The golden rule of ambitious bankers used to be: get on first name terms with the CEOs of Fortune 500 companies; build up a contact network and watch the business come rolling in as loans, bond and equity issues; get promoted; and pick up a chunky bonus. This may still be the route to the top for some but there is a growing breed of bankers who have never met a company executive of any description, much less the CEO. These bankers do their business entirely with other bankers on a scale and in a way that has never been seen before.
Welcome to the Brave New World of international finance in which a dozen or so banking powerhouses dominate fundamental businesses from foreign exchange to custody to payments processing. (As well as the advisory and capital raising of the classic Financial Institutions Group or FIG – of which more later.)
Only these key players can run, in the case of foreign exchange and transactions services, a low-margin commodity businesses with the magnitude needed to make a profit. Smaller banks must funnel all their business to the centre. They keep the corporate relationship but become customers of the large banks.
Other forces are driving this trend. Only the giants of finance can afford the huge investments in technology required to make processes efficient, reliable and state of the art. Smaller banks cannot compete in these areas.
Similarly, only the major players can provide the complex risk management and other systems to comply with new regulations on everything from anti-money laundering to operational risk. For smaller banks it is more practical to let someone else deal with this headache and concentrate on client service.
“In difficult economic times in an overbanked system, there is huge competition for business,” says Sandy Jaffee, head of financial institutions for global transaction services at Citigroup. “This leads to price compression and thin margins leave fewer dollars to invest. Only those banks that can achieve economies of scale are able to generate sufficient returns to keep investing in the latest technology.”
Business networks
Banks doing business with other banks is nothing new. International trade was built on the back of correspondent banking networks that supplanted the export-importer relationship with a bank-to-bank relationship. But what is unique about the new situation is the creation of a two-tier banking system, the wide range of business areas involved and the huge implications for the financial system as a whole with regard to risk concentration and the need for robust disaster recovery systems (see box below).
Banks in the big league may define their corporate customer base as companies with $1bn turnover or more. Any below that they cannot deal with efficiently or effectively. But that business may eventually be passed to them by second and third-tier banks that can access the broader corporate market.
By this definition, second-tier can be pretty big. Consider banks such as Fortis, US Bancorp and Commerzbank, which place around the 40 mark in The Banker Top 1000. They can deal with large corporate names but how much of the business they execute is passed to the big global players at the centre?
The new structure is more complicated than this, however. Business does not just flow from the margins to the centre. The large banks are specialised and do huge amounts of business with each other. Bank of New York and JP Morgan, for example, dominate the clearing of government securities in the US and will do this for most other banks. But Bank of New York, even though it is the second largest custody player in the world, may buy in sub-custody services from a competitor such as Citigroup in some countries where it has no physical presence.
“At times we are competitors [of the other large banks], at times we are clients and at times we are providers to them,” says Citigroup’s Ms Jaffee.
Bank of New York’s senior vice-president, Richard Shearer, says: “Banks, regardless of size, are focusing on their specific and varied core competencies. Both small and large financial institutions are relying on other financial institutions to support non-core activities. The challenge for all is to determine how best to deploy the resources we have in partnership with best of breed service providers.”
In many cases, six or seven of the largest 10 customers of one of the world’s major banks will be other major banks. These relationships must have some balance – situations in which one bank is doing all the selling normally result in a high level meeting to discuss how to even things up.
Business between banks
The trend of banks doing more of their business with other banks runs across product areas. It is true for processing businesses but it is also true for foreign exchange, derivatives, capital raising and advisory. Hence the fastest growing business area in the investment banks is the financial institutions group – the FIG as the banks call it. A typical FIG covers M&A, capital raising, balance sheet restructuring,
possibly derivative structures for insurance products and credit derivatives for banks. The clients include banks, insurance and pension companies, central banks, supranationals and hedge funds.
“FIG is by far the biggest business of the Wall Street investment banks, accounting for 20% to 30% of revenues. It is a very important business and is likely to be even more important in future,” says Oliver Sarkozy, managing director in the financial institutions group of UBS Investment Bank. Tony Ursano, co-head of FIG for Banc of America Securities, says that 23% of the European and US investment banking wallet comes out of financial institutions.
According to Simon Harris, head of commercial banking at consultants Mercer Oliver Wyman: “Everyone is talking about FIG. It used to be that the companies were the main constituency and FIG was the orphan. Now banks realise that they can make more money from the FIG than from companies.”
Accelerated growth
Sam Zavatti, global head of financial institutions and public sector for ABN Amro, says: “At one time FIG was not the most glamorous area of a bank to work in but things have changed. The restructuring of the financial sector has accelerated the growth of the FIG business. With banks holding fewer loans on balance sheets and selling them on as collateralised loan obligations, even lending business might now be viewed indirectly as a FIG business.”
Among the hot growth areas in FIG are advising on restructuring of European insurance company balance sheets and capital raising in Japan, where capital ratios have dwindled under the weight of bad loans and provisions. In the US, where the banks are in good shape, a lot of work is done by investment banks in terms of taking assets off balance sheets, packaging them up and selling them on to investors, often insurance companies. Calculated this way, the percentage of an investment or universal bank’s revenues coming from FIG will be even higher, as much as 60%.
“The senior management of a regional US bank might say to us: ‘The strong earnings trends of the last few years cannot continue, please evaluate our balance sheet and see if it can be restructured to increase margins’,” says Vikram Gandhi, co-head of FIG at Morgan Stanley.
One of the advantages of FIG business for both the large banks and investors is that, because the financial sector is highly regulated in most countries, banks generally are higher rated than corporates. By increasing their FIG business, banks can reduce their risks and hold less capital. “The risk quality of the counterparty is high in FIG. Generally banks are rated higher than corporates and that means the level of capital involved is much lower,” says Eric Lombard, head of corporates and financial institutions at BNP Paribas.
Attractive yield
For the same reasons, insurance companies and pension funds, hungry for yield, find the kind of products that can be generated out of the FIG – collateralised loan obligations, credit derivatives, hybrid capital – attractive. Yields can be compelling without an unacceptable rise in risk. The development of hybrid capital products is an art of its own with some of the techniques, pioneered for financial institutions, starting to be used in the corporate sector.
UBS, for example, pioneered a $700m hybrid convertible bond for Scottish Power as reported in last month’s The Banker (see July 2003 issue – Team of the Month).
“The financial industry’s raw material is capital and there are all kinds of hybrid products that have been developed and continue to be developed,” says Banc of America’s Mr Ursano. “Using convertibles and derivatives we can create synthetic debt and synthetic equity. The rating agencies act as quasi-regulators because you couldn’t do anything that affects an issuer’s financial strength rating. You need equity credit from a rating agency to enable many deals that lower the cost of capital to go ahead.”
The M&A side of the FIG business is currently slow. Richard Barrett, head of FIG at CSFB, puts this down to more than depressed stock prices and poor economic growth; he also cites the new US purchase accounting rules which are less advantageous to acquirers than the pooling-of-interests method that has been abolished. “Our business plan has shifted so that we expect M&A to account for one-third of revenues, down from a half, with capital raising activities filling the void,” he says.
Regaining status
Mr Barrett says that FIG has always represented a significant portion of investment bank earnings and quickly emerged as a sector specialisation in the 1980s. It may have been overshadowed by technology, media and telecoms in the late 1990s but is now regaining its status. “One of the reasons financial institutions are so important to investment banks is that they are such substantial customers of their equity and fixed income securities businesses in addition to their advisory businesses,” he says.
With FIG business, the sell side, the buy side and the intermediary may all be financial institutions. In which case, shouldn’t it be easy to put deals together? Everyone knows one another, talks the same language and there is none of that messing about in company boardrooms and public debt management offices. Right?
Wrong. Customer relations management in the FIG area is a nightmare, with every institution having multiple buying points. With companies, the golden rule is: see the CEO for M&A and equity deals and the CFO for bond and loan deals. A financial institution, by contrast, is a more complex beast.
Take Fortis for example, which as a bancassurer is an ideal FIG customer for a superleague bank. But where should the coverage begin? Fortis is organised in six businesses: three insurance companies in the Netherlands, Belgium and the US, and three banking divisions (network banking, merchant banking and private banking). Good coverage would require making contact all over the place. One estimate is that good FIG coverage requires 15 contact points per institution.
In securities and cash processing, things are no easier with banks having to make their way around multiple buying points in broker dealers, asset managers, banks, insurance companies and market infrastructure players, such as clearing and settlement houses.
“Banks have tried to respond by having a global head of relationships who is the key link into an institution. But this person may be from commercial banking and struggle to sell investment banking products or vice versa. It’s tough to know how to deal with it,” says Justyn Trenner, CEO of research firm ClientKnowledge.
Sam Zavatti: FIG has become more glamorous
Oliver Sarkozy: FIG is big business on Wall Street
Sandy Jaffee: competition leaves less to invest
Tony Ursano: hybrid products have been developed
Value-added services
Customer contact is vital because although the two-tier system is built on commodity financial products – that only the big banks can churn out competitively – the real revenue generating opportunities for the large banks come from selling value-added services. One pressure pushing the two-tier system is regulation; the cost of complying with new regulations is prohibitive for many banks. But regulation also creates new opportunities for entrepreneurial players to provide value-added services, such as anti-money laundering filtering.
One reason why FIG is more profitable for banks than corporate work is the volume of products that can be sold. “Remember that financial institutions are also corporates and that everything you can sell to a corporate you can also sell to a bank – M&A advice, derivatives, debt and equity underwriting – except that financial institutions buy a lot more,” says Mr Lombard of BNP Paribas. “Asset managers buy a lot of derivatives as do insurance companies selling products that guarantee investment returns. The balance sheet management of a financial institution is more complex than that of a corporate and they would need a lot more in the way of swaps and derivatives.”
In many product areas, smaller bank customers want to use larger bank services but make it appear to their customers as though they supply anything. There are many forms of “white labelling”, as this process is known, with the supplier bank providing everything from simple liquidity for foreign exchange services through to a specially-designed platform. “From our perspective, it’s about being able to go to a bank and offer them a combination of liquidity, technology, and rebranded technology that fits in with their deal flow and internal business processes,” says Scott Freeman, director of FX e-commerce at Citigroup.
The risk factor
What does all this passage of business into the centre do for the risk management of the financial system? Clearly the smaller banks are delighted to offload some of their risk. “There is a desire on the part of users to transfer risk without paying for it,” says Citigroup’s Ms Jaffee. “Banks are responsible for what goes through their system but some clients want an end-to-end guarantee, taking in such things as risks in the depository or the use of messengers where the system has not been dematerialised.”
Regulators and banks can do little about the concentration of risk; they can only encourage banks to adopt state of the art risk management. To some extent Basel II is hastening the development of the two-tier system by allowing the large banks to use their internal risk management systems whereas smaller banks are dependent on the generally agreed limits. Only the big banks with large IT budgets can afford the internal systems that allow them to hold less capital.
But Basel II’s focus on operational risk becomes all the more understandable: the financial system faces meltdown if anything should go seriously wrong with one of the central players.
Bankers and regulators find themselves in much changed circumstances. Regulators are grappling to understand and deal with the new risks of a two-tier system. Bankers are getting accustomed to a life in which they may be competing one day against someone who will be their potential customer the next. Tact, diplomacy and professionalism of the highest order are needed to survive in this new world.
Two-tier banking
The emergence of a two-tier banking system is illustrated in many ways.
The Banker’s Top 1000 shows that the world’s top 25 banks now account for 34.3% of total Tier One capital and 38.1% of assets.
In The Banker’s 2003 foreign exchange survey, Citigroup, UBS, Deutsche Bank and HSBC dominate all regions and product areas.
In underwriting, four banks – Citigroup, Deutsche, Morgan Stanley and JP Morgan – account for 31.84% of total issuance, according to Dealogic BondWare.
In custody, Bank of New York, State Street, Citigroup and JP Morgan account for 60% of world-wide custody assets, according to the portal globalcustody.net.
One interpretation of this situation could be that an oligopoly of big players is squeezing all the others to the margins. But life is as tough for the major players as it is for the second and third-tier banks, many of which have found profitable niches and are not carrying the huge overheads of their larger brethren.
Take lending, for example, which has long been a loss leader at the Fortune 500 level but can be lucrative further down the pile.
Oliver Sarkozy, managing director in the financial institutions group of UBS Investment Bank, says: “The challenge facing the large commercial banks is how to make money out of products that are highly commoditised.
“Lending to Joe’s Autobody Shop is difficult for a large bank to source and service with the same kind of quality and personalised attention that a smaller community bank can bring to bear.”
