Time To Bring Back Investment Banking

Bank of America chief executive Ken Lewis must be kicking himself right now. Less than 12 months ago, he ran a relatively steady-earner on a path to modest expansion. While some commercial banks would be taken down by overextending themselves on subprime loans, Bank of America would survive intact.

As a result of that success, he was pressured by the most powerful people in economic governance into turning his business into an altogether different risk animal. Lewis was effectively forced into hiring the very type of mathematical gunslingers his business had previously eschewed.

Now, Lewis faces losing his job, and his bank is now considered one of the riskiest prospects around. TIME’s Justin Fox sums up the story well:

BofA needs capital largely because of problems at Merrill Lynch. And it has become pretty clear in recent days that BofA wouldn’t have gone through with its acquisition of Merrill late last year unless it had been strong-armed into it by then-Treasury Secretary Hank Paulson. BofA is in trouble because it was doing Treasury a favor. How do you fairly deal with a situation like that?

After so much fuss over the demise of the traditional investment banking model at the end of last year, it’s ironic that the banks which now find themselves most under pressure in the government’s stress tests are the ones that look most like deposit-taking institutions. Tuesday, the Wall Street Journal reported that Citigroup and Bank of America were being encouraged to raise billions of dollars more to stay within the parameters of the tests. Wells Fargo, Fifth Third Bancorp and Regions Financial are all at risk of failing the tests too, according to analysts.

Type “investment banking model is dead” into Google and you’ll find several pages of articles written around September and October last year on that topic. One such article characterizes the sentiment back when Morgan Stanley and Goldman Sachs were scrambling to raise cash:

In this day and age, bulge-bracket investment banks need to be commercial banks. With fixed income in tatters, underwriting nonexistent and the equity markets in free fall, their revenue pictures didn’t look exactly promising.

How six months can change everything. Notice that the only banks the government isn’t worried about these days happen to the most traditional type of investment banks around: Morgan Stanley and Goldman Sachs, despite their own sets of problems, are currently working on ways to pay back the TARP money faster than expected.

None of this is of much surprise to seasoned bankers on Wall Street, where you can almost hear the collective ”I told you so’s” on some trading floors right now.

Just because it was the investment banks that got the financial system into trouble by designing toxic derivatives, that doesn’t mean they are not the models needed to fix it best. Mainly, that’s because investment banks — through the nature of their structures and the personnel they employ — have a better grasp of how risks works, and how to fix risk-based problems when they go wrong.

Clearly, Bank of America and Citigroup have much less experience with toxic derivatives than either Morgan Stanley or Goldman Sachs. After all, the latter two designed the products in the first place.

Rather than mandate commercial-style banks raise more money to try and fix problems they are ill-equipped to, it makes more sense for the government to try and round-up the cooperation of the original investment banks. Officials could easily entice Morgan Stanley, Goldman Sachs or a number of medium-sized investment boutiques to assume some of the departments and the risks that don’t fit so well at Bank of America or Citigroup, either by incentivizing them to buy them out directly or to enter into some kind of joint venture arrangement.

That would be better than the current strategy, which is to throw more good money after bad.