Ever since the demise of Bear Stearns in the spring of 2008, rapidly followed by the collapse of Lehman Brothers and the sale of Merrill Lynch that autumn, debate has swirled around the future of the banking industry. Are its major institutions – behemoths like JPMorgan Chase (NYSE: JPM), Bank of America Merrill Lynch (NYSE: BAC) and Citigroup (NYSE: C) – too big to fail? Too big to manage? Still able to generate enough in profits?
In spite of the furious debate in Congress and elsewhere about the first two questions, it is likely to be the third that proves the most transformative.
Prior to the Great Banking Meltdown of 2008, top investment banks like Goldman Sachs (NYSE: GS) were delivering returns on equity north of 30 percent to their investors. Return on equity, a measure of how well banks do with shareholders’ money, is a key metric for the industry. The scramble to catch up with Goldman among some of the larger blended commercial and investment banks (think Citigroup) as well as the likes of Merrill Lynch was a key factor leading to the crisis, as those institutions rushed to take on more risk but failed to manage it effectively.
In the aftermath of the crisis, ROE levels now hover in the low teens, at best, for many players – and a new report from Boston Consulting Group suggests that in the future, ROEs may languish in the range of 7 percent to 10 percent. That is very far below the levels that veteran bankers have viewed as being the bare minimum in order for the banks to attract and retain investment capital.
BCG paints a gloomy but probably accurate portrait of the future for financial firms engaged in the capital markets and investment banking. For all the public outrage about their activities in the years leading up to the crisis (and their lobbying against new regulations aimed at preventing a repetition of those events), banks have struggled to return to their glory days. Profits may be high, but employment levels are falling along with the crucial ROE levels.
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BCG’s study, released last week, focuses squarely on the institutions at the heart of the crisis: banks like Morgan and Goldman that it refers to as being part of the capital markets and investment banking (CMIB) industry. The consulting firm is correct in its analysis that the need for their services remains, as these institutions traditionally have played a key role in linking investors with securities sold by governments and corporate issuers worldwide.
But that is a quasi-utility function, and it’s certainly arguable that it shouldn’t command the kind of premium returns that characterized investment banking for much of the 1990s and right up to the 2008 crisis. Those were earned by pursuing other activities, from structuring increasingly complex derivatives and creating and operating hedge funds to proprietary trading.
New regulations will bar banks from participating in some of these more profitable arenas; indeed, BCG calculates that regulation alone will trim a whopping 10 percentage points from the ROE generated by these CMIB institutions, about two-thirds of which has already materialized. Compliance with new capital rules, BCG notes grimly, “is being achieved at the expense of ROE.”
The changes affecting banks’ ROE levels include not just activities being regulated away but also those from which banks withdraw voluntarily as they recognize that the new costs, often combined with the volatile return patterns, make them too risky. Already, nearly every month brings with it the announcement of an institution pulling out of commodities trading, or shutting down or cutting back a trading desk in some business that the board has deemed too costly to maintain.
What kind of banking system will emerge from all this? BCG describes its own vision, one in which six different kinds of institutions focus on very different kinds of activities and in which ROE levels vary widely, from “advisory specialists” like Evercore Partners (that will be able to offer investors an ROE of more than 30 percent) to “utility providers” (offering technology and other operational support for bigger entities and a return on equity of 15 percent to 17 percent). JPMorgan Chase and any other firms that end up in the “powerhouse” category – big players with a dominant market share in key asset classes – will rely on volume and “execution excellence” to generate returns.
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Still, BCG predicts, there is room for only two or three of these institutions to achieve an ROE of 15 percent to 16 percent. Even then, banks hoping to boost their ROE will have to continue to find ways to further cut costs and boost revenues, BCG says.
Banks and investors alike should pay careful attention to the BCG report. Investors will benefit from realizing that the broad category of “financial” stocks is really a far more diverse universe than many recognize. They don’t need to rely on the megabanks’ ability to generate double-digit returns on equity if they can get the same kind of performance from the likes of Lazard Ltd.; they don’t need to worry about the risks associated with hedge funds or derivatives if they opt to invest in some other niches of this universe.
Significantly, the report points out new kinds of risk that may be emerging as the post-crisis banking world undergoes this shakeout:
"Some issuers and investors are attempting to create a marketplace without intermediation.”
In other words, they are attempting to do without the public markets and the financial institutions that are regulated in the public interest.
"Certain less-regulated entities such as hedge funds and physical-commodity traders are venturing into the traditional CMIB space.”
In other words, in addition to taking advantage of those opportunities created by the ongoing shakeup of the financial sector, we may well also want to pay careful attention to its risks, which may, BCG suggests, include the development of a new kind of shadow banking system.
