"Industry Insight" is a weekly series that examines sectors through what's known as the five forces of competition, which can help separate the winners from the losers. Come back every Monday at 6 a.m. to see which industries and companies will be put under review.The fact that JPMorgan ( JPM) and Goldman Sachs ( GS) posted record profits in the second quarter during one of the worst recessions in American history is perplexing. Understanding the business model and competitive forces influencing the investment banking industry is crucial for investors. Will earnings continue to grow now that the stock market appears to have rebounded for good? Will fewer competitors drive up revenue? Investment banks traditionally helped companies raise money through debt or equity underwriting, and advised on mergers and acquisitions. Now they also engage in "proprietary trading," a fancy way of saying that firms use their own money to make bets on interest rates, currencies and commodities. While such trading is highly lucrative, it's also a reason many banks have run into trouble. Those divisions are essentially large hedge funds where traders are rewarded handsomely for risky bets that pay off, and shareholders and the government are left holding the bill when things sour. Goldman Sachs, JPMorgan, Citigroup ( C), Morgan Stanley ( MS) and Bank of America ( BAC) are the biggest players in the industry. Smaller niche firms such as Cowen Group ( COWN) are money machines too. Here's how investment banks measure up: Degree of Rivalry: Investment banks are a dime a dozen. Since the industry is so profitable, everyone wants in. Luckily for entrenched firms, the customer base is loyal. Investment banking relationships are much like a doctor-patient relationship. The investment bank is seen as a trusted expert that knows the customer better than a new firm would. That said, there is still room for firms to add to or subtract from their client lists. Defections can cause much of the turnover, which is one reason compensation packages are so high. Clients who feel they have a strong relationship with their banker may decide to also jump ship and follow their man to his landing spot. Investment banks are, therefore, extremely motivated to retain top talent with heavy checks.
That rivalry also leads firms to innovate to keep clients happy. That's part of the reason credit derivatives spread like wildfire in the 1990s. Once one firm starts to make money with a product, it will quickly be replicated by competitors to give clients no reason to look elsewhere. Investment banks need to stay on their toes to keep up with the Goldmans. Investment banking is a playground for alpha-male personalities. Proprietary-trading arms seem to use profits as a perverse form of score keeping, leading to the risky composition of trading books prior to the collapse. Bargaining Power of the Customers: Investment banks charge commissions. While most commission rates may not be much different, most of the difference among firms stems from expertise and profit maximization for clients. Or the promise of it. That's where existing relationships are crucial. Success in the past is the ultimate selling tool. No one competes on price. That would cut into profits and bonuses. For firms such as Goldman Sachs, proprietary trading plays a far bigger role in profitability than investment banking does. While the customer is still king, trading performance will almost always outweigh soft investment banking profits. Bargaining Power of the Suppliers: The only supplier in the investment banking world are employees. Since the business is built around those individuals, they are very well compensated. Luckily, there is little else besides human capital that goes into the products. With top earners pulling in seven or eight figures and lesser employees languishing at a mere six, the lack of expenses is replaced with a big-time payroll.
Many cry foul at excessive compensation. Banks claim that employees are the key "inputs" to the lucrative product -- rather than just people working for a company. However, the compensation structure is perverse and often a baffling application of standard economic motivators. For traders at these firms, the moral hazards are high. With huge paychecks rewarding outperformance, but no punishment for big losses, the incentive is to take gigantic bets on highly risky securities. This structure is the groundwork for the financial meltdown of 2008. While shareholders will share in the spoils in the good times, they will also be crushed by the collapse. Citigroup shareholders know this all too well. Threat of New Entrants: Boutique investment banks spring up like weeds. Alumni from bulge-bracket firms usually head up these operations. However, their tiny size and lack of resources make them no real threat to the Goldman Sachses and JPMorgans of the world. Competition from industry consolidation or well-funded start-ups are the real threat. When firms combine and human skills are added together, the resulting firm becomes far more competitive and puts pressure on the rest of the industry. If a dominant merger-and-acquisition shop teams up with a major fixed-income player, clients may leave their current firm for the jack-of-all-trades organization. Because of this, strengthening perceived weaknesses through poaching of top talent or investment in innovation is critical. Over the past year, the decline of Bear Sterns and Lehman Brothers -- in addition to the strong stench now emanating from Citigroup and Bank of America -- have sent many clients running to Goldman Sachs and JPMorgan. That consolidation will make it even more difficult for upstarts to gain a foothold in the market.
Threat of Substitutes: This force is really the key to the whole industry. There are no substitutes. When a company needs to raise money through issuing shares or debt, or it wants to buy a competitor to spur growth, it will need an investment banker to get the deal done. Simple as that. As for proprietary trading, its purpose is solely to benefit the company itself, so there will be scant defections. While the industry was burned badly in the financial collapse, it's difficult to imagine capitalism working without investment banking in one form or another. Investment banking profits will always soften when markets freeze up. But it seems that a thaw is under way. JPMorgan made a record $2.7 billion in the second quarter. For firms that rely on trading as a large driver of profitability, even a down market can lead to riches, assuming the right bets are made and the proper hedges are in place. It may be a cut-throat business, but it's the only game in town. Risks introduced by trading are huge, but also profitable. Investors who can't stomach huge trading losses should stick to firms like JPMorgan, which is more diversified and stable than most of its competitors.