive as is commonly believed, especially when social benefits and costs are taken into account.

While this approach may be appropriate for the business of deposit-taking and lending conducted by commercial banks, which have always been heavily regulated, it is not clear that the government's safety net and supervision need to be extended to include the investment banking industry. In fact, it has been argued that the more stable business of deposit-taking and lending should be separated from the risks associated with securities underwriting and trading (see, for instance, Gros and Alcidi, 2009).

Nonetheless, the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was recently signed into law, lays the foundation for an extension of government regulation from banks and bank holding companies to all nonbank financial firms (Fein, 2010). The rules that lawmakers and regulators will develop based on the Dodd-Frank Bill in the months to come will have to provide for government control of excessive risk-taking, as well as for the possible resolution of any financial firm that is "oo big to fail. This represents a significant challenge for our regulatory and financial systems. It remains to be seen whether this approach will prove successful.

A POSSIBLE ALTERNATIVE: PRIVATE PARTNERSHIPS

An alternative way to address the incentive problems as well as the "oo-big-to-fail" problem that are associated with the public form of ownership is to require, or induce, investment banks to operate as private partnerships. The interests of private partners as committed, long-term owners and managers with unlimited liability are much less likely to diverge substantially from the interests of bondholders, no matter what bonuses and pay packages the partners are receiving. Both stakeholder groups would have incentives to prevent excessive risk-taking in order to insure the long-run survival of the firm. Limited access to capital markets would naturally control the size of these firms, which would prevent them from becoming "too big to fail" and reduce the need for expensive government bailouts.

An added advantage of organizing investment banks as private partnerships would be the existence of strong incentives for senior partners to pass tacit skills on to junior colleagues. Thus, private partnerships would help insure the preservation of tacit human capital and sound managerial judgment in the industry. For investment banks, at this time, the rebuilding of trust and reputation appear to be more important than rapid expansion and growth.

In a recent paper, Bunting (2010) offers a legal perspective and makes strong behavioral arguments in favor of regulations that provide incentives for investment banks to choose the private partnership structure even though they could operate as public corporations.

SUMMARY AND CONCLUSION

The major investment banks are now owned by, or operated as, bank holding companies. This outcome represents an ad-hoc emergency solution to a crisis that required quick action. It is not the result of a long-term maximization process, at the end of which the current situation emerged as the best possible alternative. Going forward, the question arises as to whether the extension of the government safety net to the investment banking industry is desirable.

The alternative suggested in this paper would require investment banks to operate separately as private partnerships, exposing investment banking partners to unlimited liability. The advantages of this approach are that agency conflicts between owners, managers and debt holders would be mitigated as risk-taking incentives would be weakened. The need for increased government involvement in designing executive compensation packages for investment bankers, as well as other forms of government intervention, would be reduced. The illiquid nature of the partnership stakes would promote the development and transfer of tacit human capital, thus supporting the industry's success. While private partnerships are somewhat restricted in their ability to grow due to more limited access to financial capital, this may be a disadvantage that is worth accepting, particularly, because it would naturally constrain firm size and prevent firms from requiring government bailouts under a "too-big-to-fail" policy.

REFERENCES

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Bebchuk, L.A. & H. Spamann (2009). Regulating Bankers' Pay. Discussion Paper No. 641, John M. Olin Center for Law, Economics and Business, Harvard Law School.

Berle, A.A. & G.C. Means (1932). The Modern Corporation and Private Property. New York, NY: Macmillan.

Buntng, W. (2010). The Trouble with Investment Banking: Cluelessness, Not Greed. San Diego Law Review, forthcoming. Available at SSRN: http://ssrn.com/abstract=1660624.

Fein, M.L. (2010). Dodd-Frank Act: Implications for Bank Holding Companies and Systemically Important Nonbank Financial Companies. Available at SSRN: http://ssrn.com/ abstract=1657623.

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Morrison, A.D. & W.J. Wilhelm, Jr. (2008). The Demise of Investment-Banking Partnerships: Theory and Evidence. Journal of Finance, 63 (1, 311-350

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Polanyi, M. (1966). The Tacit Dimension. Garden City, New York Doubleday.

Carolin Schellhorn, Saint Joseph's University