Finance: A sparser future
By Francesco Guerrera, Justin Baer and Patrick Jenkins
Published: December 19 2010 18:43
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| The new Manhattan headquarters of Goldman Sachs. Legislation now bans banks from the type of proprietary investments that used to bring in up to 10 per cent of profits |
If the financial crisis and the fierce regulatory backlash that it sparked are sounding the death knell for Wall Street’s old ways, it is not a sound being heard inside Nomura’s New York headquarters.
In a skyscraper that once housed Merrill Lynch, some 2,000 traders, bankers and support staff – many of them recent hires – are striving to add a Japanese name to the “bulge bracket” club of US and European investment banks.
Taking place just steps away from another, more poignant, rebirth – the Freedom Tower that will replace the World Trade Center destroyed in the September 2001 terrorist attacks – the Nomura build-up is a sign of the financial sector’s phoenix-like ability to rebound from periodic downfalls. When firms fail, such as Lehman Brothers, or are acquired, as Merrill was by Bank of America, others take their place, in a Darwinian process that keeps the industry alive and the wheels of commerce turning.
Yet even seen from the ground zero of relative newcomers like Nomura, the investment banking landscape that emerged from the most devastating financial turmoil in generations looks dramatically different from the one that preceded it.
Tough new rules, coupled with tightened regulatory scrutiny and increased mistrust on the part of investors, are driving radical changes in business models and behaviour.
The masters of the financial universe are scrambling to find new ways of making money against a regulatory and economic backdrop that prevents them from placing the high-risk, high-reward bets of years gone by.
Some banks, including Credit Suisse, UBS and Morgan Stanley, are hoping their wealth management and asset management arms will deliver the steady stream of profits the industry has sorely lacked in previous cycles. The “universal banks”, among them BofA, JPMorgan Chase, Citigroup and Deutsche Bank, point to their retail and commercial lending operations as counterweights to the vagaries of their securities businesses.
Goldman Sachs, for its part, has defiantly rebuffed suggestions that its model is broken, counting on its trading prowess and penchant for savvy strategic moves to weather the storm. Yet all of them face the problem highlighted by Colm Kelleher, who was Morgan Stanley’s finance chief during its near-death experience in 2008 and is now charged with rebuilding its troubled trading unit: “The fundamental question facing the industry after the crisis is: can you reach an end state in which you can have a profitability profile that covers your funding costs and is acceptable to investors throughout the cycle?”
At present, the markets doubt that.
In spite of a near-miraculous profit recovery, largely due to the cheap money pumped into the system by central banks in recent years, the capitalisations of US and European lenders are hovering around their “book” or liquidation value – the money the institutions would fetch if all their assets, from trading screens to pens, were sold off in a giant auction.
This stunning sign that investors believe some banks are worth more dead than alive is almost unprecedented: aside from the dark days of the crisis, banks have traded at an average of more than twice their book value for the past decade.
The market’s chief concern is summed up in three words that are haunting many a banking chief: return on equity.
ROE is the industry’s key profitability yardstick, measuring how much profit a company can wring out from the funds received from shareholders. The huge losses suffered by banks during the crisis and the inevitable raft of regulations aimed at making the system safer are calling into question future ROEs.
With the once lucrative securitisation markets all but gone and new limits on the amount of debt the banks can use to turbocharge profits, there is a real possibility that the oversized profits and sumptuous pay packages of the pre-crisis boom will be seen as an aberration. “The best-run banks will be able to generate a ROE of maybe 13 per cent, compared with 20-25 per cent historically,” predicts Bill Winters, a former co-head of JPMorgan’s investment bank who sits on a UK government-appointed commission looking at the industry’s structure and whether big banks should be broken up. “There will be a middle tier on 9, 10, 11 per cent and then the weakest ones below that.”
At that level, slightly higher than what utilities and other “boring” stocks yield, financial groups will have to lure investors with the twin promise that they are both best in class and much less likely to implode every decade or so.
Banking chiefs say they will pull three levers to achieve that objective: overhaul their trading operations, change geographical mix towards emerging markets, and reduce pay and staff levels.
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For a decade, trading, especially in the debt markets, was investment banks’ main profit engine and their executives’ quickest way to the top – as Goldman Sachs’ Lloyd Blankfein and Morgan Stanley’s John Mack would attest. But since the near-suicidal plunge by lenders into ever more exotic securities paralysed the global economy, regulators have passed rules severely restricting leverage – the on-balance-sheet debt that has been dubbed the cocaine of the financial sector.
The Basel III international agreement on capital standards more than triples the broad capital reserves that banks must maintain, limits leverage and provides strong incentives to move out of certain businesses. In spite of a painfully slow implementation, Basel will have a profound impact on trading businesses. In a recent note entitled “Is trading as we know it dead?”, Brad Hintz, an analyst at Bernstein Research, came to a sobering conclusion: “Over the period 2000-2010, on average, Wall Street trading firms were only able to beat profitability hurdle rates by employing excessive amounts of leverage.”
The banks’ plight has been deepened by the Dodd-Frank legislation in the US, which bans them from placing trading bets on their own account and limits other “proprietary investments” in private equity and hedge funds, which in good years have accounted for up to 10 per cent of the profits of banks such as Goldman. The drive by US regulators to push derivatives – which make up an estimated 15-20 per cent of banks’ trading profits – away from over-the-counter markets towards clearing houses and exchanges will also reduce profits.
Forced to go cold turkey on leverage, “prop” and derivatives, banks are focusing on areas such as underwriting equity offerings, which yield high returns but are episodic; trading government debt, which uses little capital; and managing other people’s assets for a fee. But reshuffling their balance sheets is unlikely to enable banks to make up for the loss of go-go businesses such as securitised products and proprietary investments.
For that, Wall Street and the City are looking towards Asia, Latin America and even Africa. “Regardless of how you feel about US and European economies, other parts of the world are growing very rapidly,” says Jon Corzine, the former Goldman chief who now runs MF Global, a derivatives dealer. “The returns on capital associated with that should be very attractive.”
The story is seductive: as countries develop, finance becomes a larger part of the economy, increasing the trading and advisory services consumed by the rising corporate giants of the east and south. “We need to put more capital, systems and people in emerging markets,” says Jes Staley, the head of JPMorgan’s investment bank.
He contrasts his stint in Brazil in the 1980s, when he worked mainly for US companies, with the work done by his colleagues today on behalf of local champions such as InBev, the brewer.
“JPMorgan today is helping companies in developing markets become multinationals just like 20 years ago it was helping US companies become multinationals,” he says.
John Havens, Mr Staley’s opposite number at Citigroup, whose securities unit derives 60 per cent of its revenues from outside the US, is even more categorical.
In his large but sparsely decorated New York office, Mr Havens points to two paintings of ships that used to hang in the offices of Walter Wriston and John Reed, the late 20th-century architects of Citi’s international expansion. He uses them as a reminder that the next battle for investment banking supremacy will be won by those with expertise on the ground in developing economies.
“You cannot do investment banking in emerging markets with passports and plane tickets. You have to be local, because both your clients and your banking partners are,” he says.
The problem is that capital markets in developing economies are not only small but crowded with domestic competitors that have strong ties to corporate elites. Investment banking revenues in Asia are estimated at around one-third of those in the US and about half of those in Europe. Even allowing for rapid growth, banks cannot expect emerging markets to be an immediate panacea. Fees tend to be lower and the governments that control big chunks of economic activity are not keen to see western banks enrich themselves at their expense.
That is why cost cutting is vital if the industry is to succeed. Recent predictions of a 15-20 per cent fall in bankers’ average bonuses for 2010 – in line with falls in revenues – could be a harbinger of future developments. As one top Wall Streeter laments, “We are all trying to put the compensation genie back in the bottle.”
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That will not be easy. Banks have consistently siphoned off around 50 cents of every dollar they make to pay their staff and have been loath to reduce their pay-to-revenue ratios for fear of a brain drain. But Kenneth Jacobs, the chief executive of Lazard, an investment bank that eschews trading in favour of advising companies, thinks the dynamics could change.
“Leverage created revenue at these firms and, because the compensation was more or less fixed as a percentage of revenues, leverage created compensation,” he says. “The compensation pressures at the larger firms should benefit our model.”
Others counter that Wall Street will have to keep rewarding its top performers handsomely – but could cut its wage bill by employing fewer people and shifting jobs to emerging markets. Meredith Whitney, an independent analyst, recently forecast up to 80,000 job losses in the US securities industry in 2011 – a 10 per cent cut on current levels, to be added to the 8 per cent reduction caused by the crisis.
But bankers are more sanguine about prospects, expounding a faith in the industry’s penchant for reinvention. JPMorgan’s Mr Staley argues that the sceptics are missing a crucial factor: information technology. “There is a technology revolution going on on Wall Street,” he says. “The digitisation of information seen in other parts of the economy is being seen in banking too. I believe it will ultimately make the business more efficient and less costly to run.”
To prove his point, Mr Staley went back to data from 1970, the year he joined Morgan Guaranty Trust, one of JPMorgan’s ancestors. He found that in 2009 JPMorgan’s investment bank produced 30 times the revenue of his alma mater with just over twice its headcount – a leap in productivity he attributes mainly to IT progress.
Morgan Stanley’s Mr Kelleher also believes technology can help banks take advantage of the push to get derivatives traded on exchanges, by boosting volumes and reducing costs.
The test will be whether investors buy into the story of a new era of less profitable but also less risky investment banks. Brady Dougan, the Credit Suisse chief who steered the Swiss group away from the worst of the crisis by relying on its private bank and lower-risk trading activities, says he believes the market is ready for the investment bank of the future.
“If we can drive a ROE of around 18 per cent through the cycle – when in the good times we’re 24 per cent and in the bad times we’re 12 per cent – there will be certainly a class of investors that really finds that very attractive, as opposed to a business where you run 35 per cent ROE in the really good times and minus 35 per cent ROE in the bad times.”
For once, top bankers – whether in New York, London, Frankfurt, Zurich or Tokyo – must hope one of their fiercest rivals is right.
Additional reporting by Megan Murphy
Copyright The Financial Times Limited 2010
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