Investment banks have gotten fat off the land since 1982, when the great U.S. bull market got its start. Their business has multiplied many-fold, and their earnings have soared into the stratosphere, to a level far higher than any other sector.

Now, JPMorgan Chase & Co.  (NYSE: JPM) has issued a report suggesting that investment-banking returns on capital will be sharply down over the next few years. Perhaps this will be only a moderate downturn.

However, there’s also a good chance that labor-cost pressures – combined with tightening margins – will take the likes of JPMorgan and Goldman Sachs Group Inc. (NYSE: GS) down a path similar to that of General Motors Corp. (NYSE: GRM) and Chrysler Group LLP, both of which earlier this year declared bankruptcy.

Challenging Headwinds

JPMorgan anticipates that the regulatory changes that are likely to take place over the next year or so will reduce investment banks’ return on equity (ROE) to around 11% – down from its previous forecast of 15%.

More capital will be needed for trading activity, which naturally reduces the return on capital from that activity. However, there will also be effects from new transparency requirements on derivatives. (Most – if not all – derivatives will have to be traded and cleared across central exchanges.) And tighter limits on commodities positions will prevent firms from cornering less-active markets.

This effect will be concentrated on investment banks themselves – firms such as Goldman Sachs and Morgan Stanley (NYSE: MS) – as well as on the investment banking activities of such firms as Credit Suisse Group AG (NYSE: CS), Deutsche Bank AG (NYSE: DB), Citigroup Inc. (NYSE: C), and JPMorgan Chase.

Old-fashioned commercial banking, on the other hand, will likely become somewhat more profitable. That’s because the sharp reduction in securitization activity has reduced the excessive competition for much of the lending business. It’s also improved the lending business profitability.

Investment banks will have to reduce their headcount by another 3% from present levels and cut their overall cost per employee by another 15%, to around $543,000 in 2011, according to the JPMorgan study.

What agony! (Actually, that joke is not quite fair – the cost per employee includes the building, the equipment and all the fancy information services, so the take-home is much less. Even so, these guys – at least those who keep their jobs – won’t starve.)

The New Reality

We are so used to investment banking growing and becoming increasingly more profitable – on virtually an uninterrupted basis – that we have never even considered what might happen if that trend were to reverse.

Even after last year’s crash, Goldman Sachs reported record second quarter profits in 2009. Spreads in all kinds of trading widened dramatically and Goldman found its market share dramatically increased after the demise of Lehman Brothers Holdings Inc. (OTC: LEHMQ).

But here’s the thing: The trillions of dollars poured into the markets by the U.S. Treasury Department and the U.S. Federal Reserve were the driving force behind those profits. Investment banks like Goldman weren’t just given a level playing field – they were given one that was essentially (and artificially) cleared of obstacles. Even the few “competitors” that remained were hobbled by their past mismanagement.

Investment banking is not particularly difficult or intellectually challenging. And the proliferation of new and complex products that turbocharged the profit growth of investment banks during the past few decades won’t continue. Any new financial product will be forced to run a gauntlet of regulatory bureaucrats before being allowed to emerge.

Had the credit-default swap (CDS) been invented today, can anyone doubt that it would have been fenced in by restrictions so onerous that the damaging derivative would have never made it to market? The painful memories of last year’s near-unraveling of the global financial markets are still fresh. So it’s unlikely that investment banks would be able to get the regulatory nod for a big-risk strategy that is likely to result in a taxpayer bailout.

The bottom line is clear: The reduction in U.S. investment banking profitability is likely to be permanent, with various rent-seeking scams blocked. In this post-crisis era, investment pools from China, the Middle East and other parts of Asia – backed by increasingly sophisticated financial players in those markets – will acquire the necessary capabilities to enter the market and further reduce the returns of domestic investment banks.

We have seen this before: An industry, previously very profitable, finds itself hemmed in by government restrictions and its most-profitable products get regulated out of existence. Foreign competition enters the market and grinds away at the domestic market share.

The natural reduction of competitors doesn’t happen, as one or more are bailed out by taxpayers and survive to continue competing for the business.  Legacy costs of remuneration promises made when things were better place an ever-increasing burden on the industry’s returns. Reducing the work force pay becomes very difficult, as the workers have great power over production and resist the necessary downsizing of their excessive pay.

Sound familiar? Last time, it was the U.S. auto industry, and the eventual result was the bankruptcy of GM and Chrysler. Reducing pay to a work force when market conditions become harsh is extremely difficult, if now downright impossible.

Of course, investment bankers have no United Automobile Workers (UAW) representing them. But shareholders will know from past experience that the investment-banking work force’s ability to suck up available profits is huge, whereas losses suddenly devolve back on shareholders.

Don’t forget, militant autoworkers could only beat up “scabs” when their livelihood was threatened. Militant traders could re-jig the computer systems so that the trading algorithms worked backwards, producing losses instead of profits. In an era of credit default swaps and millisecond trading, this could wipe out shareholders in half an hour of frantic activity before anyone realized what had gone wrong in an era of credit default swaps and millisecond trading.

It may take a couple of decades for the investment banking business to decline, as it did for the much larger U.S. auto industry. But by 2030, collapse could loom.

The comparison isn’t a stretch. In fact, it wasn’t just a ticker-symbol letter – “G” – that  the two companies shared: GS for Goldman Sachs, and GM when General Motors was still a public company. It turns out that their underlying business models also shared similar strategic flaws. And those flaws put the two on a similar path to ruin at the hands of forces that grew out of the crises in their particular industries – crises that they each helped create.

Source: Could Goldman Sachs Share GM’s Fate?