The biggest casualties of the global credit crisis so far have been the big, independent investment banks who have either gone bankrupt or converted themselves into traditional banks. Is this the end of Wall Street as we know it? By Vivek Sharma

As recently as January this year, the list of top five independent investment banks read Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. Nine months later, the list has been completely transformed with the top banks now being Raymond James, Jefferies & Co, Greenhill & Co, Keefe Bruyette & Woods and Piper Jaffray.

It is just fine if you haven't heard these names before. Not many outside Wall Street know them!

It is not just the names that have changed; the average size of top investment banks has also shrunk dramatically. At the beginning of this year, the top five banks had a combined market value of around $250 billion with the top firm, Goldman Sachs, valued at nearly $90 billion.

The combined market value of the top five firms in the new list has shrunk by a factor of 20, to just around $12 billion.

Over the last three quarters, top firms in the investment banking industry have been transformed beyond recognition. Bear Stearns was the first to go, saved from the brink of bankruptcy and acquired for a pittance by JP Morgan (See:US Fed clears JP Morgan's acquisition of Bear Stearns bank)

Lehman Brothers went bankrupt and its various businesses across the globe are slowly being sold to firms like European bank Barclays and Nomura Securities of Japan (Nomura to buy Lehman's banking, equities units in Europe, Middle East).Merrill Lynch rushed into the arms of Bank of America and saved itself from total collapse ( Bank of America buys Merrill Lynch)

The last men standing, Goldman Sachs and Morgan Stanley, both converted themselves into regular banking companies and are now seeking to raise capital ( Goldman Sachs, Morgan Stanley surrender investment bank status). While Japanese bank Mitsubishi UFJ has acquired a stake in Morgan Stanley (Mitsubishi UFJ to acquire 20 per cent in Morgan Stanley for $8.4 billion), none other than Warren Buffett has agreed to invest $5 billion in Goldman Sachs (Warren Buffett invests $5 billion in Goldman Sachs )

So, within a few months, the once omnipotent masters of financial universe who ruled investment banking have all gone. The remaining are small boutique firms who don't have even an iota of the aura the erstwhile big boys had. Is this the end of investment banking or Wall Street as we know it?

How Wall Street bloated and then killed itself

In the good old days, investment banking was only about offering corporate finance and investment advice besides some broking and other services. The firms were small and mostly private partnerships, more like the large law firms. Business depended on personal relationships and trust built over many years. As the capital bases of private partnerships were small, they stayed away from risky ventures and excessive leverage.

By the late '90s, Wall Street saw some dramatic changes. One by one, the top firms shed their private partnership structure and went public. Business models were transformed as riskier, and more profitable, ventures dominated the structure. As the firms were highly profitable, nobody paid much attention to the excessive risks they were taking.

In a way, Wall Street was forced to move beyond its traditional bouquet of investment banking services by the changing competitive landscape. By then, the legal wall that separated investment banks and traditional banks had disappeared.

Big global banks like Citigroup, JP Morgan and many of the European banks started competing with Wall Street firms for the traditional investment banking business. Wall Street firms didn't have much choice but to expand aggressively elsewhere to keep growing their bottom lines and, of course, the fat pay cheques.

The spectacular growth of hedge funds offered big opportunities to the investment banks. Under prime broking services, the big investment banks offered every service hedge funds needed, including investment advise and risk management. The private equity boom, which led to a surge in corporate buyouts, saw substantial growth in traditional investment banking services as well.

Still, the craving for even more profits and bigger risks of big Wall Street firms were not satiated. Attracted by the huge money hedge funds were making, the big investment banks expanded their proprietary trading operations and placed huge bets in equities and commodities.

They launched their own hedge funds, private equity and alternate investment operations across the globe. Quarter after quarter, the bulge bracket firms beat market expectations and bonuses of top executives went sky high.

The new lines of businesses required bloating their balance sheets with more and more debt. The top Wall Street firms were leveraged three or four times more than conventional banks. Though the only major difference between a firm like Goldman Sachs and a global bank like Citigroup was that the former didn't accept deposits from retail customers, Wall Street was subject to far lighter regulations when compared to conventional banks.

In the US, while the investment banks are answerable only to the Securities and Exchanges Commission, traditional banks are supervised by multiple regulators including the US Federal Reserve. There was yet another significant difference. While traditional banks had unlimited and permanent access to liquidity provided by central banks, the investment banks, which were even more leveraged and therefore more likely to face liquidity problems didn't enjoy such support. It is only when the mgnitude of the brewing financial crisis revealed itself this year, that the US Fed altered this by opening up the liquidity window to investment banks as well.

When the credit crisis hit, Wall Street was excessively exposed to risky credit securities and were highly leveraged. The huge losses and the eventual folding of some of the hedge funds promoted by firms like Bear Stearns and Goldman Sachs were only teasers to the big blow-out that was to follow. As liquidity dried up and big clients became cautious to deal with them, the investment banks were facing serious difficulties.

The US Fed's liquidity support provided only temporary relief as these firms desperately sought additional capital. Though Goldman Sachs managed to weather the early storms by taking some smart trading bets, it too came under pressure in recent quarters.

More than the business losses, it was the huge erosion in confidence that brought these firms to their knees. The excessive leverage accentuated their troubles as they didn't have adequate capital to survive and raising additional capital was impossible during the crisis.

In the end, Wall Street gave up. The big firms let themselves absorbed by traditional banks or became traditional banks themselves, and surrendered to regulatory supervision.

What will change?

The days of excess leverage, bloated risk appetites, fat profit margins and even fatter pay cheques are definitely over. The remnants of Bear Stearns, Lehman Brothers and Merrill Lynch will become small units of big universal banks. Goldman Sachs and Merrill Lynch will become traditional banks at least in the US, by acquiring smaller regional banks or converting their retail broking networks into bank branches.

The smaller, still independent investment banks will limit themselves to the traditional business model of corporate and investment advisory services and intermediation. They will stay away from riskier bets, shun excess debt and seek comfort in a strong capital base. Some of these firms may be taken private, to the old model of partnerships. Until it announced the investment by Warren Buffett, even Goldman Sachs was rumoured to be considering going private. 

However dramatic this upheaval may appear, it is not as if Wall Street will disappear. The big, independent investment banks may have disappeared, but investment banking as a business will continue to thrive even if as small pockets of huge universal banking empires.

Wall Street has become just an adjunct of Bank Street!