Investment banks are struggling to work out how the different parts of their business fit together and how profitable they are. It could all come crashing down. My column for Financial News (from March 2013).
No pressure or anything, but as you ponder whether to shut down your Asian cash equities business, close your European correlation trading desk, or pull out of the US securitisation market, are you absolutely sure that you’re not going to bring your entire investment bank crashing down around your ears?
As investment banks struggle to get to grips with a less profitable world, one way of looking at the challenge they face is to imagine they are locked in a giant game of Jenga. For those of you who missed Jenga as a child, you build a tower of wooden blocks and then have to remove the blocks one-by-one without the whole pile collapsing.
Of course, it’s easy to start with. The challenge – as with investment banking today – comes as the game progresses when you have to work out which blocks are holding everything together and which bits you can do without. The answer is not always as obvious as it might seem.
If a bank is too bold or pulls out the wrong piece, it could kill off another part of the business. Too timid, and a bank could consign itself to a vicious circle of ever-decreasing profitability…
The imperative of reducing costs and capital consumption is forcing banks to understand – perhaps for the first time – how interconnected different parts of their business are, how the underlying economics of each business work, and the extent to which different businesses cross-subsidise each other.
Take a bank like UBS that is downsizing its fixed-income business. It is not just a question of – which parts of its fixed-income trading business could it shut down on a standalone basis to have the biggest impact on capital and profitability? It must also think about – which parts of the business can it afford to cut or exit without undermining its ability to price, distribute, trade and hedge securities in the primary debt markets? And how much debt capital markets activity can a bank give up before it starts affecting its advisory business with corporates or private equity firms?
Looking wobbly
This chain reaction can get out of control. If you start losing debt and advisory business with private equity firms, can you really afford to keep that equity capital markets business you built to handle all of those promised private equity-backed exits? Come to think of it, how big a primary equities business do you need to feed your secondary equities business? Or should that be: how big a secondary equities business do you need to support your primary business?
How much lending can banks take off the table before clients start finding polite excuses to take their advisory or new-issue business elsewhere? And at what point does too much lending start to drag down profitability not just for the loan book but for the rest of the investment bank as well?
Banks face the same conundrum at a geographical level. What would happen, say, to the US equities business at a bank such as Citi if it shut down or drastically cut back its European equities franchise? Does Barclays need a big investment banking and equities business in continental Europe and Asia to support what it is trying to achieve in the US and UK?
The banks didn’t have to ask these difficult questions when they were putting these businesses together.
So long as the top line kept growing and the cost of capital was artificially low, there was enough business going around for everyone to look like a strategic genius. That is what is making banks so much harder to dismantle now.
It is only now that banks are having to ask awkward questions about whether businesses are profitable on a fully costed standalone basis, and if not, whether they deliver enough marginal benefit at sufficiently low marginal cost.
In the past, banks may have accepted that specific business lines lost money on the assumption that they helped other businesses make money. But as volumes decline, many banks have found themselves instead with a collection of interconnected but loss-making businesses.
What now?
All investment banks have made significant cuts to their business – although some have gone further than others in taking more radical and difficult decisions.
But a lot of banks are promising that cross-selling and synergies will still be able to ride to the rescue. The big US and European banks such as JP Morgan, Citi and Deutsche Bank have pegged their future on combining corporate, transaction and investment banking, while banks such as Morgan Stanley and UBS are almost entirely dependent on the cross-selling opportunities between wealth management and investment banking.
Almost all investment banks have retreated to focus on their biggest and most important clients (who, funnily enough, are often the same from one bank to the next), and while many banks have cut back outside of their home market, there is a vogue for saying that in order to remain relevant to core clients in one market, banks have to be relevant in other markets too. This is tantamount to admitting that they’re not quite sure which parts of their business are essential and which not, so for the time being they’ll be taking out as few blocks as possible and sitting tight until it’s their go again.
We are still in the early rounds of this particular game of Jenga. So far, so good. No bank has yet come crashing down. But with each turn, the decisions are getting harder as to which blocks to remove and what to cut next – and the stakes are only going to get higher.
–This article first appeared in the print edition of Financial News dated March 11, 2013