Why Investment Bankers Work for Free

Too bad this gift economy is limited to the elites.

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This post originally appeared in Money Stuff.

Investment banking, I often like to sayoperates as a sort of gift economy in which banks do lots of free favors for companies in the hopes of getting lucrative paying work from those companies later on. But this is a little different from the gift economies that anthropologists describe in traditional societies. In traditional gift economies, the gifts that I give you today and the gifts that you give me tomorrow tend to be of a similar category: I give you luxurious cloth or a lavish dinner today, you give me back fancy armor or an even-more-lavish dinner tomorrow.

In the investment-banking gift economy, though, the gift that the banks give to the companies is free work. (Also sports tickets and steak dinners and jobs for the companies' executives' kids, but principally free work.) And the gift that the companies give back to the banks is the opportunity to do more work. In both cases, the transaction looks like the bank doing work for the company. It's just that when the bank is buttering up the company, it undercharges for the work; when the company is rewarding the bank for its loyalty, it overpays for the work.

So how do you decide what work is free and what work is overpaid? There are some intuitive dividing lines: Banks do lots of free work analyzing potential mergers, and then are lavishly compensated for executing actual mergers, and it would obviously be strange to do the reverse. Charging for analysis of a merger that goes nowhere leaves a bad taste in everyone's mouth, but if a company is merging out of existence, or spending billions of dollars buying another company, a few tens of millions of dollars of bankers' fees seems trivial.

But a lot of the divisions are arbitrary and shifting. (Part of the point of MiFID II, after all, is to shift the gift economy so that research is no longer a free gift for institutional clients.) When I was a banker, for instance, a perfectly normal approach would be to do lots of financial analysis for a company in the hopes that it would one day mandate you on a bond offering. Bond offerings can be easy and lucrative, and so are a sensible reward for companies to give to banks who have demonstrated their loyalty through free work. But there is nothing necessary in that, and in Asia the bond offerings themselves seem to have become the free work:

Barclays PLC and Standard Chartered PLC were among seven banks that recently helped sell a total of $1.3 billion in dollar-denominated bonds from three state-owned Indian companies, effectively providing their services free of charge. The three Indian companies paid a dollar in underwriting fees to each bank that handled the sales, according to company representatives and people familiar with the matter.

A similar trend is emerging among banks underwriting some Chinese bond offerings, bankers say, particularly in the case of state-owned corporations that have large pools of underwriters to choose from and tend to be stingier with fees.

Banks that agree to arrange bond offerings for ultralow fees are generally hoping to build relationships with corporate clients for future deals. They are also hoping to generate revenue from related businesses, such as fees for setting up foreign-currency swaps or on bond-trading commissions.

Instead of free analysis for a lucrative bond offering, the exchange now is a free bond offering for a lucrative swaps trade. The trick, if you are a penny-pinching client, is to roll this forward indefinitely. Banks are always hoping to build relationships with corporate clients for future deals, which means that if you ask nicely and persuasively enough you can get pretty much anything you want for free. They'll do your financial analysis for free in the hopes of getting your bond offering, they'll do your bond offering for free in the hopes of getting a swap trade, they'll do the swap trade at scratch in the hopes of getting a privatization mandate, they'll do the privatization for free in the hopes of getting a merger mandate, it can go on and on. This only works, though, if you are a big enough company that the banks can tell themselves that you'll one day give them a lucrative deal. If you're not big and rich, you'll have to pay for stuff. The free stuff is limited to the companies that don't need it. This gift economy, like many traditional gift economies, is limited to the elites.04

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