The Future Belongs to Smaller Players

By Roy C. Smith

18 years ago when Financial News first appeared, the market capitalization of all the stocks and bonds in the world, according to McKinsey, was about $80 trillion, or two and a half times world GDP, and there was a lot to write about.

The financial world had just entered an exciting, dynamic and optimistic decade, sweet-dreaming of deregulation, global integration of capital and merger markets, transformational new technologies, easy money and, most of all, a new powerful financial vehicle to capitalize on it all – the global universal bank with a big balance sheet and a kick-ass “flow-trading” business model.

By the end of FN’s first decade, global market capitalization had exceeded $200 trillion, almost three and a half times world GDP. 

The dreams had all came true. Big banks repeatedly merged with each other to form the $2 trillion behemoths they are now, they leveraged their equity 30 times, provided all the “liquidity” any client could ever want, bet on markets themselves, paid out big bonuses, and believed it all was because they were so smart.

In FN’s second decade, there was just as much to write about but it was much less pleasant as the financial world experienced and adapted to the great Financial Crisis. Mostly, FN was reporting on the industry’s recurring nightmares of forced deleveraging, re-regulation, write-offs, layoffs and litigation.

In the aftermath of the Crisis, much of what was done in the sweet-dreaming years was undone.

Big balance sheet business models are being dissolved. Dynamic flow trading is just a memory. And much of the profitable business of the global giants has migrated, along with much of their talent, to hedge funds, boutiques, private equity and other locations within the non-systemic “shadow banking “world.

Over the next 18 years, this long unwinding dynamic will have fully played out.  Banks will have a new role model: Wells Fargo, today’s most valuable bank with a market capitalization of $260 billion from a growing and profitable national commercial and retail banking franchise that pays out more than half of its earnings to shareholders. They could make a worse choice.

Still, the banks will keep their hands in the capital markets, they being the principle link between clients and markets. They will lend, underwrite and advise, as they do now, but they will distribute most of what they originate to the countless investing entities of the shadow-banking world, which will become the real source of credit and liquidity.

What will be left of bank trading will be done electronically, with better markets and lower costs.

What will be new will be deeper dive that banks take into finding better ways to securitize mortgages, restructure government debt and organize privatizations in the many places where this is needed, provide finance for trillions of dollars of infrastructure investment, and help pension funds around the world realign their portfolios.

18 years from now, markets could easily be capitalized at $500 trillion. No better alternative to market economics has yet been found, so the markets will continue to grow. But the key players in it, as they always have, will change. Big, systemically important banks will have their role to play, but a universe of smaller, less-regulated, non-systemic, non-banks will be the source of much of the innovation and energy that sustains the markets.

They will coexist and supplement each other, just as they did fifty years ago.

From eFinancial News, May 19, 2014

Barclay's Epiphany is Long Overdue

Roy C. Smith

The market warmly welcomed Barclays’ announcement on May 8th that it was going to slash the headcount and risk-weighted assets of its investment bank. Its stock price rose 7% on the news.  

It was about time. Barclays’ 2009 acquisition of the US business of Lehman Brothers proved to be a bridge-to-far that destroyed shareholder value and left the bank with an unstable business model.

Barclays ranked 5th on a 2013 list of global capital market leaders by origination of transactions. But membership in this elite group proved to be very expensive for Barclays, whose commitment to capital markets after the Lehman acquisition was too much for it to manage, and too heavily dependent on fixed income, currencies and commodities.

Its decision to back down from investment banking will mean that it will probably disappear from the top ten list and there will no longer be any UK owned bank among the market leaders, even though the market is still centered in London.

Of course, Barclays, like all its global banking peers, never expected the investment banking business to be so difficult over such a long period – five years -- nor did it fully appreciate the extent of the aggregate regulatory burden that would be imposed on it, or the costs of legal settlements and reputation damage that it would incur.

These factors have largely destroyed the economic viability of the global capital market business model. Since 2009, the leading banks, on average, have failed to earn their cost of capital, with eight or nine of the top ten banks each year generating negative EVA (economic valued added, or ROI less the cost of equity capital).

A Need to Change Strategies

For the past few years it has been fairly obvious that the global investment banks would have to change their business models significantly to adjust to the times.

Citigroup and Morgan Stanley were the first to act with the sale of Citi’s Smith Barney retail brokerage business to Morgan Stanley. Though mainly a downsizing act for Citigroup, which left its large investment banking unit intact, it reflected a major strategy change for Morgan Stanley, which diluted its investment banking exposure by the addition of one of the world’s largest retail businesses.

Morgan Stanley’s revised strategy has still not produced a positive EVA, but over the past two years its stock price has risen 125%, more than any of its US investment banking competitors.

The next to move were Credit Suisse and UBS, both of which announced a Barclay’s like downsizing of investment banking a year ago. While UBS dropped in the global investment banking league tables to 9^th position in 2013 (and may drop out of the top ten in the future), its stock price outperformed its European peers in the last year. Both banks, however, are still posting negative EVA.

Frozen in Place

But several of the global investment banks, though maintaining market share, were well out of favor. The stocks of Barclays, Citigroup, Bank of America, and Deutsche Bank traded at an average of 72% of book on March 31, 2014 and their average EVA was minus 7.8%. These banks have focused on cost cutting and eliminating non-core businesses, but have not moved to reduce their dependence on investment banking, which amounts to about half their profits. To them, the investment banking units are too important to dismantle; to investors these banks seem locked into a business model that is neither working, not viable.

Barclay’s actions seek to break the ice and return it to “normal,” which will mean concentrating on UK retail and commercial banking. 

Deutsche Bank, trading at a miserable 59% of book value and -5.2% EVA, needs to do something dramatic to free itself – possibly spinning off its London based investment bank to the bank’s shareholders.

For Citigroup and Bank of America, however, “normal” is increasing beginning to look like Wells Fargo, a growing and profitable basic-banking franchise in the US.

The New Normal Bank

Wells Fargo, with a market capitalization of $259 billion at March 31, 2014, is the world’s most valuable bank. It trades at 1.7 times book value and has an EVA of +4.4%. It finances 71% of its balance sheet (which is almost a trillion dollars smaller than JP Morgan’s) with deposits, and pays out 55% of profits in dividends and stock repurchases. Citi and Bank of America (after its reset) payout only about 1%.

Wells Fargo increased its syndicated lending activity in 2013, and landed in 10^th place in the capital market origination table for the first time with only 13% of its revenues from investment banking sources.  Its share may rise further as other banks follow Barclays, UBS and Credit Suisse out of the market.

Citi’s and Bank of America’s shareholders ought to be asking “why can’t we be normal like that?”