Outsourcing Investment Banking To Please Congress

The Congress and the Administration seem fixated on cutting the pay of financial company executives and, perhaps, the people who work for them.

The idea is a nearly perfect way to lower banking firm costs and to make sure that TARP money, money that belongs to taxpayers, does not go to out-sized bonuses.

The most recent proposal is to put a ceiling on compensation at companies that take money from the US government no matter what line of business they are in. According to Reuters,"President Barack Obama kicks off a campaign to rein in corporate compensation on Wednesday with rules limiting executive pay to $500,000 a year for companies getting taxpayer bailout funds in the future."

It is nearly certain that if the most talented bankers see this as a trend that will eventually affect pay for M&A and advisory work that the top tier of these people will move to smaller, private firms and hedge funds. There will only be room for a fraction of the most elite experts at small operations, but they are the ones who make most of they money for their employers, so they will always have a home.

That leaves the large banks in a fix. How do they get access to the best minds without paying them?

The answer is probably that investment banking will be outsourced. Money management firms already handle cash for outsiders. It may be that the best traders are willing to provide services to their former employers on a contract basis.

A system would have to be constructed so that the smaller firms would take on much of the risk of their trading and investments. Banks could invest capital with them, but they would only get a piece of profits. The operations taking the risks would have to get large rewards Most of any losses would stay with the newly created advisory firms and hedge funds. All of the losses at a hedge fund which does poorly could not be passed back to large financial rims clients. In exchange for capital the boutiques would need to provide some safety net. That might involve giving banks back their money immediately as soon as red ink started to flow..

The same sort of program could be set up for M&A. Banks with large clients could send their business outside. The banks could provide capital for mergers or LBOs, or not. The banks would get part of the M&A transaction fees in exchange for providing a steady flow of business.

The government wants banks to take risk off their balance sheets. That means taking many rewards out of their futures. To keep some of the upside for building franchises with large customer bases, the risky work may have to be exported to smaller, more adroit businesses. The government could get its way.TARP money would not go to direct compensation for executives at bailed out operations. Banks would have smaller investment banking margins, but they would not have to walk away from some of their most important profit centers.

Douglas A. McIntyre