Investment Banking is a Human Capital Business
The investment banking business is predominately driven by relationships and brains. The more traditional investment banking lines of underwriting, financial advisory, and private wealth management (the area into which many investment banks have recently expanded) are based on relationships. High-margin underwriting and financial advisory deals flow into investment banks through the connections built up by rainmakers while on Wall Street and over their tenure in the industry. Relationships with accredited investors also enable investment banks to distribute underwritten securities. Similarly, the wealth management division's financial advisors gather and retain assets from their networking and relationship management skills.
The other common legs of investment banks, asset management and sales & trading, are more a result of brains. Healthy assets under management growth comes from benchmark-beating performance and the resulting net asset inflows. The ability to generate a track record of outperformance comes from having a team with differential and superior insight. It is also firms' research analysts' insight that forms the backbone of many trading operations. Finally, it is in the minds investment banks' employees that the genesis of financial innovations that satisfy the investing and risk-management needs of clients are created.
As investment banking is a human capital business, employee headcount can be viewed as a proxy for a firm's strength and potential earnings power.
Headcount Through the Financial Crisis
From this table, we can see that most of the larger investment banks were, on net, reducing their ranks until the first two quarters of 2009. Primarily this was because it was only in early 2009 that investment banks reversed their downtrend, and began posting positive earnings due to a tripod of reasons: an overall market rally, recovery in underwriting revenues from belief in an economic recovery, and strong fixed income trading revenues. (For a more thorough discussion of that period, please read our former Stock Strategist, "Rising Profits Are Bound to Fall for Most I-Banks.") We see that most investment banks and broker-dealers had higher headcounts at the end of 2009 than at the end of 2007, when signs of the financial crisis began to show. However, there are certain companies that have outpaced their peers in building out their capabilities during the crisis.
Bulge Bracket: The Strong Become Stronger
In terms of business model changes among the bulge bracket investment banks, we believe Morgan Stanley (MS
) made a strategic shift that positions the company favorably for years to come. In the second quarter of 2009, Morgan Stanley combined its Global Wealth Management Group with Citi's (C
) Smith Barney wealth management business to form a joint venture (JV). Morgan Stanley owns 51% of the JV and has the option to purchase the remaining 49% during the next several years. This increased the company's wealth management business contribution to net revenues from 15%-20% before 2008 to more than 35% during the last three quarters. In general, wealth management is a stable business that should produce superior returns on capital over an extended period of time. The wealth management expansion also decreases the company's reliance on trading revenues, which could be negatively affected by potential regulation.
The other behemoths of investment banking took different actions based on their particular circumstances.