Stand-alone investment banks have been at pains recently to highlight what they regard as their strengths, but an investor relations offensive may not be enough to distract analysts and shareholders from weaknesses that could be painfully exposed in the months ahead.

Facing another lean year in their most lucrative businesses, and having few other businesses to fall back on, stand-alone banks will be looking to their trading desks to sustain earnings. The problem is that the bumper fixed-income revenues of 2001 are expected to wane. On trading desks throughout Wall Street, risk appetite will rise even as returns are diminishing. Earnings may not only be weaker than in previous years, they may also be more volatile.

“Last year was a phenomenal year as far as interest rate trading products were concerned,” says Ronnie Dick, global head of credit trading at Dresdner Kleinwort Wasserstein (DKW) in London. “We had 11 rate cuts and most houses were long. As the curve steepened, they just had to hold on to their positions to make a decent return. This year is already proving more difficult because the curve is flattening, and there are far fewer trading opportunities available.”

Not that the investment banks seem apprehensive. In fact a casual reader of their annual reports might imagine that Wall Street had never been more confident in its strategic vision. Lehman Brothers’ report claims that 2001 was a “dramatic vindication of our core strategy”; while Goldman Sach’s letter to its shareholders maintains: “We remain bullish about the future. We operate at the ‘sweet spot’ of global capitalism.” Morgan Stanley, for its part, notes: “The long-term growth trends that shape our strategy are intact.”

Value-at-risk (VaR) figures are one clue that stand-alone investment banks had some difficult questions to answer. Last year, VaR – the most widely used probabilistic measure of trading risk – rose at four of the five big investment banks. At Merrill Lynch it dropped slightly, year-on-year, but average daily VaR was up 5.6 per cent at Bear Stearns, 14.4 per cent at Lehman Brothers and 15 per cent at Morgan Stanley. VaR rose 39.2 per cent at Goldman Sachs.

“This is one of the things I’ve been concerned about,” says Eileen Fahey, a Chicago-based managing director in Fitch Ratings’ financial institutions group. “In 1999 and 2000, because of the underwriting strength, the Wall Street banks didn’t need ancillary income, so there was less subsistence on trading revenues. Now, without the investment banking revenues, it makes sense that they would look to proprietary trading.”

VaR – which has its detractors – is supposed to give an insight into the activity that took place behind flat numbers like revenue that, on their own, say nothing about how a bank chose to make money. An institution could be thoroughly conservative and still make the same amount of trading revenue as the freewheeling firm across the street, but VaR would highlight the differences between the two.

Peter Dutton, a London-based director in Standard & Poor’s (S&P) financial institutions ratings group, says the agency regards VaR as a general indicator of trading risk. “It has happened in the past that a bank will tell you it does very little trading, but the VaR numbers are more in line with a bulge-bracket firm. That’s where it’s useful – the easy strikes.”

Last year’s VaR figures show that at least three of the stand-alone investment banks, Goldman Sachs, Morgan Stanley and Lehman Brothers, were exposed to a substantially higher level of risk in their trading businesses than in 2000. It seems to suggest a deliberate attempt to compensate for the investment banking shortfall by accepting more risk on the trading side.

Dick at DKW says VaR isn’t solely an indicator of trading strategy: “There are many components to VaR – one being volatility.” And some markets were more volatile last year, including the fixed-income markets where Wall Street made most of its money, but the big disparities between the banks’ VaR figures suggest that volatility wasn’t the whole story. After all, if each bank were operating in the same environment, why would VaR rise 5.6 per cent at Bear Stearns and 39.2 per cent at Goldman Sachs?

“The investment banks probably were taking on extra trading risk last year, and that’s probably the best use of VaR: to underline general changes of direction,” says S&P’s Dutton.

A senior spokesman at Goldman Sachs in London confirms that the firm was looking to capitalise on fixed-income opportunities by taking more risk. “Yes, we were deliberately targeting fixed-income trading and we deliberately took on more risk. Some banks take more risk than others. We did, and some of our competitors didn’t,” he says.

Fitch’s Fahey notes that Goldman uses a slightly different VaR methodology to its peers, which may explain the relatively large increase in the bank’s VaR. “Goldman’s figures are more sensitive to recent history, which may mean that it tends to pick up more recent volatility,” she says, although she agrees that it is fairly safe to conclude that additional risk-taking activity is also reflected.

From the outside, it seems to make perfect sense. The undiluted profitability that makes investment banks so attractive when times are good is a drawback when times are hard. Morgan Stanley has its credit card business to fall back on, as well as retail brokerage. Merrill has a vast institutional and retail investment management business. Goldman has less diversified revenue streams (the Goldman spokesman prefers to say they are “more focused”) so raising the stakes in the trading business could be seen as a necessary gamble, if earnings aren’t to collapse completely.

Other leading investment banks, such as Salomon Smith Barney, Credit Suisse First Boston and UBS Warburg, are backed by the massive balance sheets and diverse revenue streams of commercial banks. As a result, there are more options open to them when advisory and underwriting revenues are weak.

So, considering the amount of risk to which Wall Street was exposed, how did the trading business perform? At Goldman, the 39.2 per cent increase in VaR was accompanied by a 7.3 per cent rise in trading revenues. At Lehman, the picture was reversed. Despite the 14.4 per cent increase in trading risk, the firm’s trading revenues actually fell by 14 per cent. At Morgan Stanley, it looks even worse: a 15 per cent increase in risk was accompanied by a 25.3 per cent drop in return.

In all three cases, the actual trading performance is unlikely to represent an adequate return on risk, under normal circumstances. However, last year’s circumstances weren’t normal and, with investment banking revenues falling by $1.59 billion, $1.54 billion and $254 million at Morgan Stanley, Goldman, and Lehman respectively, their chief executives may have cared less about risk-adjusted return and more about simply raking in as many dollars as possible.

One noteworthy feature of the three companies’ performance is that, while returns lagged risk at all three, Goldman’s comfort with a higher level of risk may well have made the difference between growing its trading revenues year-on-year or watching them fall. Maybe if the other firms had the courage of their convictions, they would also have come out ahead.

Given the apparent fairly dramatic change in risk tolerance at Goldman, it’s a little surprising that the annual report does not discuss that change. When describing the performance of the trading businesses, Goldman notes that its fixed income, currencies and commodities traders produced “excellent results … by capitalising on lower interest rates, increased volatility and strong customer demand”. Later, in the section on VaR, it fails to address the rise in the daily average, referring only to the fixed-point comparison between November 2001 and November 2000, where the rise in VaR is attributed to “significant increases in market volatility in 2001, particularly during the fourth quarter”.

“We’ve been completely upfront with people,” says Goldman’s spokesman, who denies that the firm has failed to clarify the change in its risk profile. “Anybody who’s buying investment banking stock knows that we trade. None of our investors think they’re investing in widow’s and orphan’s pensions.”

It will be interesting to see what happens to VaR in the investment banking industry this year. While Lehman’s annual report says: “We confirmed that our strategy works, in good times or bad,” it’s evident that 2001 wasn’t entirely bad. A record-breaking year for fixed-income was a ‘get out of jail free’ card for the investment banks, although it now appears that they had to adjust their risk tolerance in order to play that card. But with another lean year looming, and the prospect of a tougher trading environment in fixed-income, the same strategy may be far more difficult to execute.

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