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Future of Finance

NOTHING REFLECTS BANKING'S CHANGE IN FORTUNES as dramatically as the volte-face by Sanford Weill. The former CEO and chairman of Citigroup, who almost single-handedly tore down the Glass-Steagall Act that had separated investment and commercial banking in the U.S. since the Great Depression, came out this summer and called for the breakup of big universal banks to split retail and investment banking. His premise is that investment banks are inherently risky, engaging in activities from which risk-averse retail depositors need protection. If even an insider who made a fortune from the industry is turning against it, bankers must wonder how they can fight off more-hostile activists, regulators and politicians who all want to tame the increasingly unpopular banking beast.

A modern-day Glass-Steagall remains a long shot, but Weill’s conversion nevertheless betokens a sea change in the prospects of an industry that defined a generation of debt-charged capitalism. Five years after the outbreak of the financial crisis, investments banks are facing a battery of profit-slashing structural changes, including sharply higher capital requirements under the Basel III Accord, a raft of new U.S. regulatory restrictions in the Dodd-Frank Wall Street Reform and Consumer Protection Act and a proposal from the U.K’s Independent Commission on Banking for new barriers between retail and investment banking.

The constraints may not stop there. A recent series of scandals and missteps — including bank manipulation of the benchmark London interbank offered rate, hefty fines for money laundering and sanctions busting by banks such as Barclays and HSBC Holdings, and a nearly $6 billion loss on massive credit hedges by JPMorgan Chase & Co. — have sparked fresh outrage. U.K. Prime Minister David Cameron ordered a parliamentary inquiry into professional standards in the banking industry following the Libor scandal; a European Union expert group led by Bank of Finland governor Erkki Liikanen is considering possible structural changes to the industry; and Thomas Hoenig, vice chairman of the U.S. Federal Deposit Insurance Corp., has called for tough new restrictions on banks’ securities activities.

These days, few investment bankers hold out hope of returning to a favorable climate of light-touch regulation and soaring growth. Instead, banks will have to accept a diminished role, with business models designed for a less-leveraged and less-profitable environment.

“The proposed regulations will accelerate the return of banking to its core activities — financing, intermediation of risk and advice,” says Suneel Kamlani, the Stamford, Connecticut–based Deputy CEO of Royal Bank of Scotland’s Markets & International Banking business and a former COO of UBS Investment Bank. What that means for companies’ ability to raise capital — and with it, the larger economy — is difficult to gauge at this point, but some experts say it’s likely to raise corporate financing costs.

Only five years ago, Wall Street investment banks were at their zenith. Global investment banking revenues reached a record €310 billion ($387 billion) in 2007, according to research by Roland Berger Strategy Consultants . The industry fostered an elite culture, paying vast salaries to lure the most able graduates and maintaining close links to the corridors of political power. Goldman Sachs, the most successful investment bank, made record profits of $11.6 billion in 2007 and boasted a return on equity of 32 percent. That year it paid its employees an average of over $660,000 each and awarded $68.5 million in cash and shares — a record for any Wall Street CEO — to chairman and CEO Lloyd Blankfein. This was at a time when, according to the U.S. Bureau of Labor Statistics, the average surgeon earned $191,410 a year and the average lawyer took home $118,280.

Goldman’s former CEO Henry Paulson Jr. became U.S. Treasury Secretary in July 2006. The following year, JPMorgan hired former U.K. prime minister Tony Blair as an adviser, while his son Euan joined Morgan Stanley as an analyst. Investment banking seemed to represent the summit of the private sector, offering the most glittering prizes and prestige. Then came the collapses of Lehman Brothers Holdings and AIG, the hasty marriage of Bank of America and Merrill Lynch, the bailout of much of the U.S. banking industry under the controversial $700 billion Troubled Asset Relief Program and similar bailouts across most of Europe.

Some bankers acknowledge the industry has only itself to blame for its predicament. “It’s fair to say the investment banking industry lost sight of its core values,” says Colm Kelleher, co-president of Institutional Securities at Morgan Stanley in London and its head of Europe and Asia. “Risk models were flawed, compensation was too aligned with revenues as opposed to earnings, and in some cases banks were competing with their clients.”

Regulators tackled some of the excesses by imposing sharply higher capital and liquidity requirements under Basel III. That accord, which is being phased in through 2019, in combination with a subdued global economy is already having a dramatic impact. Aftertax returns on equity for the top 13 global investment banks will fall to an average of 7 percent from around 20 percent in the years on either side of the financial crisis, according to estimates by McKinsey & Co. ­— the result of a 25 percent decline in industry profits, from $40 billion in 2010, and a doubling of Tier 1 capital, to $400 billion.

The biggest driver of change is the new capital requirements for market and counterparty risk, which are more than double previous standards. These charges will put the hardest squeeze on the investment banks’ fixed-income, currencies and commodities businesses, which according to McKinsey have generated more than 50 percent of the banks’ revenues over the past five years.

“I would invest in a bank if I was sure it could achieve a 12 percent return on equity,” says Anik Sen, head of U.S. and European financials at asset manager PineBridge Investments in London. But even that much-reduced threshold looks beyond the grasp of most banks, primarily because of the continuing euro zone crisis. Some banks are registering small losses, notably UBS Investment Bank, which announced last November that it would scale back its ambitions and cut its risk-weighted assets by around 50 percent, to SFr135 billion ($141 billion), by 2016.

Law of Diminishing Returns
Impact of new regulations on banks' return on equity
Businesses Pre-
credit risk
OTC shift:
OTC shift:
Foreign exchange 30 -8 0 0 0 -4 0 -2 16 -45
Flow rates 19 -6 -5 4 -1 -2 0 -1 8 -60
Structured rates 15 -4 -6 1 -1 -1 0 -1 4 -80
Flow credit 18 -8 0 0 -1 -1 0 -1 6 -65
Structured credit 17 -9 -2 1 -1 -1 0 -1 3 -85
Commodities 20 -6 -3 1 -1 -2 0 -2 8 -60
Cash equities 25 -5 0 0 0 -3 0 -2 15 -40
Flow Equity Derivatives 25 -8 -1 2 -5 -2 0 -2 9 -65
Structured Equity Derivatives 27 -10 -4 1 -1 -2 0 -2 9 -70
Prime services 15 0 0 0 0 -3 -3 -1 8 -45
Proprietary trading 35 -22 -1 0 -1 -2 0 -2 7 -80
total capital markets 20 -7 -3 2 -1 -2 0 -1 7 -65
Most significant impact
Source: McKinsey & Co.

Most others are struggling too. Deutsche Bank is slashing costs after profits in the second quarter dropped by 63 percent from a year earlier, to a modest €357 million. Goldman saw its return on equity tumble to a mere 3.7 percent in 2011, although it rebounded to 8.8 percent in the first half of this year. Morgan Stanley’s ROE slumped to 3.9 percent in 2011 and 1.5 percent in the first six months of 2012. Even J.P. Morgan is rethinking its ROE target of 17 percent, although it managed to achieve 18 percent in the first half. Philip Keevil, a partner at the advisory boutique Compass Advisers in New York and a former head of European M&A at Citigroup, points out the dilemma that investment banks face in the postcrisis era: “You can’t make return on equity of 30 percent without leverage.” According to McKinsey, cutting head count and pay could push ROE back up to 14 percent. Markus Böhme, a senior partner at Roland Berger in Singapore, says the industry needs to cut its 2011 global cost base of around €170 billion by a third, primarily by trimming salaries and bonuses, and reduce its global workforce of 500,000 by 15 percent if it wants to lift ROE above 11 percent.

Yet banks are slow to take such action. While they have cut the absolute level of remuneration, with Goldman’s annualized average pay per employee standing at around $340,000 this year, down nearly 50 percent from 2007, compensation ratios typically remain in their long-standing range of 40 to 50 percent of revenues.

Goldman allocated 42 percent of revenues to compensation in 2011 — only two percentage points less than in 2007, while Morgan Stanley’s 2011 ratio was 52 percent, down from the 62 percent it paid out in the loss-making year of 2009. “They are still reluctant to slash and burn their businesses, because they believe there will be an upturn eventually,” says PineBridge’s Sen, formerly a longtime bank analyst at both Goldman Sachs and UBS.

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