Lecture 19: Investment Banks

What this lecture covers

Professor Shiller explains what investment banks actually do: underwriting new securities, advising on mergers and acquisitions, and helping companies raise capital, as distinct from commercial banking or pure trading. He contrasts investment banking's culture, illustrated through Goldman Sachs' stated principles, with the more informal culture of trading, and traces how Glass-Steagall separated investment and commercial banking in 1933, how its 1999 repeal blurred that line again, and how shadow banking and the repo market contributed to the 2008 crisis.

The second half is a guest talk by Jon Fougner, a former student who worked at Goldman Sachs and then Facebook. He describes daily life as a junior investment banking analyst, offers practical advice on breaking into finance or tech, and compares the cultures of an investment bank and a technology company. This lecture follows the course's earlier material on commercial banks and monetary policy.

Key ideas

• Investment banking core business: helping companies and governments issue stocks or bonds through underwriting, either as a "bought deal" or on a "best efforts" basis.
• Moral hazard and reputation: investment banks reduce the risk that issuers misrepresent their condition by doing due diligence, which is why reputation and trust are central to the business.
• Glass-Steagall Act (1933): separated commercial banking from investment banking in the U.S. and created the FDIC; repealed by the Gramm-Leach-Bliley Act in 1999.
• Volcker Rule and Lincoln Amendment: provisions of the 2010 Dodd-Frank Act restricting proprietary trading and swaps dealing at commercial banks, pushing firms like Goldman Sachs to scale back these activities.
• Shadow banking and repos: investment banks like Lehman Brothers financed investments through repurchase agreements (repos), short-term loans that functioned like uninsured deposits and were vulnerable to a "run" when confidence collapsed.
• 2008 collapse sequence: Bear Stearns, then Lehman Brothers (allowed to fail), then Merrill Lynch and the conversion of Goldman Sachs and Morgan Stanley into commercial banks.
• Junior banking analyst life: heavy Excel modeling, building pitch books, long hours, and taking on responsibility for coordinating a deal's moving parts.
• Click-through rate and the marketing funnel: a basic online-advertising metric (clicks divided by impressions), which matters more at some stages of getting a customer from awareness to purchase than others.

Walkthrough

Key elements of investment banking (0:00)

Shiller defines investment banking as helping organizations create and sell securities, distinguishing it from consulting, trading and commercial banking (which accepts deposits). He explains underwriting, IPOs, seasoned offerings, and the difference between a bought deal and a best-efforts offering.

Principles and culture of investment banking (9:50)

Drawing on Charles Ellis's history of Goldman Sachs and chairman John Whitehead's list of principles, the lecture discusses how investment banking culture emphasizes client service, reputation, and discretion, and contrasts this with the more informal, transaction-focused culture of trading.

Regulation of investment banking (16:54)

The 1933 Glass-Steagall Act split commercial and investment banking and created the FDIC; the 1999 Gramm-Leach-Bliley Act repealed that separation. After the 2008 crisis, the Volcker Rule and the Lincoln Amendment in the Dodd-Frank Act restricted proprietary trading and swaps dealing at commercial banks, forcing firms like Goldman Sachs, now a commercial bank, to scale back these businesses.

Shadow banking and the repo market (27:21)

Shiller describes shadow banking, unregulated activity that functions like commercial banking, and explains how Lehman Brothers financed subprime investments through the repo market. When lenders lost confidence, they stopped renewing these short-term loans, producing a run that led to Lehman's bankruptcy without a government bailout.

Guest speaker: from ECON 252 to Wall Street (33:04)

Jon Fougner, a former student who worked at Goldman Sachs, describes his path into investment banking, the day-to-day work of a junior analyst (building financial models, pitch books and coordinating deals), and life during the pre-2008 private equity and debt boom, including the collapses of Bear Stearns, Lehman Brothers and Merrill Lynch.

Steps to take today to work on Wall Street (46:24)

Fougner offers concrete advice: take relevant coursework, use professors and alumni networks, try self-assessment tools like Myers-Briggs or StrengthsFinder, and be persistent and specific when reaching out to recruiters or contacts.

From Wall Street to Silicon Valley: experiences at Facebook (53:49)

Fougner describes his move to Facebook, working on local business advertising and the "social graph," and compares the faster, more ambiguous pace of product work at a technology company to the more structured, numbers-driven world of banking.

Question and answer session (57:56)

Students ask about career transitions, company culture differences between Goldman Sachs and Facebook, and online advertising metrics. Fougner explains click-through rate and the marketing funnel, and discusses how a background in banking transferred, and did not transfer, to product work in tech.

Before you watch

• Review the course's earlier lecture on commercial banks and monetary policy for background on Glass-Steagall, the FDIC, and central bank bailouts.
• Familiarity with Basel III capital requirements, discussed in the preceding monetary policy lecture, helps contextualize the discussion of proprietary trading restrictions.

Check your understanding

1. How does investment banking differ from both commercial banking and trading?
2. What did the Glass-Steagall Act require in 1933, and what changed when Gramm-Leach-Bliley repealed it in 1999?
3. What is a repo, and why did the repo market's collapse resemble a traditional bank run?
4. What restrictions does the Volcker Rule place on commercial banks, and why did this affect Goldman Sachs after it became a commercial bank?
5. According to Jon Fougner, what skills from investment banking carried over to his work at Facebook, and what was genuinely different?