Banks are under assault. It is less public than in 2008, when bankers were cast as pantomime villains by politicians and populations looking to shirk the blame for a crisis built on the belief in the desirability of a rapidly rising housing market.
But the attack is there nonetheless. And with regulators as its principal actors, it looks set to lead to the greatest transformation in the shape of the banking sector since the formation of the bulge brackets in the 1980s and 1990s, when merchant banks across the world were snapped up by commercial banking giants.
In a remarkable serendipity that has been decisively ended with the latest crisis, the changes 20 years ago came alongside a range of conditions that made possible an extraordinary pace of expansion.
"We have been very lucky in the last 20 years to have had very large, almost unlimited, access to liquidity which has given rise to the development of investors on one side and liquidity for issuers on the other," says one investment banking CEO. "This allowed investment banks to develop their business and to leverage their balance sheets in order to generate more revenues, and benefit from the regulatory arbitrage between the capital charges versus the real risk profile of assets."
In the new regulatory world of higher capital and lower leverage, that particular money machine is seizing up. The profitability of banks which crashed in the subprime crisis only to recover strongly in the bumper period for credit trading of the first half of 2009 is once again under pressure. Profit and return on equity (RoE) targets are being abandoned. In the words of another senior banker, "the R is decreasing and the E is increasing, so net net the business model has to change".
Put simply (and not taking into consideration a Eurozone currency catastrophe that would probably lead to multiple bank collapses), that change in business model will result in fewer banks providing fewer services to fewer clients. The obvious upshot of that is a greater reliance on the non-bank sector for financing and probably less financing overall, which will ensure that developed market growth stays depressed for years.
Back five years, or 30?
It is no wonder that many heads of investment bank business lines talk of the next few years as likely to be the most depressing of their careers. According to the CEO of the investment bank division at one of the largest European firms, the situation for him and his peers boils down to one simple question: is the industry going back five years, or 30? "How you answer that question determines your strategy," he says. "And my feeling is that we are going back 30 years."
Two reasons make this argument compelling. The first is that the chosen path of regulators has been ever increasing capital requirements, and they are unlikely to stop with Basel III. The flurry of measures whether Basel 2.5, Basel III, stress tests from the European Banking Authority that are becoming unpleasantly frequent for banks, or separate rules on Systemically Important Financial Institutions (SIFIs) have had capital ratios at their heart, both core tier one and total capital.
The scope for further moves is obvious. Swiss regulators have already put UBS and Credit Suisse in a weaker competitive position in terms of capital than their rivals elsewhere through the "Swiss finish". And whether or not UK prime minister David Cameron was believed at the time when he argued that his December 9 veto of EU treaty change was in part driven by a desire to be able to regulate banks more harshly than Europe, not less, his chancellor George Osborne reiterated just before Christmas that UK banks would in the future be required to have core capital ratios of 10%, higher than the 7% set by Basel III (including the capital conservation buffer of 2.5%).
The effect of the new emphasis on capital ratios is exacerbated by the speed of implementation for some changes notably the EBAs requirement that Europes banks have core tier one ratios of 9% under the EBAs stressed scenario by the end of June 2012. At the same time, more stringent rules on the capital treatment of specific activities (revolving credit facilities will now have to be treated as if they are drawn credit, for example), make the provision of balance sheet much more expensive than in the past.
The result is that given the choice between increasing the equity capital side of the formula (expensive, and in any case difficult to achieve given the shocking state of equity capital markets) and slashing the risk-weighted assets side, cutting assets is the method that banks have adopted.
It is this reduction in balance sheet, say senior bankers, that will take investment banking backwards more than any specific prohibitions on activity such as the effective wiping out of proprietary trading by the Volcker Rule regulation in the US.
The scale of deleveraging is already affecting banks willingness and ability to trade and make markets. Many debt capital markets bankers in December were saying that perhaps no more than three firms were now making meaningful two-way markets in credit. Others are even more pessimistic: "Right now, no one is making a market," says one head of capital markets at a firm with a large trading operation. "We are posting prices of course, but they are not prices we expect to be hit."
The second reason why a regression to the banking business model of the 1970s or 1980s looks to be the most likely outcome is that bank funding costs are only going in one direction as investors increasingly steer clear of the sector.
A meeting in early December between the CEO of a European investment bank and the CEO of one of the largest insurers in Europe provides a telling picture. According to the banker, the insurer said that not only was he planning to reduce his financial sector allocation in equities from 25% to just 4%, but in the fixed income bucket he was cutting the allocation to banks from 40% to 20%.
"They are putting half the money they have been into bank bonds," says the banker. "Investors just are not willing to put money into banks."
Just what this means for the future of investment banks is a matter that creates deep divisions within the industry. Some argue forcefully that there will be a return to a world that is populated by two kinds of firm: the giant lenders which also provide basic banking services but largely steer clear of investment banking, and the merchant bank or broker style of firms, with the advisory nous and the distribution networks.
Not everyone agrees with this theory. "If some of my competitors think that this is what is going on, that is terrific but it is stunningly unimaginative and out of touch," says the head of capital markets at a firm that is a big lender and capital markets player.
"I think its wrong to say that commercial banks are going to get out of investment banking but continue to lend to large corporates," he adds. "I think they will get out of that kind of lending as well because its not economic for them to deploy their balance sheet without all the ancillary earnings."
That is a commonly held but largely mistaken view, according to the CEO of the investment bank at a firm with one of the largest corporate lending books in Europe. He argues that it is perfectly possible to be profitable without offering the high margin services that form the basis of classic investment banking. He cites the example of one of the largest German industrial companies, which his firm lends to but only banks in conventional, dull ways.
"We have a very large funding exposure to them, we dont do M&A with them, we dont do ECM with them, but we have a profitability which is very high because we do bonding and we do trade finance," he says. And there are plenty of other services that are required even by mid-caps which are not able to reward bank lenders with juicy bond mandates a few times a year. Factoring, leasing, cash management and FX hedging are among them. They can also put money on deposit with their lenders.
In addition, the biggest clients are increasingly likely to want reverse factoring in order to help their suppliers finance themselves as the cost of bank lending increases. This is still a very small part of the factoring market but one that bankers expect to grow.
This range of real-economy services is a world away from the funky product suite that investment banks like to boast of. But for firms that have loan businesses that they are trying to make pay their way, this work is essential. Happily, it is also cheaper, says the CEO. "To offer this you need local corporate bankers, and they are not investment bankers so they are paid normal salaries," he says. Not only are absolute salaries lower, but being less tied to variable compensation, the cost base is more stable.
Reversion to mean?
If this is the way that those banks with large loan books will have to operate in the future, two issues remain: what return is reasonable to expect from the sector in future, and what about those firms that are not lending-driven businesses?
The exponents of a new model for banks concede that such a change hinges on a big shift in the mindset of banks and their shareholders with regard to profitability. Pre-crisis, returns on equity of more than 20% were not unknown in investment banking, although single digit returns have been the order of the day since then. And although many firms have lowered their targets to the low teens, some ambitions are hard to shake.
"Some bankers still say they are targeting RoE of about 17%, but this is six points above many industrial companies," says the investment bank head at a universal bank. "I understand that banks can be a little more leveraged, but you cannot have such a differential of profitability on a permanent basis.
"The profitability of banks needs to go down because history has shown that you cannot have an asset class that is permanently performing better than the rest. We live in a mean-reverting world."
So which firms will get the model right? One regulatory headache that may have been eased for European firms at the very end of the year was an indication by US authorities that the country will adopt the principles of Basel III. That will take away some fears of an unlevel playing field.
But all banks are having to react sharply to the changed environment and all are slashing risk-weighted assets. Deutsche Bank and Société Générale are among those that revised their profit targets last year and both also had to look at pulling back in areas that are less productive. Deutsche is mulling the future of its asset management arm. The dollar financing crisis in August last year, which hit SG in particular, has resulted in both SG and BNP Paribas reducing their reliance on that market for funding. It could also affect their longer term strategies in the US capital markets.
Credit Suisse and UBS have had not only the "Swiss finish" to cope with but also a rapidly strengthening Swiss franc and in the case of UBS a trading scandal costing billions. Credit Suisse was nimble throughout the subprime crisis, reacting quicker than most to changes in compensation models, and it was also quick last year to say it was streamlining its investment bank and pulling out of more capital intensive areas such as parts of securitisation and the structured long-dated unsecured trades in rates, commodities and emerging markets.
"Credit Suisse is a great example of an investment bank choosing where they want to play and how they want to deploy capital," says a business head at a rival European investment bank. "To be successful, firms like that must be selective."
UBS has also announced its own cutbacks, and was able to use the excuse of its rogue trading scandal last year and a subsequent change of personnel at the top of the bank to restructure its business. It announced it was halving risk-weighted assets, and was exiting areas such as fixed income macro directional trading and equity prop trading, as well as some securitisation and complex structured businesses that were high consumers of capital.
Competitors say that incoming CEO Sergio Ermotti, who joined early this year from UniCredit to run UBS in Europe and found himself catapulted into running the whole bank when Oswald Grübel left in the wake of the trading scandal, has not gone nearly far enough.
"He had a golden opportunity to cut the business in a massive way golden," says the CEO of a rival firm. "Because of the trading fraud, he had an opportunity to say, we are becoming a private bank again and we will cut our CIB business to what we need to do for those clients. He didnt do it."
This rival reckons Ermotti should have pulled out of the US, shut down most of the trading businesses and most of the fixed income side. In the wake of the trading scandal, there were many UBS insiders who feared that this was exactly what would happen.
Reducing the investment bank to effectively being little more than a service provider to a more core part of the firm is the strategy elsewhere. UniCredit, with its very big but not particularly high returning loan book, has embarked on such an approach under its new investment bank CEO, Jean-Pierre Mustier, the former head of the investment bank at SG.
The most striking move was the withdrawal of the firm from equities last year, and the decision to sign an agreement with Kepler Capital Markets to provide what equity sales and research services are needed to support UniCredits ECM business which in turn will be mainly focused on existing lending clients of the firm. Mustier argued at the time that there was little point in retaining businesses where the firm was subscale and could not be anything else without very big investment.
That combined with regulatory and political pressure to keep the focus on home markets is an issue for many firms that are hybrids of commercial and investment banks. For more or less pure investment banks with global franchises, like Goldman Sachs and Morgan Stanley, bankers see a bright future in a world where corporates will be more reliant on capital markets transactions and less on bank lending. And their advisory franchises are well positioned for any uptick in M&A.
Where the toughest decisions may need to be taken will be at those firms that sit in between the pure investment banks and the old-style lenders. Many highlight Deutsche Bank and Barclays as examples, with Deutsche likely to come under pressure from its home regulator to keep its global ambitions in check while Barclays must decide if it can keep spending to build out its investment bank into areas like advisory and equities at a time when costs need to be cut.
One more year
Working on the basis of the banking industry slipping back 30 years looks like the safe option. But that doesnt necessarily make it right. "You can be wrong," says the CEO who outlined the "five years or 30" question. A bank moving too quickly to rein in its operations or doing so having misread the environment could find itself losing clients and staff at the wrong time, he argues.
"Remember Merrill Lynch, when they cut heavily in 2003 and 2004 and then had to hire at the top of the market in 2006 and had to take more risk because of it," says the CEO.
Its not this that keeps him awake at night, however. The biggest challenge for bank CEOs right now, he says, is getting all the key managers of a firm to understand that the world has changed, if not forever then certainly for a generation. "Everyone wants one more year of how it was, just one more year of bonus."