The new line up: investment banks battle for position
There are two clear leaders at the front of the investment banking pack, but a battle is being waged immediately behind them - and there is everything to play for. Geraldine Lambe reports.
As the dust settled from the financial crisis, two clear winners in the investment banking landscape emerged: Goldman Sachs and JPMorgan. Neither escaped some harm in the eye of the storm, but each demonstrated strong risk management and the ability to prosper through the darkest of markets.
They remain at the head of the pack, but they each face challenges. While Goldman defends its reputation and fights a fraud charge filed by the US's Securities and Exchange Commission, JPMorgan faces a resurgent industry.
During the crisis, it is estimated that 15% to 20% of market share changed hands. Much of it went to the safe haven of JPMorgan. But analysis of pre- and post-crisis revenues and market share carried out by Morgan Stanley and Oliver Wyman reveals that JPMorgan has lost much of the share that it won through acquisition and sound management. It may be at or near the top of league tables, but in Q1 it had less market share in mergers and acquisitions (M&A), equity and debt than in it did in Q1 2007. Of the two, only Goldman Sachs has retained its gains, adding 5.4% in fixed income, commodities and currencies (FICC), and 4.3% in equities, in the same period.
Now the battle for market share is raging with renewed vigour. Banks that were badly damaged in the crisis are making a comeback, delivering rejuvenated results. Others that avoided government intervention are making ground - winning clients, mandates and market share. And JPMorgan's acquisitions were not the only deals to deliver on their promises; others are also proving to be game-changing.
| Investment Banks |
There is everything to play for, but not everyone can be a winner. Last year was the year for investment banking. Rates were benign, markets were supported by government stimulus, and companies were raising capital while the going was good or to prepare for times ahead. That era of plenty may not last much longer. The next age will be characterised by tougher regulation, uncertain returns, reduced margins and scarcer capital. The winners will be banks with scale in trading, married with a good advisory business, exposure to growth markets and plenty of capital. Regional players - already gaining ground - and emerging market banks will pose ever-greater competition to the global elite.
Winning acquisitions
The mother of all winners by acquisition is JPMorgan. First it mopped up Bear Stearns, then Washington Mutual; along the way it has picked up pieces of commodities businesses from UBS and Royal Bank of Scotland. Each has been additive to the JPMorgan platform and helped to take its business into a different league.
At an investor day only four or five years ago, JPMorgan said it was not sure if it even wanted to be in equities. The Bear Stearns acquisition answered any such doubts. "Bear Stearns added a big prime brokerage and cash equities business, and gave it scale in commodities. This has transformed JPMorgan from an also-ran into a leader," says Jason Goldberg, senior bank analyst at Barclays Capital.
BarCap, too, has transformed itself, gaining a crucial leg-up in the US market with its acquisition of the Lehman business, and a ready-made platform in cash equities and M&A. It has been quick to stamp its brand on the bank. Ex-Lehman insiders speak of the Monday they came back to work about a month after the deal was done; they were welcomed by Barclays' blue neon flashing around the New York headquarters on 7th Avenue. Inside, Lehman green carpets had been replaced with Barclays blue, and every single piece of Lehman paraphernalia removed from the building, from mugs to mousemats.
If this smacks of ruthless precision, then it has paid off; most Lehman staff, then traumatised by the dramatic loss of their firm, are now impressed with the way that BarCap has integrated the businesses and made it work.
"The conditions have been good for everyone in investment banking but the best banks have been those with the ability to turn that into increased profitability and greater market share. Barclays has done a good job quickly turning the Lehman acquisition into tangible gain," says Simon Adamson, European bank analyst at independent research house CreditSights.
Bank of America's acquisition of Merrill Lynch was no less dramatic but much less seamless. It has cost the bank a CEO, most of the board and a plethora of senior managers. However, it is now looking like a better deal. The price may have been high, but the promise identified by then CEO, Ken Lewis, is paying in spades in M&A, equities and commodities. In 2009 it finished fifth for M&A globally, and fourth in terms of revenues. In Q1 this year, Bank of America Merrill Lynch (BAML) is number one for initial public offerings revenue worldwide (with another acquisition beneficiary, Nomura, in second place). This would have been unimaginable before the Merrill acquisition. Merrill gave Bank of America an international presence that it had tried, but failed, to build.
If results are a little slower to arrive in a depressed retail brokerage market, Merrill is certainly paying its way overall: of the $4.2bn net income reported for Q1 in April ($19bn pre-provisions), $3bn was attributed to legacy Merrill businesses.
"Bank of America isn't a winner; but it looks increasingly like a winner in process," says Dave Hendler, senior US bank analyst at CreditSights. "It has a way to go, but it has a great franchise with both breadth and depth."
Scale in trading
Banks may fight to gain league table position for underwriting or M&A, but it is trading where investment banks make most of their money. "The engine that matters for banks is trading; the majority of their revenues are generated in their markets business, therefore it's scale there that really matters. Goldman's risk management capability and its capital position mean that it is able to operate on a different plane to most of its competitors," says Guy Mozkowski, a research analyst at BAML.
Goldman Sachs has long been demonised for the revenue it earns from trading, relative to the revenue it earns from investment banking: in Q1 this year, trading accounted for 72% of Goldman's revenues. But if it is true that this is where Goldman makes a lot of money, it is the same for everybody else. BAML has emerged as a trading giant. Quarterly revenue data reported to the Federal Reserve reveals that it is second only to Goldman.
But with bid-offer spreads tightening after a period of more generous returns, it is the flow monsters that will have the edge. In FICC, that means Goldman Sachs, JPMorgan and BAML in the US, and Deutsche Bank and Barclays in Europe. In Q1, FICC trading soared by 85.9%, accounting for 57.8% of Goldman's $12.78bn in revenues. Also reporting in April, JPMorgan and BAML stated that trading in FICC underpinned their $7bn in trading revenues.
It is no surprise, then, that the rebuilding of UBS's dysfunctional FICC division (now being overseen by a Goldman FICC veteran) is a key component of the Swiss bank's recovery plan, or that Morgan Stanley has hired 350 people in sales and trading in the past year. While FICC is reported to have contributed $2.3bn of revenue in UBS's Q1 figures, it, and Morgan Stanley, remain a work in progress.
"UBS is making money again, but there is still a lot of work to do to turn the franchise around. In terms of fixed income, it was never the strongest bank and it has lost a lot of ground in one of that sector's best years. There is a lot to do," says Mr Adamson.
The two at the top: Goldman Sachs and JPMorgan have emerged as the investment banking arena's clear winners as the dust from the financial crisis settles
Capital is king
Whatever the eventual shape of the financial reforms, capital is going to be an increasingly competitive issue. But it will likely remain a rare resource for some time. A McKinsey report released in February modelled various scenarios for 25 global banks; in the extreme scenario, the banks would need to raise more than $600bn over the next five years, equivalent to approximately 35% of today's capital base. For banks in emerging markets, where need will be driven by growth, this may not be challenging, the authors suggest; but for some banks in developed markets, with returns on equity falling, raising such capital could be a challenge.
So banks that have it and use it well will gain market share. Goldman's well-capitalised position gives it a significant advantage. "It has about $60bn of tangible equity; it does not say how much is allocated to the institutional business, but it is certainly the lion's share. Compare this to Morgan Stanley, which has about $30bn of tangible equity, and only about $17bn of that is allocated to the institutional business," says Mr Mozkowski.
"It is likely that Goldman allocates about double the capital to its institutional business compared with Morgan Stanley and Citi; it may even be bigger than JPMorgan, which has about $40bn dedicated to the institutional business. This level of capital will be crucial in winning business from clients looking to do large transactions. Morgan Stanley is reconstituting sales and trading, and rebuilding its risk management reputation, but it doesn't have the capital to bring to bear on the kind of trading business that its competitors now have," he adds.
Advisory matters
While trading revenue drives the numbers, it is investment banking that forges the relationships. Here, Barclays, BAML and Credit Suisse may not be the biggest players, but they have seen the biggest upside. Barclays currently lies in third place for debt, equity and equity-related revenues globally, behind BAML and JPMorgan. It advised on two of the three biggest M&A transactions in 2009 and is currently at the top five in the US. In the scant 18 months since its acquisition of Lehman's US business, Barclays has virtually overtaken Deutsche Bank in advisory and equities, two areas in which Deutsche has been building for years.
In the process of repositioning itself under CEO Brady Dougan, shedding risk and exiting some businesses, Credit Suisse has regained a position in equity and advisory businesses that it ceded some years ago. It won some key equity capital markets mandates during the crisis and recently grabbed the lead M&A advisory role for US insurance company Prudential's acquisition of AIG's Asian assets from Prudential's corporate broker, UBS. In addition, it has exploited the weakness of UBS to gain ground in private banking and wealth management, further rebalancing the group.
"Although it has not been immune to losses, Credit Suisse has generally thrived through the crisis to regain its historic strength in equities and M&A," says Mr Adamson. "And the investment bank is balanced by a good wealth management business that has highlighted UBS's weakness."
Fiona Swaffield, head of financials research at brokerage Execution Noble, says Credit Suisse is more geared to any improvement in equities revenues than some European competitors. She says that every 5% up in equities revenues in 2010 over 2009 equates to a 2% increase in investment banking revenues at Credit Suisse (and UBS) but 1% at Barclays and Deutsche. She adds, however, that it still has something to prove. "Credit Suisse has also done well, and certainly from an equities and advisory perspective it has plenty of upside. But this year will be critical in proving that its superior performance versus peers is sustainable."
A waste of a good crisis?
Others are doing well - and have taken market share off the leaders - including emerging markets specialists such as Standard Chartered and European players such as Deutsche and BNP Paribas. But they do not seem to have used the crisis to their advantage to the same degree.
Deutsche, for example, is certainly not one of the losers of the crisis, but it is not one of the big winners either. Unlike JPMorgan, Nomura or Barclays, it has not benefited from the acquisition of a Bear or a Lehman. It is in the midst of a commodities build-out, but it missed out on RBS's sale of Sempra and UBS's exit from some businesses, which were snapped up by BarCap and JPMorgan. Equally, it has not been able to use the crisis to gain market share in wealth management or private banking, like Credit Suisse. Moreover, Hank Calenti, Royal Bank of Canada's European bank analyst, says some of its big revenue drivers have slowed.
"I'm not sure about the sustainability of some of Deutsche Bank's earnings power going forward. For example, it has traditionally made a lot of money from loan trading - using its balance sheet to lend and then parcelling out the loans to shed risk. This was a great business during the boom years, but has fallen flat now. I'm not certain what will generate more stable earnings going forward," he says.
Regulation: the game changer
In the weeks and months ahead, the entire playing field could change. Banks wait with bated breath to see the outcome of legislative and regulatory debate. Some of the proposed changes would transform (or decimate, depending on your philosophical stance) the banking landscape. New capital requirements being mooted in Basel would radically alter the economics of the derivatives business, for example, while the Lincoln Bill in the US would force derivatives businesses to be spun off from the banks and their door to Federal Reserve support closed. These moves, and others, including the Volcker Rule, would dramatically reshape the banking landscape.
JPMorgan CEO Jamie Dimon has become a vociferous industry defender, arguing that banking must not be demonised and, in defence of JPMorgan, that good banks should not be punished along with the bad. In his epic 36-page letter to the bank's shareholders this quarter, Mr Dimon puts forward a cogent argument about where regulation should focus, along the way urging regulators and legislators to "avoid broadly penalising all firms alike - regardless of whether they were reckless or prudent".
The Goldman affair may change the dynamics of the argument. There is little doubt that the charge is part of the US Securities and Exchange Commission's (SEC's) push to rehabilitiate its reputation as a regulatory body; but whatever the rights and wrongs of the charge - and Goldman robustly denies any wrongdoing - the storm it has unleashed is likely to redouble legislative and regulatory efforts.
It may also hurt Goldman. The firm is used to criticism, and has historically been able to shrug it off. Accusations of being more of a hedge fund than an investment bank, and for being the major beneficiary of an AIG payout, have done little to dent its business. But this episode could be more damaging.
"It has come out of the crisis with its reputation as a risk manager really enhanced, but its reputation in the eyes of the public is unquestionably damaged. People are suspicious that it has been too successful throughout the crisis, and this isn't helped by the SEC's lawsuit. We have yet to see whether this will materially affect Goldman's business; but the effect cannot be zero," says Mr Mozkowski.
CORRECTION: In the Strengths & Weaknesses table, we mistakenly said that Morgan Stanley was pushed out of the global Top 10 for equity in Q1. In fact, Morgan Stanley was 4th globally, 2nd in the US and 3rd in EMEA for ECM, according to Dealogic. The table has been amended. We apologise for this error.
1) Banks: strengths & weaknesses
