Weight of reforms forces banks to pick their battles (FN)
By Roy C Smith and Brad Hintz
Seven years after the GFC, global capital market banks have largely achieved compliance with tough new capital standards. However, the economic damage to their businesses in doing so has divided the industry into survivors, committed to strategies that are likely to succeed in a permanently changed world, and laggards that have lost their way. The banks have been forced to double the amount of capital held in reserves, cut leverage by half and adapt to a regime of stress tests, living wills, “systemic risk profiles”, new “capital cushions” and liquidity reserves. All of these measures have pleased the banks’ bondholders, who are happy to see the “fortress balance sheet” boasted of at JPM by CEO Jamie Dimon become an industry standard. However, the cost of this achievement has been a form of death by a thousand cuts for equity holders and a division of the industry into survivors and those banks whose strategies are floundering. The survivors will eventually be able to use their market share, changing business mix and pricing power to deliver satisfactory returns but the laggards, with ROEs well below their capital costs since the crisis, need to soon rethink their futures.
In 2014, continuing a pattern of the past six years, only two of the top originators of capital market transactions earned more than their cost of equity capital. The average ROE was an alarming 570bps below their COE. Seven of the largest banks had stock prices trading below BV. These results have occurred despite efforts by the pre-crisis leaders to cut costs and re-engineer operations. As a group, the banks have cut back average comp, delayed promotion cycles and reduced the percentage of highly paid MDs on their trading floors. The composition of balance sheets has changed; matched repo books have declined and credit inventories have fallen, while government security holdings have increased. Even so, as the banks have attempted to improve, the rules guiding their businesses have continued to change. The Volcker Rule has reduced earnings from market making. The OTC derivatives businesses have begun shifting to central clearing platforms, generating lower operating margins. The banks’ once-profitable commodities businesses are being discontinued due to regulatory guidance, and de-globalisation has placed pressure on overseas operations.
Piling on the burden – Essentially, the banks have faced ever-moving regulatory goalposts on both sides of the Atlantic. Capital targets have been set, additional capital cushions added and then added to again. Tight leverage limits have been imposed. In Dec, the Fed proposed new rules that would require the largest US banks to add a further capital cushion of 1.0-4.5% of RWAs beginning in 2016. The Basel Committee has proposed limiting “internal risk transfers” and Swiss authorities will further increase banks’ capital reserves to boost their “resilience”. Regulators appear to be attempting to move the largest banks into a narrowly defined, safe harbour of common strategies with similar asset mixes and risk management techniques in order to restructure the industry as public utilities. Fed chair Janet Yellen recently noted that capital charges are leading the largest banks to consider spinning off some operations. She added: “That’s exactly what we want to see happen.” In the light of the above pressures, the capital market banks have outlined their strategic visions in an attempt to regain investor confidence. With few exceptions, the banks have not announced radical revamps. Rather, their plans have been (a) simple rebalancing of their business units to limit the performance drag of capital-intensive trading or commercial lending businesses while (b) expanding the contribution of business segments viewed favourably by regulators (traditional retail banking, AM and wealth management). But these plans have disappointed investors. Indeed, to investors much of the industry seems trapped on autopilot, rolling out stale plans that represent only a pruning around the edges of a legacy business model.
The strongmen – For the two capital markets leaders, GS and JPM, having cut expenses and improved capital allocations, a simple steady course strategy may work well enough. Their commanding positions in high-margin business lines such as ECM and M&A and their global positioning and distribution strength should allow them to increase their share of target markets in this time of industry transition. Essentially, these two firms are pursuing a “last man standing” strategy, positioning themselves to win a battle of attrition with weaker competitors. Given an average ROE performance of 10.6%, very near their COE, these firms have the capacity and the time to pursue this strategy. UBS and MS are two potential survivors that have refused to remain captive to the current environment; they have announced intentions to reduce their reliance on the troubled trading businesses and materially shift their business mix. At UBS, this shift will happen by minimising capital markets activities and emphasising HNW clients. At MS, the acquisition of Smith Barney from Citi caused its wealth management business to become half of total revenues. In 2014, these two generated an average ROE above 6% (still 500bps below their COE) but the market has rewarded their strategy shifts by valuing them above BV.
Strugglers and intruders – The laggards – DB, BAC, Citi & BARC – state that they remain committed to traditional bank strategies of cross-selling underwriting and advisory, cash management, processing and lending services. At the same time, they are trying to limit the capital intensity of underperforming trading units and promising to grow other lower risk or higher return businesses. All of these banks have designated substantial “non-core” businesses they hope to shed but, despite their disappointing return numbers, they have clung to capital markets businesses, dominated by fixed income franchises, whose capital intensity limits performance. DB continues to emphasise the power of its underwriting and trading business, which clearly is in the crosshairs of regulators. BARC’s management has revised strategy several times as UK regulatory winds have changed but remains tied to an overly large capital markets balance sheet while promising improving returns from credit cards and its international franchise. BAC and Citi appear to be frozen in a state of strategic inertia, reacting to new regulation while hoping that the long-delayed cyclical recovery of their core businesses will eventually boost returns.
All of these firms remain powerful fixed income houses despite the economic pressure to resize this business. BAC’s market share of GCM rose to #2 in 2014 (ML was 8th in 2007), Citi is now 3rd (it was 1st in 2007), BARC is 4th (Lehman was 9th in 2007) and DB, 6th place (the same as 2007). However, in 2014, these banks booked an average ROE of less than 2%, 900bps below their COE, and trade at an average PBR of less than 0.7X. CS is in the most difficult strategic position of the lagging banks. The new Swiss capital rules have negatively affected the trading ROE of CS but it is difficult for this bank to shrink its capital markets businesses radically, because of its business mix. Under Brady Dougan, management has pursued only modest restructuring. This activity has not persuaded investors, as the bank’s stock has lagged. Perhaps the incoming CEO, Tidjane Thiam, a former management consultant with a neutral view of the firm’s strategy, will be more inclined to consider other possibilities.
There are two recent intruders into the list of the top originators – WFC and HSBC. Neither bank has previously been associated with high performance IB or trading, historically preferring to stick to a strategy dominated by retail banking. However, these two banks have opportunistically expanded into selected and profitable areas of the capital markets. These firms appear to be pursuing a “market share at a reasonable ROE” strategy in capital markets. WFC, the world’s largest bank by market cap (yet with $1trn fewer assets than JPM), generated a positive spread over the COE of 570bps and a PBR of 1.70X in 2014. WFC ranked 23rd in terms of market share in 2007, now (after its acquisition of Wachovia Bank) it is 10th. HSBC went from 16th to 9th.
Why keep struggling? If rule changes are making it harder to generate returns above the cost of capital and, if new regulatory initiatives are likely to continue to depress financial performance in the future, why are the industry laggards still clinging to the universal banking model? There are three primary reasons: first, despite all the challenges, the outlook for the industry is favourable. Global financial assets tend to be the driver of a large portion of bank revenues. Using the IMF forecast of global GDP as a driver, a growth rate for capital markets revenue of 4-6% can be expected over the next five years. In banking, this is a very attractive growth rate. Second, there is a strong belief among bank managements that the industry is in a period of transition that cannot continue indefinitely. Ever higher capital charges and operating limitations are being successfully met by resizing businesses and retaining capital. The end result of these efforts is a constraint on credit capacity and inventory levels at the largest banks. With dominant market shares and few new entrants in the market, the financial performance of the largest banks should therefore rebound as their cost of capital declines to reflect their stronger financial positions and as pricing adjusts to reflect the cost of new regulations. Third, bank managements assume that it is the continuing uncertainty of regulatory rule changes that is constraining banks’ business operations, not the nominal capital level itself. As the capital rules become certain, annual stress tests become more predictable and the rule-making process ends, the largest banks should be able to conform to regulatory provisions but deliver adequate returns.
Regulatory stability will allow the leading banks to use their global customer relationships and their technology to fine-tune business models and deliver improving returns. For leaders GS and JPM and for MS and UBS, banks that have made the necessary changes to shift their business mix toward less volatile businesses, the above reasoning is realistic. They will be survivors as markets adjust and re-price. The bottom half of the return rankings, however, includes five large universal banks that have large investment banking operations that are depressing their returns on equity. These banks have unsustainable returns of 8% or less than their COE, and trade at PBRs ranging from 0.54-0.81X. These banks cannot afford to retain capital market franchises that are destroying shareholder value. They no longer have the option of waiting. We have expected the laggards to recognise reality eventually and initiate major strategic changes. However, despite increasing evidence that they cannot return to what was normal in 2007 from where they are now, no strategic shifts have occurred to date. Further, it is surprising that activist shareholders have not jumped in. Activist shareholders successfully directed underperforming Chase Manhattan (1995) and Union Bank of Switzerland (1998) into mergers with smaller, better managed institutions. But systemically important banks cannot easily be acquired. There are two options available: a spin-off or a sharp resizing (or liquidation) of the underperforming businesses. We believe that these banks should investigate both of these options and pursue the one that promises to return the most to their shareholders. We recently proposed the spin-off option for DB. This option would require incorporating its IB into a separate corporation in LON or NYC, providing it with sufficient financial support to be able to obtain Baa credit ratings, and distributing the stock to the banks’ shareholders. Such an endeavour might include third party investments to shore up the capital position and provide credit lines.
A spin-off would allow the new entity to become (at least initially) a non-systemic non-bank, which would give it more operational freedom. Also, it would re-establish a partnership culture that has successfully attracted talent and capital to firms in the past, and a spin-off would avoid the operating limitations and bureaucracy associated with being part of a large universal bank. Alternatively, these banks could simply liquidate their trading inventories over time (at BV) and return capital to the parent company (trading at well below BV) for distribution to shareholders. By reducing the size of trading activities, the returns on the remaining business should rise. Dramatic actions of this kind could benefit shareholders and force the banks to be more retail-centric, better managed, surprise-free and regulatory-friendly enterprises that could aspire to approach the returns and PBR of a WFC. Robust capital markets are essential to economic growth and recovery. We need to have all of the top players operating on all cylinders to make the most of the capital markets. But for this to happen, it is time for the weakest banks to resize and adjust to the changed economics of the business.