More than three years on from the collapse of Lehman Brothers that wrought unprecedented change and consolidation in corporate and investment banking, the industry remains in transition and has lost is attractiveness as an investment proposition.
Regulatory pressure from initiatives such as Basel III means that banks must hold more capital and boost their deposits, while at the same time market volatility and fears over eurozone exposure or the rising cost of litigation arising from the financial crisis is raising liquidity fears.
Meanwhile, as markets are being buffeted, investors are hoarding cash and that is hitting the client-driven trading revenues of investment banks. After a miserable first half, few expect a brighter picture to emerge during the rest of the year. Analysts at Citi recently published a note in which they reduced their revenue estimates for the banking sector by 45% for the third quarter.
Against such a tumultuous backdrop it appears that only firms with scale or specialist strength can survive as they cut costs and close down or sell off activities that are unprofitable or unloved by regulators.
As one global head of investment banking at a US firm says: "Theres an acquisition ban on every big global firm. In some cases national regulators and governments have said so explicitly, in others, that is simply the prevailing mood music."
It has never been more important for M&A bankers to foster close relationships with governments and regulators, because it is they that will decide on the next mega-deal in the industry.
Despite banks being better capitalised than ever before, the current eurozone sovereign debt crisis is raising the same questions about bank funding and liquidity that the credit crisis first exposed, and with revenues under pressure, few merger experts believe the era of the crisis-driven banking M&A deal to be over.
While big-ticket activity will be driven and constrained by national governments, tough new capital requirements and falling returns are forcing banks to run a fine toothcomb over every one of their businesses and that is creating prospects for M&A dealflow.
Mandeep Ahluwalia, managing director and global head of banks in the financial institutions group at Lloyds Bank Corporate Markets, says: "Western investment banks are being forced to rethink their models by the slew of regulation and against a backdrop of declining revenues. We expect to see further bolt-on acquisitions as banks look to their strengths, whether by geography or product, and seek to build on their existing capabilities. Similarly, some banks will exit or sell off certain businesses."
For most banks, the emphasis is on divestment rather than acquisition and the process of deleveraging can be quite granular, focusing on the sale of portfolios or parts of portfolios, down to individual trading desks.
In terms of what might be defined as traditional M&A, deals are more likely among mid-tier players struggling for scale and it is they not banks deemed too big too fail that may face the biggest challenge.
Leo Greve, global head of strategic origination for financial institutions at ING, says: "One of the unintended consequences of regulators trying to prevent banks from being too big to fail, and of forcing them to be highly capitalised and very liquid, is that they are creating an environment, especially in these market conditions, in which only the larger banks can actually comply with these conditions. This may put pressure on smaller players to seek defensive mergers with peers."
Regulators as the new rainmakers
M&A bankers enjoy being masters of the universe, but when it comes to their own industry, they no longer have free rein to shape their strategic destiny. The direction of regulatory travel means that the banking industry is not geared towards acquisitions and the era of the big transformational deal is over.
One head of FIG at a European bank says: "There is very little scope for consolidation among investment banks for a number of reasons. Firstly, the outlook is uncertain, secondly banks lack capital and thirdly, they do not want to take further risks on their balance sheet."
Basel III regulations force banks to set aside a greater proportion of their capital when they make acquisitions and the current environment works against activities that consume lots of capital, while the increased power of regulators means that even if a banking chief executive wanted to pull off a big deal, it would suffer severe scrutiny.
"From the banks perspective, anything that attracts a lot of cost will come under considerable scrutiny from management," says the head of the bank practice at a leading consultant. "No one feels like being aggressive in the M&A market in the current business and regulatory climate."
This is in stark contrast to Basel II, the previous banking rules under which banks were allowed to apply their internal risk-based models when deciding how much capital to set aside for acquisitions under a certain size. Under this system, investment banks bought up mortgage provision companies and enjoyed a lower level of capital treatment, making deals of a certain size easy to transact.
Instead, any deals undertaken by big banks now are likely to come as a result of the demands of governments of regulators trying to shore up national champions or to prevent peer firms from going bust.
"The too big to fail issue has not been resolved," says the head of corporate and investment banking at a European firm. "The impact of the collapse of Lehman means that regulators would probably prefer an M&A solution to letting another big bank go bust."
In August, rumours swirled in the US that the Federal Reserve was trying to persuade JP Morgan to help back a possible bail-out of Bank of America, which is understood to need more capital to meet mortgage liabilities. The rumours were denied as Bank of America insisted its business was strong. On August 25 BofA accepted a $5bn investment from Warren Buffet.
One of the ironies of the mergers and acquisitions business is that the professional firms that earn fees advising on big global transactions have such a parlous record when it comes to doing deals within their own industry. This is down to the fact that investment banks are people businesses. In boom times, a bank might be able to convince shareholders that the cost of acquiring a top brand would be worth it for the incremental rise in revenues and the benefits of removing a competitor.
Now, any chief executive seeking a big ticket acquisition in investment banking would be regarded as reckless in the extreme. "The main problem from a shareholders perspective is that there have been very few successful mergers between corprorate and investment banks and its hard to imagine them sanctioning say, a merger of equals," says a head of FIG at a European bank. "At any rate, regulators will have the final say on deals of size."
Investors, like banks, also suffer from 20-20 hindsight when it comes to M&A. The last jumbo deal struck by investment banks that was not forged in the white heat of a global financial crisis was the 71bn purchase of Dutch Bank ABN Amro by a consortium led by Royal Bank of Scotland that was completed in October 2007.
The deal, financed in cash through a rights issue by the bidder, was fiendishly complex and depleted the capital, resources and morale at RBS just when the bank needed to focus on the unfolding financial crisis. It ultimately brought the bank to the brink of collapse and triggered a bail-out by the UK government, which remains an 80% shareholder. The deal will serve as a yardstick for failure with which investors will beat future chief executives.
The bulk of banking deals fail because of poor integration. "Banks are people businesses. If you get the integration wrong, people walk and the business is destroyed," says one M&A banker. Aside from the increased execution risk that has long been associated with investment banking deals, potential bidders will also be put off by a lack of transparency about what lurks on the balance sheets of chosen targets. Aluwahlia adds: "The problem for potential buyers is the struggle to correctly value some of the assets in the portfolios they are buying so execution risk is high."
Where banking chief executives used think about the next big deal, now they are concerned with whether they have the right scale and the right product mix to ensure they can thrive.
"Strategic M&A is not high on the agenda for banks in mature markets because at the moment they are focusing on core activities and core products and if anything shrinking balance sheets to comply with new regulations," says Greve.
Unpopular asset class
Investment banks whod want to own them? That is the unavoidable conclusion to draw from the sliding share prices of the worlds biggest players in the sector. Before the financial crisis, investment banks were producing returns on equity of as much as 25% as their diversified business model knew no bounds. Now, with group RoEs closer to 12% as low as 8% for their investment divisions, the investment banking industry faces an uncertain future.
At a cursory glance, the M&A deals associated with the global financial crisis appear to have removed capacity on both sides of the Atlantic. In the US, the Treasury engineered the sale of Bear Stearns to JP Morgan, and the merger between Bank of America and Merrill Lynch. In the UK, the forced merger between Lloyds Bank and HBOS consolidated their markets operations, while in France BNP Paribas has subsumed the operations of Fortis.
In the immediate aftermath of the crisis, banks re-trenched to their domestic markets. However, firms that emerged from the crisis in a relative position of strength have expanded, building equities and advisory businesses.
In some cases the land-grab has been dramatic, with Barclays building out its global investment banking operation following the acquisition of North America and Canadian business of Lehman Brothers.
Japans Nomura has absorbed Lehmans market share in Europe. In the mid-market, Jefferies has hired hundreds of bankers as part of a successful build-out of its international business.
As a result of this expansion, the capital markets are, if anything, over-banked. At the same time, banks are having to set aside more capital to meet regulatory requirements, slashing their return on equity. The knock-on effect is that investors are selling out of the sector.
Western banks may want to sell their least profitable businesses, but they cannot find buyers for them, so in many cases it makes more sense to close them down or hold on to them until valuations recover.
By contrast, the need for capital means that banks are more tempted to sell more valuable assets in faster-growing markets. Last month, Bank of America sold 5% of China Construction Bank to a group of investors for $8.3bn in cash and an after-tax gain of $3.3bn.
The picture is also mixed when it comes to the sale by banks of their illiquid holdings, such as stakes in companies, private equity or real estate assets or non-performing loans.
Bankers point to the real estate sector as one where banks will be most active. RBS has earmarked £45bn of property assets for sale as it continues to shrink its balance sheet.
The financial crisis accelerated the secular trend of capital flows moving eastwards. Sovereign wealth funds were busy acquirors of stakes in stricken global investment banks but they have exhausted their patience in the sector.
But it is in the emerging markets where the M&A pictures appears most dynamic and built on growth, rather than retrenchment. "The balance of power is shifting among banks and we are seeing banks from fast-growing markets less affected by the crisis emerging stronger and seeking to buy stakes in peers in other growth markets such as Africa, Asia and Latin America" says Ahluwalia.
"Some of these banks will have a big role in shaping the future of the industry."
Last month, Industrial & Commercial Bank of China (ICBC) paid $600m for some assets controlled by the Standard Bank Group in Argentina in its biggest takeover in more than three years.The Chinese bank paid cash for an 80% stake in Standard Bank Argentina, Standard Investments and Inversora Diagonal.