News over the weekend had it that one of the world’s biggest universal banks is essentially shuttering a significant portion of its investment banking operations. UBS, the giant Switzerland-based bank, was reacting to changes in the marketplace as well as tighter regulations for capital adequacy as they came along.
The Financial Times reported that UBS will cut 10,000 of its 63,000 global jobs over the coming years; the bank will also put a large part of its trading fixed income, currencies and commodities under the stewardship of its one of its old co-heads of investment banking with a view to shutting down the business over the next few years.
In essence, the “non-core” part of the bank will be seen as a separate entity that houses the assets considered overly risky by the rest of the bank, which will then be free to focus on private banking, wealth management and investment advisory services as well as a swathe of more traditional investment banking (mergers and acquisition advisory, traditional corporate finance advisory and the like).
If the news is confirmed in coming days, it marks the withdrawal from “holistic investment banking” of one of the more hallowed names in the world of banking.
UBS was no slouch in these businesses, and despite suffering an embarrassing series of gaffes in the business since 2008 when a giant book of problem assets was identified in a little-known hedge fund inside the bank to more recently the scandal around fake equities trading that cost the bank over US$2 billion, the rest of the investment bank still held a strong market share in a number of areas and was considered particularly excellent in a few of these.
There are multiple reasons that account for such a withdrawal and certain lessons we can draw from this trend; while the main ones are generally positive for the world of banking, there is one issue that will gnaw at the purse strings of policymakers and markets over the next few decades that bears close watching.
Regulators, in particular the Swiss National Bank, can feel some joy that their attempts to rein in “casino banking” has by and large succeeded with the UBS announcement and before that the changes of strategy echoed by Morgan Stanley, RBS and Barclays. Arguably, disputes of this kind lay behind the surprise firing of Citibank’s chief executive a couple of weeks ago when the US bank announced barely-there earnings for the third quarter of 2012.
They increased supervision of these operations, insisted on more management accountability and lastly pushed for significant increases in the capital allocated to such activities as proprietary trading and holding fixed income assets.
The sum total of these changes was to make the business deeply unprofitable for the major banks; after those changes, the regulators (at least in Switzerland and the United Kingdom) stepped back and let the markets deal with the banks: which they did promptly by forcing CEOs to directly address both compensation and capital efficiency (return on capital employed).
The cyclical nature of investment banking as well as the capital effects of the banks’ favored strategy for counter-cyclical earning smoothing – namely inflating the balance sheet and piling on more assets in an attempt to capture higher returns against their borrowing rates – both run counter to what is now being demanded by both regulators and shareholders.
The second major reason for the UBS withdrawal is the fact that excess competition has pushed down fees and made the business simply uneconomic for most players in the middle of the last decade.
In the first instance, banks bulked up their balance sheets going into the 2007 crisis. After the crisis, central banks, fearful of a mass dumping of assets, pushed liquidity through the system, thereby creating conditions for a more gradual withdrawal of balance sheet activity.
As a number of assets have now started accelerating towards maturity, banks following that strategy have been exposed as the proverbial “swimmers without bathing trunks” in the Warren Buffet aphorism.
As readers of this column know, I believe that this excess liquidity created by central banks is an erroneous strategy that will eventually have deleterious consequences on the financial system. One of those consequences was the excess employment in the financial sector from 2009 and the other was the lack of accurate marking of distressed assets; all a bit like the old Soviet joke about “we’ll pretend to work and you’ll pretend to pay us”.
The continued provision of liquidity has not gone to the pockets of homeowners but rather has lined the pockets of banks; it is this subsidy that allowed banks to absorb the financial impact of all the dud assets on their books. But with a zero-interest policy in place for so long, the flip side started hurting the banks – namely, the lack of returns on assets and equity over the course of latter half of 2011 and over the course of 2012.
Thus, the score stands at 1:1 between regulators and well, regulators; in the sense that while some moves to supervise the banks and get a better handle on risks have been worthwhile, the efforts were waylaid by the excess liquidity generated elsewhere in the central banking system. In effect, global banks weren’t any more under the control of their regulators in 2012 than they were in 2009.
This is where the third development over the past few years has become important not just for central bankers but also for the wider appreciation of new risks in market capitalism.
Since the crisis, it has become increasingly clear that the size of the pie – that is, the fee and revenue pool – has been declining for investment banks. The primary reason is that large global companies have become immensely cash rich, and as such are not so dependent on banks for funding. Given the murky economic outlook, they haven’t been focusing on M&A either, so there haven’t been a lot of high-fee days for bankers.
The Asian model
Meanwhile, a number of owner-managers have started exerting more control on their firms, in essence bringing the “Asian” model of business into the global market place.
This hasn’t always been intentional but must be understood in the context of two factors – firstly that banks have lent businesses a lot less (putting their cash into buying assets from the central banks instead), which has increased the pressure on businessmen to support their firms.
Secondly, the absence of real returns in most asset classes – bonds and other fixed-income instruments primarily – has meant that wealthy folk have had to either take big risks or else accept mediocre returns. That’s why a number of businessmen have been ploughing money back into their businesses or funding growth with their corporate platforms.
Curiously enough, businessmen borrow money from their banks – the private banking side – to fund some of these investments. Hence the rising profits of the private bankers even as investment banks have seen their profits tumble. That’s why the likes of Morgan Stanley and UBS have refocused away from investment banking towards private banking.
When banks deal with these businessmen, they often find it easier to provide them assistance through their personal portfolios against a diversified portfolio of property, companies owned by the family, valuable artworks and so on.
That’s different quite often from lending within the corporate umbrella, where the main exposure is to the corporate assets. In any business downturn, these assets will lose value and expose banks to losses; which is why diversifying their “collateral” through other assets that may not be correlated (eg artworks).
Why is this development troubling? Quite simply, because in this world of asset-based rather than credit-based lending, a lot of things could be going wrong fairly quickly. Documents are murkier than in the case of lending to companies; and in most cases there is no disclosure of the facilities required in annual accounts because private banks are bound by confidentiality requirements and their customers are private individuals without any reporting requirements.
When I wrote last week about regulators failing to spot changes in technology (see Regulators fail the nerd test, Asia Times Online, October 27, 2012), the same is also true of banking.
Once again, markets have proven to be stronger in pushing for changes, with or without regulatory realities. Alongside though, an increasing if not large part of the world of banking has gone private, beyond the disclosure requirements of the corporate world.
It’s not that the road ahead is particularly narrow or treacherous; it just that the lights have been switched off.