Was JPMorgan’s Loss the End of an Era for Global Banks?
JPMorgan Chase’s derivatives trading loss will lead to an even tougher environment for the investment banking business model.
WHEN JPMORGAN CHASE & CO. CEO JAMIE DIMON admitted to at least $2 billion in losses on a complex derivatives trade in the second quarter of this year, he may well have signaled the end of an era for big global banks. Until then it was clear why investors paid up for such institutions: Banks with a big capital markets franchise made oodles of money, especially for fixed income, commodities and currencies — the so-called FICC business, as the industry categorizes its trading operations. The capital markets business represented nearly two thirds of the revenues at the top 13 global banks as recently as 2010, according to research by consulting firm McKinsey & Co.
But this rosy picture is about to change dramatically as a result of slumping demand and a slew of new rules and regulations for leading global banks. Demands for higher capital; new definitions of what constitutes risk-weighted assets, against which they must reserve capital; and now, thanks to JPMorgan’s losses, heightened demands for restrictions on virtually any proprietary trading or risky hedging, will impact the FICC business at most banks, hurting their profits and forcing them to rethink their strategies. Some business lines are likely to be closed or sold off.
“There will be major changes at the big banks,” says Roy Smith, a longtime partner at Goldman, Sachs & Co. who now teaches finance at New York University’s Leonard N. Stern School of Business. “I suspect all of these businesses will have to be regeared. You may have three or four of the top ten investment banks veering off into significantly different business or so de-emphasizing fixed income that they will leave a lot of ground to be picked up by others.”
These changes are already forcing sweeping reductions in staff and substantial cuts in the traditional year-end bonuses that fixed-income traders have long taken as a birthright. Could the age of the fixed-income master of the universe, as characterized by Michael Lewis in Liar’s Poker and Tom Wolfe in The Bonfire of the Vanities, be coming to a close?
JPMorgan is already paying a heavy price for its derivatives loss, which Dimon confessed “violates our own principles” on acceptable risk-taking. The CEO canceled a planned $15 billion share buyback in the wake of the trading loss, causing the bank’s share price to plummet and leading analysts to wonder whether JPMorgan is still worth a premium. But because the losses occurred in the chief investment office, which attempts to mitigate risk by investing excess deposits, rather than in the investment bank, some analysts believe that when the smoke clears, JPMorgan will remain among a select group of bulge-bracket investment banks that controls even more of the pie in FICC trading.
Christopher Wheeler, banking analyst at Mediobanca Securities in London, predicts that the three banks with the deepest pockets — Barclays, Deutsche Bank and JPMorgan — will end up capturing greater market share. “They are the ones who are not having to force themselves into looking at getting out of any of these businesses,” Wheeler says. “JPMorgan is too tough a cookie and too well regarded to suffer much.”
Others aren’t so sure, simply because the regulatory landscape may change more radically than anticipated. “There will be some things, fair or not, that the banks won’t be able to do as freely as they were before,” says NYU’s Smith. “Most of the systemic risk in the world is concentrated in 20 banks.”
The new capital requirements not only make it more expensive for the investment banks to carry out their traditional FICC business, they open the market to new players that will provide potentially stiff competition. Smaller banks like Jefferies Group, which are not considered systemically important, will face lower capital requirements and thus be able to compete with lower prices. In addition, asset manager BlackRock, which has huge liquid assets, announced in April that it was starting a bond-trading platform called Aladdin Trading Network that allows institutional investors to bypass traditional market makers. Aladdin “would be particularly detrimental to firms that derive a significant proportion of total revenues from FICC,” according to a report by Moody’s Investors Service. Moody’s named Barclays, Deutsche Bank and Goldman Sachs Group as the most vulnerable outfits.
For three decades the fixed income, commodities and currencies business has been the cash cow of investment banks. The term “FICC” dates from 1981, when Goldman Sachs acquired commodities dealer J. Aron & Co. as well as its CEO, Lloyd Blankfein. And Goldman rode the FICC boom better than most, generating an astonishing $23.2 billion in revenue from the business — more than 50 percent of the firm’s total — in 2009. But that is all likely to change under the crush of reduced trading and increased regulation.
McKinsey, in a report titled “Day of Reckoning?,” estimated the costs of the new regulations by sector and concluded that the investment banks’ overall return on equity would fall from about 20 percent to 7 percent. The report said that with mitigation efforts banks could limit the decline to only 11 or 12 percent, but that’s still an enormous drop from the business’s traditional level of profitability.
Hardest hit, in the McKinsey analysis, were the rates business (government bonds and interest rate swaps) and structured credit, where ROE may fall by 80 to 85 percent. Commodities trading ROE would decline from 20 percent to 8 percent, according to the report. And McKinsey saw ROE for foreign exchange trading falling from 30 percent to 16 percent.
The market for interest rate swaps is by far the largest derivatives segment, and it is “seen [by regulators] as the culprit for the financial crisis,” observes Max Neukirchen, who coauthored the report and is a partner at McKinsey in New York, working in the risk management practice.
The other areas of FICC seen as likely to be most heavily impacted are structured credit, which consists of portfolios of credit hedged by a number of credit default swaps, and structured rates, a combination of interest rate swaps, sometimes across currencies. Neukirchen says regulators believe these products are more risky and less transparent — a belief that the JPMorgan loss has clearly strengthened.
Institutional Investorasked the major banks about McKinsey’s estimates, but only Morgan Stanley was willing to comment.
“The broad framework [of the report] is correct. I don’t think there is any question about that,” says Kenneth deRegt, global head of fixed-income sales. “The capital requirements are going to impact firms and fixed income in a number of different ways.” But deRegt would give no specific estimates of the impact on his business.
A more indirect answer came from Goldman Sachs CFO David Viniar, who was asked by an analyst during the bank’s first-quarter-results conference call what impact the new regulations would have on Goldman’s mortgage debt and securitization business. “It’s hard to see that business for us or anyone else under those rules making sense, and I think you’d have to see a big pullback,” Viniar said.
The new regulations come on top of what has been a substantial decline in fixed-income trading since the financial crisis. Coalition Development, a London-based analytics firm focused on investment banking, says fixed income was the weakest business for the top ten global investment banks last year, with revenues falling 25 percent from 2010. Revenues were down a full third from the boom year of 2009. According to Coalition’s study, credit’s contribution to banks’ revenues has fallen from 21 percent in 2009 to only 8 percent last year. Securitization revenues were down by two thirds.
Not surprisingly, the top ten investment banks have slashed their head counts, especially in those two trading areas, Coalition reports. The number of revenue-producing employees fell 6 percent globally in the 12 months through early April, the firm says.
Second-tier investment banks were hit equally hard. At France’s Société Générale, fixed-income revenue plummeted 31 percent last year, and the head of the investment bank, Michel Péretié, departed, along with a number of top executives in fixed income. At BNP Paribas revenue in fixed income was down 18.8 percent, excluding losses from sovereign bond sales.
Most of the big banks saw an improvement in their fixed-income business in this year’s first quarter, but revenues were still well below the previous year’s levels. JPMorgan’s investment bank did the best, with fixed-income revenue hitting $4.6 billion, but that was 11 percent below the year-earlier amount. At Citigroup fixed-income revenue reached $3.6 billion, a 4 percent decline; Goldman Sachs reported a 20 percent fall in FICC, to $3.46 billion. At Bank of America Merrill Lynch, FICC revenue was $4.1 billion in the first quarter, up from $3.7 billion a year ago. But April was “absolutely brutal,” and “the credit market evaporated,” says Mediobanca’s Wheeler. As a result, J.P. Morgan Cazenove, the London-based JPMorgan investment banking unit that compiles an investment bank ranking, is forecasting a 20 to 25 percent decline in industry FICC business in the second quarter compared with the first, but says the decline will be even steeper if the environment worsens. “Deteriorating macro news flow,” principally the possibility that Greece could exit the euro, means FICC revenue is likely to be down 32 percent in the second quarter, the bank said.
Coalition, which has started publishing a league table of investment banks, ranked JPMorgan first in FICC in 2011, followed by Deutsche Bank and Citi. In 2010, Goldman was in second place.
One of the reasons the outlook is so unclear for investment banks is that many of the rules that will affect their fixed-income businesses have not been finalized. This is especially true in the U.S., where the new rules spelled out in the Dodd-Frank Wall Street Reform and Consumer Protection Act are being implemented by a welter of regulators at the Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency.
The new rules fall under two headings: increased capital requirements and regulatory changes in areas like proprietary trading and derivatives. The new capital rules are based on the Basel III standards agreed to last year by the Basel Committee on Banking Supervision. A new Basel market risk framework came into force in December that increased capital requirements for trading positions by adding a “stressed value-at-risk” charge in addition to the existing VaR charges and a new charge for securitizations.
Basel III, which will be phased in by 2019, raises the minimum capital requirement for banks to 7 percent for core tier-1 capital. Banks considered systemically important — a category that includes all the big FICC players — will have to hold an additional capital buffer of 2.5 percent.
Dodd-Frank adds a dizzying number of rules for U.S.-based banks. They include the Volcker rule, which bans most proprietary trading. The massive losses at JPMorgan — the exact amount is not known but could be offset by what Dimon describes as $7 billion in unrealized gains elsewhere in the bank’s portfolio — are likely to ramp up pressure for a stricter interpretation of the Volcker rule, which had left wiggle room for hedging operations and market making on behalf of clients.
Although JPMorgan has not disclosed the exact holdings that led to the losses, they are believed to include a number of indexes, such as the Markit CDX NA IG Series 9 maturing in 2017, a portfolio of credit default swaps, a type of insurance against default, for investment-grade bond issuers such as Wal-Mart Stores. This kind of hedge is known as a macro hedge because it protects an entire portfolio rather than a single security.
As of late May regulators were split about whether to allow macro hedging as part of the Volcker rule, whose final wording was initially expected in July, before the JPMorgan flap reopened consideration of the issue. Because the JPMorgan losses occurred in what is essentially the bank’s treasury department rather than in the investment bank, Mediobanca’s Wheeler expects the Volcker rule to be applied to the core operations of big money center banks, not just to their investment banking arms. He noted that several European banks’ treasury operations had invested excess deposits in subprime loans before 2008 and subsequently suffered heavy losses. As a result, Wheeler believes, the Volcker rule will have a much wider impact than previously thought, when Dimon was leading the industry’s charge against restrictions on hedging and market making.
In addition to the capital requirements and the Volcker rule, Dodd-Frank contains a derivatives provision, based on a Basel standard, that requires most derivatives trading to move to exchanges with central clearinghouses, ending the current practice of firms trading bilaterally in the over-the-counter market. That alone will steeply increase banks’ costs because they will have to put up collateral for the first time and the increased transparency of exchange trading will significantly reduce spreads. There is also a new requirement that firms retain 5 percent of new securitizations.
Most of the Dodd-Frank regulations are supposed to take effect in July, but that is likely to be delayed because, after fierce opposition from Wall Street, no decision has been reached on the exact wording on many of the rules.
Dimon himself once blustered that the limitations contained in Dodd-Frank were “anti-American.” But he told investors in February that he is not worried about the new rules affecting his business. “I’ll be damned if we don’t have record profits for the next year or two,” Dimon said.
Among the issues being hotly contested are whether U.S. investment banks can make markets in foreign sovereign debt and what exactly constitutes proprietary trading. In response to these kinds of concerns, Deutsche Bank, which has one of the largest investment bank operations in the U.S., announced in February that it had dropped the bank holding company status for its U.S. subsidiary Taunus Corp. “That was to avoid being covered by the capital requirements inherent in Dodd-Frank,” says Linda Allen, a professor of banking and finance at the Zicklin School of Business at the City University of New York.
One big potential hit to banks’ FICC business would come from the so-called single counterparty limit. This rule limits the exposure any systemic firm, defined as having more than $500 billion in assets, can have with a single counterparty to 10 percent. The five firms that fit that bill are Bank of America Corp., Citigroup, Goldman Sachs, JPMorgan and Morgan Stanley.
The Clearing House, a New York–based trade association for banks, has prepared a study that suggests that more than $1.2 trillion in current outstanding credit would have to be either moved to other institutions or left unhedged.
“What would happen is, if a company reaches a cap with a counterparty, then it can’t offer a product to that counterparty,” says Sujit (Bob) Chakravorti, chief economist at the Clearing House. “So now that counterparty has a couple of options. It can go to another counterparty where it hasn’t reached a cap, and maybe that counterparty isn’t as well diversified or creditworthy, or that shortfall can’t be made up elsewhere.”
Complicating matters is the fact that not all Basel rules are being adopted in the U.S. For example, Basel requires the market risk framework to be determined in part by credit ratings; Dodd-Frank demanded that all references to credit agencies be removed from U.S. regulations. Instead, the Fed has drafted a notice of proposed rulemaking that would use other standards of creditworthiness, such as stock market volatility and company-specific financial information. But when this rule will take effect is still anyone’s guess.
Outside the U.S., regulators have been equally active. The European Banking Authority required all major European banks to boost their core capital from 5 percent to 9 percent by June 15. Britain is about to adopt a new rule requiring what’s called ring fencing: Big banks like Barclays can’t use their domestic retail banking assets to support their investment banking operations.
Kian Abouhossein, who covers European investment banks at J.P. Morgan Cazenove, says European banks have already shed an estimated $2 trillion in assets because of the new Basel III requirements and the recent sovereign debt crisis. “Several tier-2 and tier-3 European investment banks have announced plans to scale back or completely exit certain business areas, as they lack sufficient scale, and increased capital requirements [make] these businesses unattractive from an ROE perspective,” Abouhossein says.
Switzerland last year adopted the most stringent capital requirements for banks anywhere, telling Credit Suisse and UBS to increase capital to 19 percent of risk-weighted assets, and imposed high liquidity requirements. Although the Swiss example is not likely to be followed elsewhere, the response of the Swiss banks gives an indication of the kinds of fixed-income businesses that will be trimmed by other countries.
Carsten Kengeter, CEO of UBS’s investment bank, said in an investor presentation in November 2011 that the bank would exit three FICC businesses — macro directional trading, asset securitization and structured products — because they were no longer attractive. He said UBS would make “a large decrease” in risk-weighted assets in its long-end flow rates and global correlation businesses, and smaller reductions in short-end flow rates and credit flow in the U.S.
Kengeter said UBS, which had Sf230 billion ($250 billion) in risk-weighted assets in its core investment bank in 2011, would cut that to Sf150 billion by 2013.
Rival Credit Suisse, which suffered a Sf1.3 billion loss in the fourth quarter of 2011, saw its fixed-income revenue plummet by 96 percent in that quarter from a year earlier, to Sf36 million. The bank said it was ahead of schedule in its plan to reduce risk-weighted assets by Sf80 billion. Credit Suisse also slashed its compensation bill by 41 percent in 2011.
Although there have been head count reductions in fixed income at all the major investment banks, Morgan Stanley is the only other large bank that has detailed where it is cutting back in risk-weighted assets.
At a financial services conference in March, Colm Kelleher, co-president of institutional securities, said that when the new regulations for securitized products became clear, Morgan Stanley began to “downsize our risk-weighted assets” in securitized products, taking the capital saved by this maneuver and putting it in other businesses.
Fixed-income sales chief deRegt says the focus of the cutbacks also includes structured credit, securitization, non-investment-grade mortgage securities and counterparty credit. The firm is not exiting any of those businesses, he says, but it is being more cautious about the size of its positions and the quality of its counterparties.
Kelleher, a former CFO of Morgan Stanley who stepped in when the head of institutional securities, Michael Petrick, was shown the door after a disastrous 2009, also acknowledged at the March conference that the bank had fallen behind in the rates and foreign exchange businesses, and had set about rebuilding its sales and trading staff in those key FICC areas.
Although improving trading returns is a goal of the bank, Morgan Stanley CEO James Gorman, a 53-year-old Australian, has made clear that he plans to give weight to the less-capital-intensive brokerage joint venture with Citigroup that he founded in 2009 by merging the firm’s Dean Witter unit with Citi’s Smith Barney brokerage. It’s been a battle royal at Morgan Stanley ever since Philip Purcell, who was head of Dean Witter, Discover & Co. when it merged with Morgan Stanley in 1997, was ousted as the firm’s CEO in 2005 after a long struggle for power between the brokerage business, which Purcell favored, and Morgan Stanley’s investment bank.
Gorman has reduced expenses, cut salaries for his top executives and told those who complained earlier this year: “If you put your compensation in a one-year context to define your overall level of happiness, you have a problem much bigger than the job. And if you’re really unhappy, just leave. I mean, life’s too short.”
Analysts are now going over the balance sheets of the investment banks, trying to determine where other cuts may occur.
Barclays, whose 2011 FICC revenue declined 27 percent, to £6.3 billion ($10 billion), has announced a small paring-back of its risk-weighted assets. Chris Lucas, the bank’s finance director, was relatively vague during the company’s presentation of its 2011 results as to what assets might be jettisoned, saying only that there will be “further reductions in legacy assets, tight management of counterparty risk and reductions in securitization positions.”
According to Mediobanca’s Wheeler, the bank with the biggest capital problem is Deutsche Bank, where Anshu Jain, head of the investment banking unit, takes over as co-CEO in June. Wheeler estimates that Deutsche’s increase in risk-weighted assets will be a whopping $360 billion under the new regulations. At the same time, he says, the bank has only 7 percent core tier-1 capital under the Basel III guidelines, compared with 9 percent at JPMorgan and 9.8 percent at Barclays.
Thus two of the tasks facing Jain and his new management team are sharply reducing the level of risk assets and raising core capital in the next couple of years. Wheeler forecasts that the bank will have a core capital shortfall of $16.6 billion. It’s no wonder that management altered its U.S. subsidiary to escape U.S. capital rules.
Deutsche Bank is also leading the charge to diversify into less-capital-intensive retail banking. It bought Deutsche Postbank in 2008 and intends to shift more business away from investment banking into retail. At the same time, rivals Morgan Stanley, Credit Suisse and UBS say they are concentrating on private wealth management.
“The real question is whether the large, multiplatform universal banking model that has large inventories in fixed-income securities will continue to be a viable business model in the future,” says NYU’s Smith. “There is some doubt in my mind that it will.”
Apart from a few global titans like JPMorgan, Barclays and Deutsche Bank, there could be a real scramble in the months ahead as investment banks scale back capital-intensive lines of business that have been profitable for many years. Some may decide it is now in their financial interest to become greater distributors of financial products and less aggressive traders. Or they may focus on narrow business lines where they can sharply increase volumes, earning more even though profit margins are slimmer. In either case fixed income is headed for the biggest changes in a generation. And the big bankers who have long ruled that world will have a harder time benefiting from it. • •