US investment banks are under siege. Competitors have long tried to force open the doors to the lucrative world of US investment banking. In 2000, when Congress repealed the Glass-Steagall Act, which prevented banks from offering both commercial- and investment-banking services, the final barrier to integration fell. Today, commercial and universal banks, such as Citigroup and J. P. Morgan Chase, as well as European-owned banks, including Credit Suisse First Boston and UBS, are a formidable competitive threat.

Spurred on by the fact that investment-banking services are far more profitable than commercial-banking ones (Exhibit 1), universal and commercial banks are grabbing an increasing share of the investment-banking market. Their strategy for winning new business in it is often to give clients credit facilities as well—something that investment banks traditionally haven't done.

Still more worrying for investment banks is the fact that some clients now demand credit in return for M&A and underwriting business. In the spin-off of the microelectronics unit Agere Systems, for example, Lucent Technologies did business only with banks that were willing to provide credit too; J. P. Morgan Chase and Citigroup each committed as much as $1.25 billion in loans, while investment bank Morgan Stanley agreed to buy $2.6 billion in Lucent debt. Goldman Sachs, though it had co-led the original spin-off of Lucent from AT&T, declined to take part in the credit package and was excluded from the deal.¹

The return on equity of investment banks could fall by 30 percent if they were to provide all their clients with credit at rates recently seen

Rough analysis suggests that the return on equity of the investment banks could fall by as much as 30 percent if they provided all clients with credit at the rates recently seen. Yet the prevailing view on Wall Street is that lending has become a necessity in the investment-banking world and that universal banks thus have a critical advantage. Investment banks, it is held, must obtain their own credit capabilities, even at the cost of depressing their rates of return. Some people have gone as far as to suggest that the linking of credit with investment banking will spell the end of the independent investment banks as the remaining ones are forced to merge with or acquire commercial banks to remain competitive.

We disagree. While providing credit is an important competitive advantage right now—at the height of a severe credit crunch—it is not sufficient justification for rushing into a potentially difficult merger with a commercial bank on unattractive terms. Certainly, to remain competitive, investment banks will need to build their credit capabilities and to offer loans selectively to clients. But once the credit cycle improves, credit will not make up for a lack of top-tier capabilities in the investment-banking business. Some universal banks will undoubtedly rise to the top of it, but only by developing superior skills.

Are the lines blurring?

Universal and commercial banks are currently gaining market share in almost all product categories (Exhibit 2).² More important, they appear to be leveraging their existing client relationships to win investment-banking business (Exhibit 3). Closer consideration of the figures, however, suggests that the advantage of offering credit may be overstated.

Universal and commercial banks have made their biggest gains in debt products, in which they now account for more than half of new issues. This development is hardly surprising, since the underwriting of debt products requires skills that are closely related to credit, the traditional area of expertise for both commercial and universal banks.³ Moreover, it is the CFO or treasurer who purchases both product lines, an arrangement that confers useful opportunities to cross-sell products.

Even in debt products, though, universal banks have not systematically captured market share in every part of the business. While J. P. Morgan Chase and UBS have captured organic market share in both investment-grade and high-yield debt, Citigroup has won organic share only in high-yield-debt issues, and Deutsche Bank's increased share has been focused in the investment-grade-debt sector.⁴ This indicates that customers may well be choosing these banks for their underwriting expertise, not simply for an offer of credit.

The loss of share in debt underwriting should not be overly worrying for investment banks, since it is the least profitable part of their business, and margins are falling. Many on Wall Street assume that it is only a matter of time before the universal banks make significant inroads into more lucrative investment-banking products, such as equity underwriting and M&A advisory services, but this isn't necessarily true. Debt is the least complex and most commodity-like part of investment banking. Top-flight corporate customers have thus far been quite willing to trust commercial and universal banks with simple debt issuance but less so with the more sophisticated merger-and-acquisition and equity deals, for which such companies still choose to rely on the independent investment-banking specialists.

Apart from debt products, the erosion of the investment banks' market share has resulted primarily from acquisitions rather than direct competition (Exhibit 4). In M&A, for example, the universal banks' market share jumped from 11 percent in 1995 to 39 percent in 2001—a seemingly impressive gain. Yet if acquisitions are taken out of the equation,⁵ the universal banks' market share grew by only 1 percent, to 39 percent, from 38. This was actually a decline from a peak of 44 percent in 2000, largely reflecting the fact that leading investment banks such as Goldman Sachs and Morgan Stanley won back market share.

In equities, commercial and universal banks have made the biggest inroads with IPOs, in which they jointly had a 49 percent market share in 2001. This success, however, has come mainly from spin-offs by credit-hungry corporations, such as Lucent's sale of Agere. Given the current economic downturn, these companies badly needed new credit, so linking spin-offs with new funding made sense. When the current credit crunch eases, this trend could fade.

Skills still matter most

All banks, as they explore future strategies, have to look beyond today's market conditions. When the current credit crunch eases, offering credit at below-market rates will not be enough to win in investment banking.

Success in this field, particularly in M&A and equity advisory services, takes top-tier skills. In medicine, you want the doctor with a track record in life-saving surgery, not the one who offers a discount on your next checkup. For M&A and IPOs—both life-changing events for corporations—skills and experience are vital; discounts on other products are pretty well irrelevant. When credit becomes more available, it is sheer expertise that will again determine which firms win the lucrative fees at the sophisticated end of investment banking. Credit will be a tool to sweeten deals or build client relationships, but only for banks that have top-notch investment-banking credentials. Although universal banks have made significant progress, they cannot yet match the depth of expertise of the top independent investment banks across the full range of high-margin products.

Market research shows that large corporations simply do not want a one-stop shop for banking

Moreover, the potential for commercial and investment banking to complement each other has been overstated. Market research shows that large corporations don't want a one-stop shop for banking: although they may currently be using fewer financial-service providers, they still pick the best of breed in each product category. More serious still, banks that bundle credit with investment-banking services will end up with the riskiest borrowers, since corporations that can't borrow easily are the most likely to welcome this strategy.

In the end, providing customers with credit at unattractive rates can't be sustained, even if it confers a foothold in investment banking. Anecdotal evidence already suggests that many universal and commercial banks may end up with credit losses that far outstrip any investment-banking fees they have earned. Moreover, the very fact that universal and commercial banks have entered a number of investment-banking markets has pushed margins down—for example, in debt products, where these banks have made the greatest headway. Average margins in the investment-grade-debt business, in which some universal and commercial banks have done well, are only half of what they were a decade ago (Exhibit 5).⁶

Sooner or later, banks of all stripes will have to raise the price of their loans because the primary source of credit—syndicated loans—will become more expensive. Many commercial banks, in hopes of increasing and diversifying their loan portfolios and of eventually winning a leading role in other, higher-margin businesses, such as cash management, played a large part in loan syndicates. But the gamble hasn't paid off: sooner or later, these banks will either have to cut their losses and downgrade this activity or charge more for participation. Moreover, the commercial banks will probably have to think again because of the new Basel Capital Accord,⁷ which will increase capital requirements for lower-rated borrowers to better match the risk involved.

Many commercial and universal banks are already cutting back their loan portfolios. Indeed, industry insiders suggest that even now it costs universal and investment banks more money to syndicate the loans they have arranged than they earn in fees. As these trends play themselves out, we believe that offers of credit to investment-banking clients at low rates will become increasingly rare.

Winning the battle for customers

The current battle for customers has no end in sight, and credit will continue to be a weapon. If universal banks can quickly build top-tier investment-banking capabilities, the granting of credit could well be the differentiating factor in the battle for supremacy. Investment banks must therefore arm themselves with credit capabilities while being careful to put in place tight internal controls to limit their total exposure. Universal banks need to continue building their investment-banking skills, and commercial banks must revisit their strategy entirely.

Investment banks

Investment banks shouldn't give in to the current pressures to merge with commercial banks just yet—at least not if the only motivation is to gain credit capabilities. The merger or acquisition route is fraught with pitfalls; integration between the two types of banks is difficult, particularly in today's tough market conditions. The leading investment banks still control the most lucrative parts of the business and will continue to do so if they maintain their advantage in skills long enough to build credit capabilities. Second-tier investment banks, which do not have the same skill advantages over the leading universal banks, face a more acute challenge. But even they should avoid mergers in the current environment.

Investment banks lack experience in extending and managing credit portfolios, but this can be overcome by hiring the right people from commercial banks. Morgan Stanley, for example, lured a credit team from Bankers Trust, created a new position of chief credit officer, and filled it by hiring the former head of risk-rating assessment at J. P. Morgan Chase. Other investment banks should follow suit.

A much more difficult obstacle to establishing a viable lending operation is the fact that investment banks have relatively small balance sheets—typically as small as 5 percent of a universal bank's balance sheet. Investment banks must find funding sources for their loans and ways of laying off credit risk to protect their limited risk capital. In the short term, an alliance with a commercial bank would solve both problems. Such a partnership would naturally require the investment bank to pay the commercial one for providing funding and risk capital. But it has the advantages of avoiding the massive integration costs of a full merger and of establishing a working relationship with a commercial bank—a relationship that could later lead to a merger if the industry dynamics make that necessary.

Investment banks should also look for creative capital market structures to duplicate the commercial banks' funding and risk-capital capacity. Credit derivatives and credit insurance already make it possible to lay off credit risk, but at present there is no way to provide guaranteed loan funding, particularly for the backup credit facilities (commitments to provide credit if and when it is needed) that companies are now demanding. One option would be to create a prefunded, securitized vehicle resembling a mutual fund and then to sell participation in it to insurance companies or other investors.

However investment banks may build up their lending capabilities, they should choose their borrowers carefully. To ensure selectiveness, banks must develop explicit criteria for providing credit. It should be offered to clients who use investment-banking services intermittently, for example, and only when it is demanded and only when the overall transaction has an attractive return on equity. Investment banks could extend credit more generously to their most profitable clients as a way of building up long-term relationships, but this approach should be the exception rather than the rule.

Senior management must also provide active oversight to guard against systematic optimism by individual bankers: giving a loan has no downside for them, so they see loans simply as a way to capture more business. Annual reviews of the profitability of individual clients would provide a sensible backup for strictly enforced lending criteria, which might include such ideas as granting loans only if they carried a higher spread than others in the same credit-rating band or were profitable in their own right, or lending only to blue-chip clients that had a realistic chance of yielding future business. In addition, bankers might be made accountable for holistic client profit-and-loss (P&L) statements, not seen today, that included all investment-banking and lending revenues and costs.⁸

Universal banks

A few universal banks are well set to improve their position in investment banking, but they will have to build on their current success in debt products, develop competitive skills in equity issuance and M&A advisory services, and provide credit more selectively and at realistic prices. Prevailing market conditions provide an opportunity to recruit the top-tier talent the universal banks need. In 2001, equity issuance and M&A in the United States were down by more than 40 percent and 50 percent, respectively, from the previous year, and compensation at investment banks has been slashed as a result. At the same time, the volume of debt underwriting—a stronghold of universal banks—is up. Talent at top investment banks looks ripe for the picking.

Besides recruiting the right people, universal banks will have to create stronger links between their commercial- and investment-banking organizations. In many institutions, these activities remain in largely separate silos, in part reflecting the fact that investment-banking operations were usually acquired rather than developed internally. Universal banks need to develop a system of overall accountability for both businesses so that they can be integrated properly. Creating client profit-and-loss statements that take into account risk-based capital charges would be an important step, though few banks have taken it yet.

Long-term success, however, will also demand a far more judicious view of credit operations. In the future, universal banks must link credit to the type of investment-banking transactions in which they are trying to build market share, critically examine their portfolios of loans, and reassess the rationale and realized profitability of each client. The probable outcome is that these banks will cut their lending portfolios radically.

Commercial banks

Commercial banks are less well positioned than universal ones to break into investment-banking business and should therefore set realistic aspirations. Although commercial banks have been gaining market share in simple debt products, in the equity and M&A markets the position of these banks has weakened: their market share in IPOs (after excluding acquisitions) fell from around 9 percent in 1995 to 3 percent in 2001 while their share of M&A edged down from 4 percent to 3. Commercial banks are likely to be most successful in simple debt transactions in which they can leverage their strength in credit, but otherwise they should abandon investment banking.

They should also critically reassess their participation in loan syndicates, participating only when a deal is profitable on its own or there is a real prospect of winning other, profitable business. If such criteria were strictly applied, commercial banks would find that in many cases their participation in loan syndicates isn't worthwhile. At the very least, the banks should be charging a higher price for participating.

In the end, commercial banks may be better off by cutting their loan portfolios and concentrating their efforts on the middle market—clients that are already heavy users of products in which commercial banks excel, such as cash-management, credit, and structured-debt products. Indeed, our research indicates that middle-market customers explicitly reward their lead banks with more attractive cash-management business.⁹

The idea that convergence between commercial and investment banks is inevitable reflects a reading of short-term trends. The game isn't over yet. Its outcome will be determined by whether investment banks can build up their credit capabilities faster than universal banks can build up their equity-underwriting and M&A advisory skills. One thing is certain: the winners will have top-tier investment-banking expertise.