The bigger they are, the harder they fall. Photo:blog.diversityjobs.com

Today saw the demise of investment banks on Wall Street. The last of the two large independent investment banks -- Morgan Stanley and Goldman Sachs -- have asked to be supervised by the Federal Reserve Bank (Fed) of the US, like all other commercial banks.
The two banks had applied to the Fed to be banking institutions that would give them the liquidity through the Fed funding window, and offered to be regulated by the Fed.
Investment banks from Wall Street once ruled the world of finance, till hubris and greed drove them to believe they were invincible.
Investment banks are in the deal making business. They match buyers and sellers of stocks and bonds, by acting as brokers and also as bankers; they raise finance for companies from third party investors, and help buy and sell companies through mergers and acquisition.
Typically, and in the most traditional sense, investment banks only act on behalf of clients, and take a fee for matching the needs of their clients. However, from the '90's, they changed their role in pursuit of profit.
By then, with most of them listed and with access to more capital, they had essentially turned gamblers by betting on markets with their own money through leveraging their balance sheets.
Transitioning from a safe model, where it matched buyers and sellers with little capital at risk, to taking long and short positions on its own balance sheet meant gearing up on its capital. And this is what caused the downfall of the industry, manifested in the demise of Bear Stearns (that was bought over by JP Morgan), Lehman Brothers filing for chapter eleven, and Merrill lynch being gobbled up by Bank of America.
And the final nail in the coffin came today with the remaining two largest independent investment banks left -- Goldman Sachs and Morgan Stanley -- folding as investment banks and re-emerging as commercial banking institutions with the blessing of the Federal Reserve Bank of the US.
Some of the cleverest people from B school join investment banks, partly drawn by the challenge of the cut and thrust of markets and the opportunity to deal with high finance and partly by the massive potential upside in compensation.
Many would say it is the chance to be quick millionaires that drives people into this industry, and this may not be far from the truth.
Fundamentally, there is nothing wrong with that -- after all monetary incentive is often a key criterion for choice. But when financial compensation leads to greed and to moral hazard then society will have a problem with the breed of investment bankers.
According to Wikipedia, "Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.
Moral hazard arises because an institution does not bear the full consequences of its actions, and, therefore, has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions." This is precisely what happened in the industry.
The investment banks were responsible for creating the Credit Debt Obligations (CDO's) in the market. These were mortgage loans securitised as CDO's or collateralised bonds with a pile of mortgages inside them and because they were sufficiently over collateralised, meaning that the mortgages were worth more than the value of the bonds being issued, the rating agencies gave the bonds triple A or double A credit ratings which made it easy for them to sell.
So here is how the moral hazard happened. Investment banks told the mortgage lenders to create as many new mortgages as they could. The mortgage lenders did precisely that, without much caring about the ability of the borrowers to repay the loans.
The loans were than repackaged by investment banks as CDO's and sold to investors, leaving very little of the assets on the books of the mortgage lenders or the investment banks, but both parties did handsomely on fee compensation in the whole process, paying out large bonuses to the bankers.
The investment banks or the mortgage lenders had no concern with the quality of the mortgages, as default on the mortgages would only affect the investors holding the CDO's and not them.
Or so they thought. Creating CDO's involved putting complicated tranche structures in the collateralisation process, and the rating agencies rate each tranche separately. Some of the tranches get the highest rating of triple A, which investment banks like to hold themselves because of their rating and more then commensurate return.
They, indeed, looked fairly safe in the beginning as it would need a whole lot of default on the mortgages inside the CDO's before the triple A tranches got effected. The mistake was that no one anticipated the torrent of default that followed with the weakening of the US economy and, lo and behold, the triple A tranches also turned into junk and ate into the capital of the investment banks, resulting in the demise of an industry,.
Could all this be avoided? Yes, of course. The clever investment bankers should have known that economies don't always grow. Business cycle is part and parcel of growth and a little sensitivity analysis of a downturn would have shown the weakness of the CDO structure.
It's now all water under the bridge, but let us hopes that we have learnt our lessons and will not allow this monumental financial disaster to occur again and shake the very foundation of capitalism.

Ghalib Chaudhuri is a freelance contributor to The Daily Star.