Wednesday, November 11, 2015

Building the European Champion

By Brad Hintz and Roy C. Smith

Barclays, Deutsche Bank and Credit Suisse have all announced plans to cut back capital market activity under new CEOs brought in to revise the business models.  What to do with the investment banking remnants is the difficult part, but an imaginative solution is available.

The three European universal banks have used investment banking as a way to supplement slow growing domestic banking and subscale asset management businesses. Over many years, going back to Big Bang, they have poured their dreams and capital into acquisitions of businesses and talent that they hoped would enable them to occupy the high ground of global capital markets, only to encounter wave after wave of pain and suffering. Finally they appear to be bowing to the inevitable – cutting back investment banking to the bare minimum needed to sustain and protect their basic banking businesses, and, one way or another, jettisoning the rest.  
What makes this difficult to do is that investment banking represents 20-40% of these banks net revenue, and over half of their balance sheet. What makes it good to do is that at least 70% of their troubles come from this culturally alien business that they have all had to engage mostly American hired guns to manage. 

The lost income and the prestige will be missed, but the impaired balance sheets and the debilitating exposure to regulatory constraints and litigation will not. Getting rid of the troublesome investment banks leaves the parents with much diminished scale and more limited aspirations, but the rebooted banks would be able to concentrate on their commercial and retail businesses and have a chance to improve their stock prices considerably, as UBS has done, while greatly easing the minds of their regulators.

But transitioning out of investment banking is not easy. A simple solution might be to transfer some portion of the unwanted assets to the non-core pile and liquidate them over time. Doing this might release required capital of 10% or so held against risk-weighted-assets (RWA), but the liquidation itself is likely to require haircuts that would consume most of it.

We looked into Barclays Chairman John McFarlane’s suggestion that a “European champion” capable of competing with the Americans might be put together from among the parts of the European players.  We studied a combination of Barclays Capital and Deutsche Bank’s investment bank, two of the strongest, to test the feasibility of the idea. 

In terms of market share, the idea is compelling. With over $28 billion in revenues this new European champion would command a number two market share in fixed income trading, number three in institutional equity trading, and in investment banking it would hold the leading market share in both debt and equity underwriting and would be number two behind Goldman Sachs in mergers and acquisition advisory. Even if one were to assume a 10% client defection this new combination would remain a top three investment bank with powerful positions in Europe, the USA and Asia.

The regulatory capital position of the new entity looks reasonable with an equity capital to RWA ratio of 12.9% compared to a 13% ratio for the Goldman units. On a pro forma basis the new entity would generate an 8.2% ROE in 2014 versus Goldman Sachs estimated ROE of 9.4% in its investment banking and trading businesses. This performance remains below the cost of capital for a standalone investment bank but the potential for some merger synergies, balance sheet rationalization and a shift in the mix of the product portfolio makes a 10% ROE a reasonable near-term goal.

But there were some problems.  The combined balance sheet of the new firm is 50% larger than Goldman’s balance sheet due to the new firm’s heavy reliance on fixed income sales and trading and therefore the pro forma leverage ratio is too high. It's RWA to asset ratio also is suspiciously low which may imply challenging regulatory discussions in the future.  All this will require further surgery and adjusting to shrink the trading units to a more reasonable size with a balance sheet able to secure a BBB debt rating.

For such a combination to work it will require new some new entrepreneurial energy, capital and resourcefulness beyond what’s available at the parent banks. This could be obtained by pairing up with one or more private equity investors to build a new, viable business outside the EU banking regulatory regime, though the firm most likely would be considered a SIFI and subject to Basel and some other rules. The new investors would assemble a high-grade, well-incentivized management team from the best in the business that would pull together such other assets and talents it needed.

The new firm could be funded in part by offering cash, some debt, Buffett-like preferred stock, or equity to banks selling the RWA, and by selling LP interests to institutional and other investors. Ultimately the new firm would present itself as an independent privately owned investment bank, with managers and employees owning significant stakes. It would hope to have an advantage over the banks in attracting both top talent and capital.

Such a solution is complicated, but doable. The large discounts from book value at which Barclays and Deutsche Bank stocks currently trade leave room for negotiations that incentivize new investors and still recover shareholder value for the banks.

Barclays has selected Jes Staley, an American investment banker, to become its next CEO. Although this suggested to some that Barclays was committed to retaining its commitment to investment banking, a different message seems more likely. As McFarlane surely knows, and Staley will soon find out, the future of Barclays Capital after ringfencing in 2019 is bleak. The two thus will be forced to look for alternatives to simply continuing as before. What exactly they or the other banks will do we will have to wait to see, but Barclay’s choice for its next CEO, with long experience in asset management, and more recently with hedge funds, understands the private equity terrain very well and would know how to explore a solution from that direction.

 eFinancial News, 9 Nov. 2015

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