Tuesday, February 9, 2016

Barriers to Entry on Wall Street

By Roy C. Smith

It is now suggested that barriers to entry in global investment banking are so high as to create a powerful oligopoly – don’t be so sure.

A recent editorial in the WSJ suggested that Hillary Clinton, who was paid an inflated $675,000 for a speaking engagement by Goldman Sachs, invoked a silent quid-pro-quo in which she would say she would be tough on the banks, but in reality would protect the industry.  Wall Street must believe it because Ms. Clinton’s campaign has received more contributions from the financial services industry than any other candidate’s has.

The editorial went on to float the idea that Wall Street has benefitted by Dodd Frank, Basel III and all the other increased regulation of systemically important financial institutions, because they have raised the barriers to entry to the global investment banking business, leaving those that were well entrenched (like Goldman Sachs) safely within an oligopoly.

Indeed, Goldman Sachs’s CEO, Lloyd Blankfein, was quoted as saying last year that the “intense regulatory and technology requirements” have made  “this is an expensive business to be in if you don’t have the market share in scale.”

This may be true, but the value of being a member of the oligopoly was certainly not so clear as of the end of 2015.

All of the oligarchs reported earnings significantly diminished by heavy litigation costs, layoffs and cost-cutting measures and by sizeable write-offs of goodwill from earlier acquisitions to build market share in scale.

Despite a record year in mergers, 2015 was by no means a good year for the oligopoly. Global securities market new issues totaled $6.9 trillion, down from $7.5 trillion in 2014, but a third less than the record $10.2 trillion raised in 2006.  Securities issues were 58% of total capital raised (including from syndicated bank loans) in 2015, as compared to 69% in 2006.

Further, the market shares attributed to the top ten lead-managers of combined global debt, equity, syndicated loans and M&A transactions dropped to 66% in 2015 from 94% in 2006.  The top five represented 41% of the market in 2015, but 57% in 2006.

Market shares have also been pared by competition from non-oligopic banks and by specialized nonbanks, such as the dozen of so boutique investment banks (about half of which are less than ten years old). Lazard Frères, the largest such boutique, ranked 11th in the combined 2015 lead-manager league tables, despite being active only in M&A. Three other similarly focused boutiques ranked among the top twenty originators for the first time in 2015.

The oligarchs’ market shares in trading, derivatives, hedge funds, private equity and venture capital, all of which contributed significantly to their profits in the past, also have been reduced by regulatory changes that limit the ability of major banks to compete in these areas.

More important than market shares, the intense pressure on profits from greatly increased capital and liquidity requirements, much reduced leverage, and an endless wave of litigation seeking settlements for sins for the crisis period, complete the picture of life today among the oligarchs. 

In the political arena, oddly, most of the leading candidates from both sides want to break up the banks. The popular perception continues to be that big banks that wrongly were bailed out during the crisis are still too powerful and dangerous. The reality, however, is that they all have been forced to drink from a poisoned chalice and only the strongest, and most adaptable can be expected to survive.

All of the European investment banks have undergone major management changes to affect these adaptations. UBS has done the most to shrink its investment bank (and its market share has shrunk accordingly); the others have promised something similar, but have not yet done enough to convince their long suffering investors that they are truly turning things around.

The American oligarchs appear to be relying on a strategy of “optimizing” their balance sheets.  This is a complex re-engineering task that forces all the different business units to justify the capital allocated to them. So far, this is proving more difficult to do than they thought – many of the variables involved in such an effort, are themselves variable, and vary differently over changing market conditions that are hard to predict.  And the regulatory constrains to be optimized are very tight.

Despite several years of such effort, it is starting to become clear that optimizing will not work, at least not for Bank of America, Citigroup or Morgan Stanley. Even if they could balance things out optimally, the resulting return on equity is still too low to cover their ongoing cost of equity capital.  The market already knows this, even if the boards of these banks do not.  Like the Europeans, they will have to adopt more radical changes to get to where they need to be.

The changes, by the way, cannot come from scaling up market shares through mergers – as was done over the past twenty years. Investors know they don’t work well, and because, under Dodd Frank, regulators would probably deny most large bank mergers.

The changes will have to come from the banks breaking themselves up – so Bernie Sanders or Ted Cruz or their EU equivalents won’t have to.

For the supreme oligarchs, JP Morgan and Goldman Sachs, which are already very focused on capital markets, it may be possible to achieve optimization through management improvements and major upgrades in technology, but the market remains skeptical, even of them. They, however, can hope that the other oligarchs will quietly fold their tents and slip away, leaving the battlefield to them when market volumes return to what they once were.

It is true that the regulatory climate has left the capital markets industry surrounded by near impossible barriers to entry – that is, barriers to entering the business as it was. The barriers protect the survivors, but have also changed the survivors’ former business into one that no one can live with.

Aversion of this article appeared in eFinancial News on March 9, 2016.


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