By Roy C. Smith
First quarter results have raised questions again about whether the combination of structural and cyclical factors has ended the long reign of the global investment banks. This seems to be the case for the weakest in the herd, but what about the strongest?
Most analysts agree that the two strongest among the top dozen banks are JP Morgan (JPM) and Goldman Sachs (GS), who ranked 1 and 2 in Dealogic’s 2015 investment banking revenues league table with 15% of all revenues between them. (They ranked 2 and 4, respectively, in 2005.) JPM is a diversified universal bank, with only about 18% of its $93 billion of revenues from investment banking and market operations; GS is the “purest play” in the industry with 81% of its $34 billion in revenues from investment banking fees, sales and trading and principal investing.
Darwin’s idea of the survival of the fittest did not rest on the fittest being the strongest – he claimed that the fittest would be those that adapted best to changes in their environment. The last five years have certainly demonstrated that a lot of environmental change is going on in the investment banking industry that will continue for some time.
As I have expressed many times in previous posts, the effect of these changes has most visibly appeared in returns on equity (ROE) being persistently less than the banks’ cost of equity capital. For the strongest, this differential is now relatively modest, but for the weakest the differential is in double-digit negative percentages. Within the industry, the ability to adapt this ratio into positive territory, more than anything, will determine fitness, and therefore survival.
For some, adaptation may have to be quick and substantial, perhaps dramatic. But JPM and GS have avoided the dramatic for a steady, well-aimed series of small adjustments they hope will work best. The two firms are the only ones in their industry led by long experienced chief executives in place before the 2007-2008 crisis; both CEOs have laid out plans to re-engineer their firms rather than shake them up significantly.
Since 2010, JPM has parsed through its businesses and cut back on those made less profitable by regulatory change, and, accordingly total revenues have declined by 9%. At a time when many of its competitors are engaged in asset sales, layoffs and sharp cost cutting, JPM reduced headcount by only 2%, while increasing risk-weighed assets by 30%. It has also increased its compensation ratio (total compensation costs as a percent of net revenues) from 27% to 32%, and increased its annual technology and communications budget by 32% to a robust $6 billion. Even after these cost increases, JPM’s ratio of pretax operating profits to net revenues has increased by a third to 33% since 2010.
JPM has been aided in its effort, some say, by its experience with the 2012 “London Whale” $6 billion trading mishap, which brought urgent attention to the importance of risk management and accountability for mistakes.
GS had a similar “learning opportunity,” not from a trading loss but from bungled Congressional testimony related to the firm’s pre-crisis trading in mortgage bonds, and a consequent, poisonous “Vampire Squid” article in Rolling Stone that went viral in 2010. These public relations disasters seriously damaged the firm’s public reputation and helped inspire Bernie Sanders’ frequent attacks on the firm during his presidential campaign.
But, behind the scenes, GS has been adapting to its new environment steadily. As the most concentrated pure play in investment banking, it has had a lot of structural change to adjust to, and it has had to deal with cyclical factors more than others – its first quarter earnings per share were down 55% because of adverse market conditions, more than any of its major competitors.
Though GS’ 2015 revenues were 14% less than in 2010, risk-weighted assets increased by 22%, and headcount was up 3%. The firm is known for its profitability and high compensation, but its compensation ratio in 2015 had shrunk to 38%, well below the Wall Street historical norm of 50%. In 2015, however, GS reported ROE of only 7.4%; it was 11.4% in 2010.
GS’s most visible adaptation over the past five years is the reduction of its trading related businesses (Institutional Services, and Lending and Investment) to a combined 61% of net revenues from 75%, and in increasing its global reach. Fees from investment banking and investment management rose to 39% of net revenues from 25%, and more than 50% of the firm’s pre-tax earnings were from non-US sources in 2015.
GS prides itself in having transitioned into an information technology company (25% of its workforce). It relies on new technologies to enable it to “optimize” the firm’s balance sheet, manage risk, cope with all the new compliance and reporting requirements, and to capture the benefits of the on-line banking business it recently acquired from GE Capital.
GS also is proud of its unique, post-partnership culture in which a few hundred “Partner-Managing Directors” are paid based on how the whole firm performs, and another 2,000 or so Managing Directors who are rewarded for being culture carriers and enforcers throughout the various operational units of the firm.
However, for all their success in adapting to the future, both JPM and GS are lagging well behind where they want to be in terms of shareholder returns. Though JPM’s market capitalization is 39% greater now than in 2010, it is still $23 billion less than Wells Fargo’s, which is 30% smaller in terms of assets. JPM now trades at 104% of book value (WFC is at 150%), and in December 2015 had a ROE only 0.10% greater than its cost of equity capital (WFC’s was 5.70% greater).
GS has also done better than most, but not as well as JPM. Its present market capitalization is 20% less than in 2010, its stock price is now 92% of book value and its net return on equity after capital cost was -1.80% in December 2015.
Darwin never said it was easy. Adaptation to radically different environments takes time and is painful and uncertain. But someone has to emerge as the fittest, and capture the benefits of survival. JPM and GS are betting it will be them.