Outrageous fortune

Investment banking, an industry that was in desperate need of resuscitation only a year ago, is booming again as companies and governments raise vast amounts of fresh capital to shore up their finances. According to new research compiled by analysts at Morgan Stanley, the top 12 investment banks have raked in total revenues of $136bn before expenses in the first half of the year.

Institutions such as Credit Suisse, Goldman Sachs and JPMorgan have recorded stellar gains in their securities units following a rush of corporate bond sales, high customer trading volumes and wide bid-offer spreads. But their success – just one year after being bailed out by national governments – has also left politicians and regulators scratching their heads about what to do next. Goldman Sachs, lambasted by Rolling Stone magazine as a “great vampire squid wrapped around the face of humanity”, has already set aside $11.4bn to pay staff for the first six months of the year. If its second-half earnings stay on track, it would pay out an average of $770,000 to each of its 29,400 employees. The prospect of million-pound bonuses being distributed to thousands of workers has rankled critics who feel that the sector has not been suitably chastened for its role in the crisis.



The Securities and Exchange Commission is trying to think up ways of making the industry more transparent, as well as curbing excessive pay without making the sector any less competitive. Other regulators are following suit, though some are mindful that the levels of regulatory scrutiny and transparency may differ from one country to the next. In July the UK’s financial regulator warned that it is tightening its scrutiny of investment banks due to a “real danger” that regulators might fail to make a radical overhaul of the banking system. Lord Turner, chairman of the Financial Services Authority, said that while investment banks insist they are engaged in lower risk areas such as interest rate derivatives and foreign exchange, “our challenge is to make sure we are really tracking whether that story is right. I can tell you we are watching very, very carefully the investment banks and trading arms of major commercial banks to make sure we truly understand the risks.”

But so far, the threat of increased scrutiny has had no impact on the industry’s balance sheets, or banks’ aggressive drive to become more competitive. In August Barclays and HSBC recorded bumper profits from their investment banking businesses. Barclays Capital, headed by Bob Diamond, revealed it had doubled pre-tax profit to more than £1bn ($1.7bn) in the first half of 2009 on revenue of more than £10bn. While a hefty portion of those gains stemmed from the acquisition of the US operations of Lehman Brothers, the unit also performed well in emerging markets, currencies and commodities. Pre-tax profit at HSBC’s global banking and markets unit on the other hand, led by Stuart Gulliver, more than doubled, increasing to a record $6.3bn for the first half.

Opportunity in risk
Société Générale, France’s second largest bank, returned to profitability in the second quarter, as strong performances from its retail and investment banking units helped offset balance sheet write-downs and weakness in its Russian retail banking division. SocGen’s corporate and investment banking division reported revenues of €1.3bn, almost double the €655m reported in the second quarter of 2008, boosted by the rally in equity markets and by market share growth in the group’s fixed income, currencies and commodities division.

And the bank has said that it is going to follow a highly aggressive strategy to become even more competitive and solidify its position in the market. Frederic Oudea, the bank’s chairman and chief executive, said that “in an environment of global recession, the group is focusing on consolidating its market share, controlling risks and restructuring the activities most severely affected by the crisis in order to adapt to the new environment and prepare for the future.” However, Oudea also said he would be on the look-out for acquisitions, especially in retail banking, over the next 18 months. “This crisis involves risk but also creates wonderful opportunities,” he said. “We want to grow our retail banking unit. Our idea is to identify banks that would provide growth, and consider them as potential acquisition targets.”

The real key to success for investment banking has been due to the intensive capital raising of the past six months, which has created opportunities for bankers to make money. As the equities and commodities markets have rallied, investment banks have benefited from high trading volumes and price volatility. In the credit market, wide bid-offer spreads have also driven big gains. With less competition in the marketplace following the collapse of key operators such as Bear Stearns and Lehman Brothers, they can also command a higher premium for their services. The fees charged to underwrite corporate rights issues in the UK, for example, have risen to as high as 3.5 percent, from an average of 1.8 percent in 2008. Analysts estimate that the margins on European government bond sales have increased between 25 and 50 percent.

But probing beneath the headline-grabbing numbers reveals that investment banks have earned huge sums from a combination of market conditions that are unlikely to prevail for much longer. Analysts say that longer term, the outlook for the industry is more opaque as market conditions become more “normalised” and cheap government funding dries up. Bid-offer spreads have tightened significantly, and firms will not be able to rely as much on the fees generated by financial restructuring.

Furthermore, while investment bankers may be raking in the profits from trading activities, but revenues from advising companies on mergers and acquisitions have still not recovered. Fees from completed M&A fell for the fourth consecutive quarter to US$3.7bn in the second quarter, representing 21.2 percent of the total investment banking fee pool, according to estimates from Thomson Reuters and consultancy Freeman & Co.

Since 2006, M&A has contributed an average of 44 percent of total fees and has never previously contributed below a third. Robert Parkes, equity strategist at HSBC, said: “As a proportion of total revenues, M&A has fallen considerably as other areas of investment banking have taken over”. A dearth of mid-market deals – which typically account for a third of M&A volumes – has exacerbated the rapid decline of overall M&A fees.

Deals valued up to $500m fell by almost 46 percent during the first half of the year, generating just $5bn in estimated fees for investment banks.

As well as the threat of a protracted recession, regulatory changes are also expected to have a profound impact, particularly with respect to capital costs and liquidity requirements. The global regulatory crackdown in the wake of the financial crisis is likely to cut long-term profitability at US and European investment banks by nearly a third, forcing them to cut bonuses and shed staff, says a study by JPMorgan. The report calculates that investment banks’ return on equity will fall from 15 percent to just under 11 percent in 2011 and that Deutsche Bank, Goldman Sachs and Barclays have the most to worry about over the next few years as new regulations of investment banks’ activity eat into profitability.



In a pair of research reports on the world’s leading investment banks (excluding JPMorgan), the analysts project that regulatory changes will on average slice 30 percent off banks’ 2011 profitability. Deutsche’s investment banking return on equity (ROE), previously forecast to be 10 percent, would fall to 6.7 percent – the sharpest fall, and the lowest end result. The bank would be hit, in particular, by its leading position in derivatives, the over-the-counter trading of which is set to be overhauled by regulators. Only Credit Suisse, UBS, Goldman Sachs and Morgan Stanley have returns on equity projected above 11 percent for their investment banking operations. And that, says Kian Abouhossein, JPMorgan analyst, is a problem: “You cannot run an investment bank with a normalised ROE of 11 percent.”

The analysis is based on the expected impact of eight separate regulatory changes aimed at curbing investment banking risk, encouraging traditional lending, and slaping down bank bonuses. The drive to move derivatives trading on to exchanges with clearing will, for example, increase transparency to such a degree that profit margins will be forced down. Investment banks will be irritated by the conclusions. Revenues are thriving for the time being, as banks benefit from a disappearance of competition in the wake of the failure of groups such as Lehman Brothers and Bear Stearns.

According to the research, factoring in banks’ non-investment banking businesses changes the overall group rankings. Measured by return on tangible book value, Barclays is set to be the weakest performer, on 9.4 percent, with Goldman Sachs also on a relatively low 10.9 percent return. Credit Suisse, with a return of nearly 23 per cent, is the clear winner, according to the analysis. The data has led JPMorgan – which will itself be hit by the regulatory changes, particularly in derivatives trading – to conclude that investment banks are no longer an attractive bet for shareholders.

Eastern attraction
But emerging markets may throw investment bankers a long-term lifeline. For decades, banks have wanted to invest more heavily in Asia, but have been put off due to the tight rules regarding minority stake ownership. However, there are signs that some Asian governments may waive these preconditions if the right bank comes along. For example, Thailand has announced plans to sell off large stakes in two small banks – Siam City Bank and ACL Bank – with the incentive that foreign investors could secure management control. 

Korn Chatikavanij, the country’s minister of finance, said in August that he was willing to set aside limits on foreign shareholdings if the right bidder came along. “I am willing to waive the 49 percent limit as long as buyers meet our provisos, including that they are world-class institutions which can enhance the quality of competition in the local market place,” he said.

Foreign banks, including HSBC and Standard Chartered, are keen to expand their footprint in the Thai banking sector but are wary of getting into the market without being guaranteed management control. Korn said that his ministry and the Bank of Thailand were in the process of finalising their second financial sector master plan. The aim, he said, was to improve competition by strengthening the system rather than broadening it. “We always said we would consider getting rid of these stakes if it would help strengthen the overall banking sector through bringing in new entrants to the banking sector,” said Korn.

Some Middle Eastern states are also preparing to open up their banking sectors. In August Barclays and SocGen were granted investment banking licences for Saudi Arabia, becoming the latest international banks looking to tap into the Arab world’s largest economy. Abdulrahman al-Tuwaijri, chairman of the Capital Market Authority (CMA), the country’s financial services regulator, said that the regulator is also planning to enable investment groups to launch Exchange Traded Funds (ETFs) before the end of the year as it seeks to develop the Saudi market and attract more institutional investment.

Following a liberalisation of the financial services sector, the CMA has authorised more than 100 licences to investment entities since late 2005. However, some bankers in the kingdom question whether there is enough business for all the new entrants, with suggestions that some may turn out to be little more than suitcase banks. Saudi Arabia has also been impacted by the global economic crisis, with its oil-dependent economy expected to contract this year.

But Tuwairji said the banks “are not looking at this year or next year – they are looking at the potential of this country”. Saudi Arabia is home to the region’s largest stock market, the Tadawul, which has a market capitalisation of about $304bn. But it has been one of the most restrictive in the Gulf for foreign investors, who were until recently only able to access stocks through mutual funds. Last year, however, the CMA took a step in opening up the market by allowing foreign investors to trade shares by entering into swap agreements with “authorised persons” in the kingdom.

Despite the credit crisis – and their role in it – investment banks do not seem to have lost their competitive edge. While margins may be squeezed in their key markets due to increased regulation and enforcement impacting on their products and they way they are sold, the sector’s main players are looking for new opportunities to exploit – even buying up the operations of their rivals, or looking for new markets to tap.

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