The Bi-Polar World of Capital Market Banks.

By Brad Hintz and Roy C. Smith

(An edited version appeared in eFinancial News on March 23, 2015) 

Seven years after the crisis, 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, those institutions committed to strategies which are likely to succeed in a permanently changed world, and laggards, those firms that have lost their way, captive to an uncertain environment and unable to embrace the surgery needed to improve performance.

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 Jamie Dimon’s “fortress balance sheet” 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.

Struggling Against the Tide

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 return on equity was an alarming 570 basis points below their cost of equity. Seven of the largest banks had stock prices trading below book value.

Exhibit 1 – Financial Performance of the Largest Capital Markets Banks

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 compensation, delayed promotion cycles, and reduced the percentage of highly paid managing directors 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. New technology has been rolled out to provide traders with new risk management and trade pricing tools. Support functions have been outsourced and businesses automated. Teams of consultants have been employed to optimize inventories and control capital.

Even so, as the banks have attempted to improve, the rules guiding their businesses have continued to change. The US 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-globalization has placed pressure on overseas operations.

Essentially, the banks have faced ever-moving regulatory goal posts 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 December, the US Federal Reserve proposed new rules that would require the largest US banks to add a further capital cushion of 1.0% to 4.5% of risk-weighted assets 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 harbor of common strategies with similar asset mixes and risk management techniques in order to restructure the industry as public utilities.  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.”

It is not surprising that increasingly skeptical investors are at last questioning the universal bank model.

Stale Strategic Responses

In light 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 favorably by regulators (traditional retail banking, asset management and wealth management). But these plans have disappointed investors. Indeed, to investors much of the industry seems trapped in an autopilot mode, rolling out stale plans that represent only a pruning around the edges of a legacy business model and unwilling to abandon their hard won global footprints and capital markets franchises.

The Survivors

For the two capital markets leaders, Goldman Sachs and JP Morgan Chase, 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 targeted markets during 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 cost of equity, these firms have the capacity and the time to pursue this strategy. 

UBS and Morgan Stanley 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 minimizing capital markets activities and emphasizing high net worth clients. At Morgan Stanley, the acquisition of Smith Barney from Citigroup caused its wealth management business to become half of total revenues. In 2014, these two generated an average ROE above 6% (still 500 basis points below their cost of equity), but the market has rewarded their strategy shifts by valuing them above book value.

Exhibit 2 - 2014 Market Share – Leading Capital Markets Banks by Transaction Originations 

The Laggards

The laggards, Deutsche Bank, Bank of America, Citigroup, and Barclays, 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 attempting 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 “noncore” 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.

Deutsche continues to emphasize the power of an its underwriting and trading business which clearly is in the crosshairs of regulators. Barclays’ 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.  Bank of America and Citigroup appear to be frozen in a state of strategic inertia, reacting to new regulation while hoping for 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.  Bank of America’s capital markets market share rose to 2nd place in 2014 (Merrill Lynch was 8th in 2007), Citigroup’s is now 3rd (it was 1st in 2007), Barclays’ is 4th (Lehman was 9th in 2007), and Deutsche Bank, 6th place (the same as 2007). However, in 2014, these banks booked an average ROE of less than 2% or nine hundred basis points below their cost of equity and trade at an average price book of less than .70.

Credit Suisse is in the most difficult strategic position of the lagging banks.  The new Swiss capital rules have negatively impacted the trading ROE of Credit Suisse, but it is difficult for this bank to radically shrink its capital markets businesses due to its business mix. Under Brady Duggan, 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.

New Disciplined Competition

Two new banks, Wells Fargo and HSBC, have entered the list of the top originators for the first time. Neither bank has been previously associated with high performance investment banking or trading, historically preferring to stick to a retail banking dominant strategy. However, these two banks have opportunistically expanded into targeted and profitable areas of the capital markets. These firms appear to be pursuing a “market share at a reasonable ROE” strategy in capital markets. Wells Fargo, the world’s largest bank by market capitalization (yet with $1 trillion fewer assets than JP Morgan), generated a positive spread over the cost of capital of 570 basis points and price-to-book of 1.70 in 2014. Wells Fargo 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 Such Inertia Among the Universal Banks?

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 favorable. 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% to 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, which are constraining banks’ business operations, not the nominal capital level itself. As the capital rules become certain, annual stress tests become more predictable and the rules-making process ends, the largest banks should be able to roll 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.

The Market is No Longer Patiently Waiting

For leaders Goldman Sachs and JP Morgan Chase and for Morgan Stanley 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 reprice.

The bottom half of the return rankings, however, include five large universal banks that have large investment banking operations that are depressing their returns on equity. These banks have unsustainable returns of 8.0% or less than their cost of equity, and trade at price-to-book ratios ranging from 0.54 to 0.81. These banks cannot afford to retain capital market franchises that are destroying shareholder value. They no longer have the option of waiting.

Where Are the Activists?

We have expected the laggards to eventually recognize reality 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 Bank (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 Deutsche Bank. This option would require incorporating its investment bank into a separate corporation in London or New York, providing it with sufficient financial support to be able to obtain Baa credit ratings, and distributing the stock to the banks’ shareholders.  Such an endeavor might include third party investments to shore up the capital position and provide credit lines. Such an endeavor 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 nonbank, 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 book value) and return capital to the parent company (trading at well less than book value) for distribution to shareholders. By reducing the size of trading activities, the returns on the remaining business should rise.

We believe that 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 price-to-book ratio of a Wells Fargo. 

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 we have. But for this to happen, it is time for the weakest banks to resize and adjust to the changed economics of the business.