Investment banks: sheep or shepherd?

Haunted by an epic near collapse… Harnessed by an increasingly strict regulatory environment… Hamstrung by antiquated risk management mantras…

While the financial crisis continues to cause ripples throughout the industry the investment banking community needs, now more than ever, a new wave of banking innovation and revenue-generation to emerge. Yet the industry, in many ways, remains paralysed — both in terms of compliance to mounting regulation and by a herd-like obedience to industry norms.

That latter point is both critical and ironic. While the investment banking community has, arguably, never faced a period of such macroeconomic volatility, there has also never been a period of such industry uniformity. Service differentiation is all but dead. Indeed, all of the global banks and increasingly many of the banking boutiques offer carbon-copy services in the same geographies, covering the same jurisdictions (whether for a new M&A advisory, or a new hedge fund deal).

And the sheep-like mentality has extended itself to risk management. The industry has long viewed risk mitigation as a necessary evil to the primary goal of generating revenue. Indeed, in the past, industry leaders were so focused on revenue generation that they often ignored the processes they took to get them there. In other words, banks rarely took a critical eye to whether their risk mitigation techniques were as efficient as they could be. When the market was up and revenues were driven at avalanche-like proportions and speed, they never needed to. But, with leverage no longer an easy option to drive returns on equity, and proprietary trading now seen as risky by both regulators and shareholders, investment banks are no longer the revenue-generating machines they once were. Bank leaders are now faced with the difficult task of propelling their returns on equity back to something close to pre-crisis levels. Any extra (inefficiency) costs, just serve to make that task even more difficult than it already is.

So, as with all herds, there are a select few that are distancing themselves — taking a look at the total universe of risk mitigation processes and attempting to drive efficiency therein. Some global banks have found a unique and previously unrecognised path to increased efficiency. That path takes a closer look at traditional cost centres, like the legal department. And, chief among the costs within the legal department is the contracts management function.

Ask any general counsel, division head or, better yet, in-house lawyer the biggest culprit of legal resource drain, and the answer will undoubtedly include low-level, repetitive contracts (eg, non-disclosure agreements, engagement letters or ancillary documents). Yet outsourcing such work — to anything other than the biggest white-shoe law firm, has been akin to heresy. Why? Because, though often repetitive and labour-intensive, these contracts are, nevertheless, critical.

And that motor oil has, typically, been entrusted to only the most pedigreed of house mechanics. Indeed, industry norms mandate that these relatively simple banker-reviewed agreements for prospective transactions be addressed and handled by in-house M&A lawyers.

It doesn’t take a rocket scientist to recognise the inherent inefficiency in that model. Not only is the in-house team’s time being diverted from revenue-generating and/or bet-the-company transactions, but the industry solution is also an expensive one: relatively low-level documents handled by very senior lawyers. Moreover, because in many instances, the M&A attorneys are too busy on deals to properly address the contracts burden, that work is sent to law firms with resulting big bills.

Add to the heavy financial costs the almost incalculable costs of delayed turnaround: while the documents are relatively simple, they must be turned around quickly to support the internal business clients who are under competitive pressure to review a deal or bring a new client through diligence. With work handled by a large collection of M&A lawyers and law firms on a piecemeal basis, not only are turnaround times slow and inconsistent, but also there are further inconsistencies in terms, negotiating positions and commitments.

Why the industry commitment to such an inefficient and, at times, ineffectual means of legal support? In its most complex form, the answer involves a blinding loyalty to conventional risk-management procedures.

In fact, it is only of late that in-house legal teams and GCs have felt the same downward pressure to control costs as their peer business units. Many have found this component of the job (managing costs) to be directly at odds with what has historically been their ultimate priority and guiding principle: managing risk.

That way of thinking finds its roots in the industry’s obsession with the “who” of delivering legal work, associating quality control with the resume of the lawyer doing the work. Pedigreed lawyers are expensive and so, says this logic, if you have less money, you’re going to get less pedigree and more risk. In that context, if a GC feels that they’re being asked to make a zero-sum trade-off between cost-mitigation and risk-mitigation, they will always choose risk-mitigation.

That’s the complex answer. The simpler, perhaps truer, answer to the industry’s allegiance to contracts management inefficiency is the lack of a clear, more efficient solution.

Changing the “who”, after all, often becomes a slippery slope: “No longer may we use our New York firm for this type of matter. The new rules for outside counsel management say we have to use a regional firm for this or no firm at all. In fact, we have to use contract lawyers for that kind of work. No, wait, actually, we can’t use contract lawyers for this anymore, that task must now be outsourced to India.”

The only reason the relentless march ends with India is that there is currently no one with a lower hourly rate. At least for now.

To find the right answer to address the inherent inefficiency in the system, the banking industry must rephrase the question: In delivering legal work, is it the “who” or the “how” that we should care about?

The good news is that there are a select few banks who are asking “how” and not “who”—and by doing so are finally ending this stalemate between cost and quality. These banks are breaking with historical notions of how we control quality in the first place, focusing on the application of process innovation, the use of technology and the creation of tools that drive standardisation, consistency of risk positions, faster cycle times and increased efficiency. In this paradigm, the same constructs and behaviours that improve risk compliance also reduce cost.

Let’s revisit the in-house legal function with this new paradigm in mind. Standard operating procedures has a haphazard team of senior in-house M&A attorneys diverting their attention from more pressing matters to handle the entirety of the contracts burden. When that burden becomes, well, too burdensome, they outsource it to overly-pedigreed lawyers who do what they do best: bill. The result is a costly solution with inconsistent, often slow and unfavourable results.

Conversely those banks that are shepherding a new process-led approach to legal contracts increasingly are outsourcing the work to a growing but short list of alternative providers. In this scenario, instead of a team of over-qualified lawyers, a team of lawyers around the globe can provide coverage for bankers across all geographies/time zones. The team is led by a lawyer with significant experience and staffed with more junior lawyers with less, but still notable expertise. The aggregate team would have to consist of someone who understands data collection, interviews, high-level workflow design and resource model preparation, who would complement the in-house legal team. The intent is that they operate with only moderate oversight by a senior in-house lawyer, to free up the time of the in-house team.

In this model, incremental efficiencies are driven through consolidation and standardisation, redeploying senior lawyers to focus on high-value, more complex work and eliminating inefficient law firm spend. Perhaps more important, the lower cost solution delivers faster and more consistent response/turnaround times anytime of the day, anywhere in the world and helps bankers turnaround deals more quickly in an increasingly competitive market.

But any good banker will tell you, it’s not about the who, the how, the why, or the what — it’s about the bottom line. By taking a “how” versus “who” approach to contract management, banks can realise up to 30% to 50% savings on the previous process.

Any good banker recognises that in this volatile market, cost savings of that nature — that come without the far too steep price of an increased risk position — are hard, if not near impossible to come by. Any good banker will also tell you that in this market of uniformity, the ability to differentiate by transaction speed is worth its weight in gold… often literally. Any good banker abides by the bottom line. So, what kind of banker are you, sheep or shepherd?