Books: What gives them the edge?

This book sees investment banks as sleek conglomerates that override boundaries to win business from awestruck executives. John Kay hopes it will be widely read.

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Last Updated: 31 Aug 2010

The Greed Merchants; Philip Augar

Allen Lane; £20.00; MT price; £16.99

To order, visit www.mtmagazine.co.uk

Anthony Sampson described the nature and sources of power in British society half a century ago in The Anatomy of Britain. Only a modest part of one chapter was devoted to those elite institutions then called merchant banks. Unlike many other City firms, merchant banks often required brains as well as breeding from their recruits, and found the gene pool of several of the hereditary families, which remained central to their operations, surprisingly fertile in continuing to provide them. Originally, merchant banks had financed governments and international trade, but their modern role was less clear.

Siegmund Warburg, a brash outsider, began the process of change, his meritocratic approach confounded only by an insistence on the value of graphology. The development of corporate advisory functions and the deregulation and globalisation of financial markets transformed the role and nature of these institutions.

As Sampson realised when he updated his book, the rise of merchant banks, now called investment banks, is perhaps the most significant change in the nature of influence and power in Britain since the 1960s. Investment banks today are not just the intellectual powerhouses of the City, concerned with exotic financial matters, they have a major influence on the structure of industry and on policy issues as diverse as pensions and third-world poverty.

Philip Augar's earlier book, The Death of Gentlemanly Capitalism, described the process by which conservative and complacent British firms were squeezed out of this market by aggressive and professional Americans - why today it is Goldman Sachs rather than Kleinwort Benson that leads the rankings of City institutions. In The Greed Merchants, Augar turns from history to analysis. He writes as a former City insider, having spent 20 years in financial services, ultimately as group managing director of Schroders. Augar knows where the bodies are buried.

He begins with an obvious but fundamental question: who pays the salaries and bonuses of City high-flyers? His answer is that, ultimately, the general public does. In their various roles as consumers, savers and taxpayers, the public pays every commission, fee and expense incurred by corporations. So what does the public get in return for its remarkable largesse?

Not a lot, Augar argues. The sources of the profits of investment banks are diverse and vary substantially over time. Sometimes mergers and acquisitions have been the driver of revenue, sometimes new issues, sometimes proprietary trading. But, he says, conflicts of interest are not only inherent in modern investment banking, they are largely responsible for its profitability. The multiple roles of the investment bank create what he describes as 'the edge'.

Augar exaggerates when he says that 'the large investment banks know more than any other institution or organisation about the world's economy' - their forecasts are no better than anyone else's. But banks do know more about the flows of funds around financial markets, and they profit handsomely from this information. They do indeed have the edge.

Regulation - under-resourced and politically emasculated - has proved too weak, argues Augar, to tackle conflicts of interest. He says that structural separation into distinct advisory, trading, issuing and market-making functions is the only solution. But why doesn't the market produce this outcome? Why do clients not rebel against financial conglomerates?

The principal answer he offers is that clients are naive. Blinded by the intelligence and sophistication of the employees of businesses that have swept up much of the ablest talent in Britain and the US for several decades, corporate executives are flattered and exhilarated in the meeting rooms of Wall Street and the City. Pension fund trustees are part-time and amateur. Retail investors imagine that people who advertise for their money are genuinely on their side.

There is much truth in this response, but many of those who place business with investment banks are themselves complicit in conflicts of interest. In the new-economy boom, this sometimes degenerated into overt corruption: underpriced stock was placed with corporate executives who repaid favours with their company's business. But mostly it is enough that we now live in a world in which being well thought of in the City is an essential attribute of the ambitious manager.

This book deserves to be widely read. It provides an essential bridge between hair-raising accounts of life on the trading floor and diatribes on the iniquities of global finance. It is better informed, better balanced and better written than most books in either category.

Economist John Kay is author of The Truth About Markets and Everlasting Light Bulbs.

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