By Bill Blain – Strategist at Mint Partners
Well placed rumours say a number of large European banks are about to pull out of investment banking and markets. Credit Suisse is said to be mulling the closure or sale its investment bank and focus on Wealth Management instead. This comes on the back of similar stories about Deutsche, Barclays and others. It feels like the era of European universal investment banking is drawing to an end. And maybe that’s a good thing. What’s not to like about creative destruction? It’s long overdue in the European banking sector.
Since 2007 the global finance industry has changed utterly, with profound implications for investors and markets. But after seven years of fudged repairs to the damage inflicted by the liquidity crisis of 2007 and the subsequent collapse of Lehman Brothers in 2008, Europe’s banking sector is still not fit for purpose. Everyone has anecdotal tales of how difficult mortgage finance has become; how hard it is for small firms to obtain business loans; or for private investors to retain wealth management services – if you aint got a couple of million in easily identified readies, forget it.
The reform of banking since the crash has been a fraught, confusing and difficult process. Politicians have revelled in “bash a banker” rhetoric, regulators have delighted in producing thick and obscure rule books, while compliance officers now hold the top paying jobs. Talk to any financial CEO and they will confirm they spend more time managing for regulators than they do for shareholders. Meanwhile, markets have changed and become far less liquid than they were, leading to increased fears the next crash will make what we saw in 2008 look a storm in a tea-cup.
Despite talk of banking union, European banks essentially remain an ill-assorted hatful of sub-scale national institutions. Few aspire to globalisation – but even those that do are weighted towards national thinking and directives. There is certainly no European bank that can even claim to be pan-European – American banks have offices in more European nations than any European bank!
Most banks are facing up to the challenges of generating returns and growth in the new global market reality. The big names like Credit Suisse and Deutsche are looking to increase profits and returns by pulling back from less optimal businesses – which could see closures or sales of investment, commercial and retail banking divisions. The banks seek to exit low return, high capital trading and prime brokerage businesses. They will optimise themselves to best address the current capital/regulation/funding/interest rate environment.
As more banks look likely to pull out of the securities game because of its sub-optimal nature, what does that mean for the future of market making, investment financing and the prospects for growth? We are in an evolutionary environment. A recent report from banking consultants Oliver Wyman said that“diminishing returns on capital from market making [trading] demand even greater efficiency, dexterity and scale to achieve 10-12% returns… more firms will trim this business, ultimately leaving an attractive prize for those able to endure.”
I’m pretty sure that among the prize winners will be the remaining US investment banks. Or maybe new Chinese institutions that buy whatever the European banks decide to discard.
It’s interesting how US banking came out of the crisis faster, in better shape and essentially fitter for purpose. I’d argue the speed at which the US sorted out their banks is the key reason the US now leads global economic growth. No “kicking the can down the road” from the Fed, but a swift and brutally enforced recapitalisation programme, directing banks into clear niches, and frankly better regulation. It’s worked. JP Morgan has seen its share of the global banking fees wallet from Fixed Income, Currencies and Commodities jump from 6% in 2006 to 18% in 2014! That is staggering – no wonder the Europeans are giving up.
Compare and contrast to Europe where the ECB still has to play to national interests, giving the impression it doesn’t understand the simple truth that an unfixed banking system equals a stagnant economy. What’s the real volume of bad loans in the banking system? 10%? How much provisioning to come? (Clue: you should probably use trillions in your answer.) The EU is trying to fix it with nods to non-bank lending (which is critical in the US, but barely established in Europe), compromised stress tests, and all against a backdrop of unresolved national self-interest.
Trillions of European banking assets are still marked at 100% on banking books. In the US the hedge funds cleared the sclerotic banking arteries and bought billions of distressed US bank assets – but suspiciously little in Europe. Moreover, while the Fed defibrillated securitisation to ensure banks could keep and develop lending, Europe banned financial innovation and ended up funding banks for free through LTROs (Long-Term Repos), which was essentially back door QE used to prop up crashing sovereign bond markets – but that’s another story…
Sure, US banks have some critical advantages – their accounting rules allow them to net derivatives, and the fact they can originate mortgages and pass them on to the GSEs (Fannie and Freddie). European banks are stuck with mortgage and derivatives on balance sheet making their leverage look awful.
Adjusting to the new environment remains work in progress for most European banks. Some will successfully evolve into sleeker, more nimble institutions by dint of reinventing themselves and new management. There will certainly be business for them – the sheer volume of the project finance pipeline and corporate growth means there is plenty to go round. But it should go to the most capable firms.
The right firms may not be the current “Universal” or “Regional” banks. Big banking is under attack from regulators and shareholders, but it’s not enough to simply split investment banking from universal banks. It’s more subtle than that. I am told an industry lobby body ran the numbers, and of the 17 European dealers they examined, only 9 would be able to achieve sustainable post-separation returns.
But there is a good argument to split simple “utility banking” from “innovation banking”. Innovation can happen outside the current banking sector. Spinning off investment banks to create shareholder value looks certain to happen – there are a raft of hedge funds and foreign players poised to fund breakup and pick up the pieces from capital arbitrage trades. There are also more innovative ways to approach financing and trading markets. Fortunately, that is alreadly happening as new brokers and financial boutiques morph into new Merchant banks matching capital and borrowers.
Sadly, I fear a number of European banks will remain mired in the past, and are set to become increasingly bothersome with more and more names joining the likes of SNS, BES, and HAA on the European Banking Embarrassment Bench.
When it comes to figuring out which are the cheap European banking stocks, it looks like the old CAMEL analysis (Capital, Assets, Management, Earnings and Liquidity) is no longer sufficient. And the good old bank adage: “buy banks that are dull, boring and predictable” is just too restrictive.
Maybe a better rule would be to buy banks that are: “optimised for value”? Investors have quickly adapted to likely bail-ins on bank debt, and to the end of the Too Big To Fail banking put, but understanding “optimised for value” rule probably means smaller banks are simpler to follow.