INVESTMENT BANKING This page intentionally left blank Investment Banking: Institutions, Politics, and Law ALAN D. MORRISON AND WILLIAM J. WILHELM, JR. 1 3 GreatClarendonStreet,Oxfordox26DP OxfordUniversityPressisadepartmentoftheUniversityofOxford. ItfurtherstheUniversity’sobjectiveofexcellenceinresearch,scholarship, andeducationbypublishingworldwidein Oxford NewYork Auckland CapeTown DaresSalaam HongKong Karachi KualaLumpur Madrid Melbourne MexicoCity Nairobi NewDelhi Shanghai Taipei Toronto Withofficesin Argentina Austria Brazil Chile CzechRepublic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore SouthKorea Switzerland Thailand Turkey Ukraine Vietnam OxfordisaregisteredtrademarkofOxfordUniversityPress intheUKandincertainothercountries PublishedintheUnitedStates byOxfordUniversityPressInc.,NewYork (cid:1)c AlanD.MorrisonandWilliamJ.WilhelmJr.,2007 Themoralrightsoftheauthorshavebeenasserted DatabaserightOxfordUniversityPress(maker) Firstpublished2007 Allrightsreserved.Nopartofthispublicationmaybereproduced, storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans, withoutthepriorpermissioninwritingofOxfordUniversityPress, orasexpresslypermittedbylaw,orundertermsagreedwiththeappropriate reprographicsrightsorganization.Enquiriesconcerningreproduction outsidethescopeoftheaboveshouldbesenttotheRightsDepartment, OxfordUniversityPress,attheaddressabove Youmustnotcirculatethisbookinanyotherbindingorcover andyoumustimposethesameconditiononanyacquirer BritishLibraryCataloguinginPublicationData Dataavailable LibraryofCongressCataloginginPublicationData Dataavailable TypesetbySPIPublisherServices,Pondicherry,India PrintedinGreatBritain onacid-freepaperby BiddlesLtd.,King’sLynn,Norfolk ISBN0-19-929657-X 978-0-19-929657-6 1 3 5 7 9 10 8 6 4 2 Contents Prologue vii ListofFigures xi ListofTables xiii 1. Introduction 1 Markettrends 7 Industrystructure 15 Investmentbankactivities 21 Thegrowingdichotomybetweenspecialistsand generalists 30 Conclusion 35 2. InstitutionalTheory 37 Propertyrights,institutions,andthestate 38 Non-stateinstitutions 45 Statedecision-making,thelaw,andextra-legal contracting 59 Conclusion 62 3. AnInstitutionalTheoryofInvestmentBanking 65 Information,innovation,andpropertyrights 67 Informationmarketplacesandinvestmentbanking 71 Internalorganization 88 Industrialorganization 92 Conclusion 95 4. InvestmentBankingOrigins 97 Informationexchange 98 Institutionsandthelaw 101 Mercantilenetworks 107 Earlycapitalmarkets 117 Conclusion 120 5. TheRiseoftheInvestmentBank 121 Merchantbanking 123 vi Contents Thelegalandpoliticalenvironment 126 Theevolutionofinvestmentbanking 136 Conclusion 153 6. InvestmentBankingintheAgeofLaissez-Faire 155 Legalandpoliticalenvironment 156 Technologicaladvances 157 TheCivilWarandretailinvestmentbanking 160 Investmentbankersafter1873 162 Investmentbankingafter1873 170 Conclusion 184 7. LeviathanandtheInvestmentBanks 187 Changestothelegalandpoliticalenvironment 188 Legislation,regulation,andinvestmentbanking 196 Industryevolution 215 UnitedStatesversusMorganStanley 220 Conclusion 223 8. TheModernIndustrialRevolution 225 Earlycomputeradvances 227 Earlychangestomarketstructure 231 Real-timecomputation 238 Therevolutioninfinancialeconomics 242 Newhumancapitalbusinesses 249 Conclusion 263 9. InsidetheInvestmentBank 265 Investmentbankpartnerships 267 Thejoint-stockinvestmentbank 280 Conclusion 291 10. WhatNext? 293 Large,complexbankingorganizations 294 Small,focusedinvestmentbanks 300 Conclusion 309 Bibliography 311 Index 333 Prologue TheSecuritiesAct[of1933]willbefullyjustifiedifitdrivesthegovernment intotheinvestmentbankingbusiness.(WilliamO.Douglas)1 Justice Harold R. Medina stated in 1954 that ‘it would be difficult to exaggeratetheimportanceofinvestmentbankingtothenationalecon- 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 pressandgovernmentscrutinyforoveracentury. 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 literatureanalyzestherulesunderwhichsharesareissuedandtraded, andafinancialandeconomicliteraturedescribestheincentivesfacing 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.Thisisthegoalthatwehavesetourselvesinthisbook. It is not enough to answer this question in purely financial terms. Mucheconomicpowerisexercisedthroughinvestmentbanks,andto avaryingextent,politicianshaveassumedthatsomeofthispowerhas beendevolvedtothebanks.Thequotationatthetopofthispageisan excellentillustrationofthispoint.WilliamDouglaswasagraduateof ColumbiaLawSchool,workedbrieflyasanewlymintedattorneyfor 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 duringtheNewDeal,andlaterwouldbethelongest-servingSupreme CourtJusticeever.Hiscommentreflectedawidelyheldcontemporary 1 In correspondence to Felix Frankfurter on February 19, 1934, quoted in Skeel (2001:123). 2 Medina([1954]1975:15):seechaptersevenforthecontextinwhichthisremark wasmade. 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 offinancialmarketregulation. 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, investmentbankscollectivelyhadattainedalevelofpower,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- quencewasfurtherregulatoryinterventionintheindustry. 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 developmentofAnglo-Americancapitalism. 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 investmentbankingshedssomelightontheevolutionofthemodern investment bank, and helps to explain the legal and political aspects of investment banking. But it comes at a price: although we are not lawyersorhistorians,writingthisbookhasforcedustoconfrontlegal and historical questions. We are not attempting to create fresh schol- arship in either field; we hope instead to use the legal and historical literaturestoshedsomelightupontheoperationofacentraleconomic 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 HaroldR.MedinaPapers,andtheSecuritiesIndustryAssociation. Forinformativeandinstructiveconversationsaboutthepracticeof investment banking we are particularly grateful to Don Chew, Peter Engel, Jim Harris, Shaw Joseph, Mike Millette, Bill Schnoor and Vic Simone.EdPerkinsandAlexanderLjungqvistwereparticularlyhelp- fulincheckingacademicfacts.Ourearlythoughtsregardingpartner- ships were shaped in conversations with Bruno Biais, Zhaohui Chen, StevenTadelis,BharatAnand,OrenSussmanandColinMayer;David Smith made some very helpful comments upon early drafts of the historicalmaterialinthebook. Finally, our families suffered almost as much as we did while we workedonthisbook,andwearedeeplyappreciativeofthesacrifices thattheymade.Wehopethattheythinkitwasworthit. AlanD.MorrisonandWilliamJ.Wilhelm,Jr OxfordandCharlottesville,2006