Back from the abyss
When Lehman Brothers collapsed a year ago and sent the global financial services industry into meltdown, the UK’s three investment banks were thrust into the eye of the storm. Since that watershed moment they undergone a transformation, with two now partially owned by the government. And while it looks like the worst could be over, they still face a stern test of their strategies. David Rothnie reports.
In the aftermath of the collapse of Lehman Brothers, the point at which the credit crunch threatened to turn into a complete financial collapse, the UK's banks looked like they would lead the march into oblivion. The Royal Bank of Scotland, which suffered the biggest losses in the subsequent market carnage, was especially vulnerable: its ill-timed acquisition of ABN Amro had weakened its capital base, triggering a rescue rights issue and a bailout by the UK government. Meanwhile HBOS, which relied heavily on the wholesale financial markets for its funding, was forced into an emergency merger with Lloyds TSB and a taxpayer bailout.
The crisis had first threatened to engulf Barclays, but the bank has emerged as a winner. It snapped up Lehman’s US and Canadian investment banking businesses, embarking on a dramatic transformation into a full-service investment bank. But Barclays’s expansion and survival has come at a price: in seeking to remain independent of state aid, Barclays sought a controversial capital injection from the Middle East and sold off its asset management arm, Barclays Global Investors.
With markets rebounding and the Bank of England restoring confidence with a series of initiatives, the UK’s banks are on a more stable footing. Their investment banking businesses have returned to profitability. Yet stiff challenges remain. RBS faces unprecedented scrutiny following its part-nationalisation, and must prove its recovery is sustainable. Its new management team must deliver on an aggressive programme of asset disposals. Barclays Capital must succeed where it previously failed and prove it can build a full-service investment bank, following an expensive high-profile recruitment drive. Lloyds Banking Group, which had the least exposure to investment banking, nevertheless has a big integration challenge following its shotgun marriage.
Back from the brink
RBS has endured a torrid time in a year that saw its plans for global domination through the €71bn acquisition of Dutch bank ABN Amro reduced to tatters. The architects of that strategy, led by Sir Fred Goodwin, the bank’s former chief executive, were forced to step down. The bank, 70% owned by the UK taxpayer following a £20bn bailout last October, has a new chief executive in Stephen Hester. He has launched a new strategy and set about reversing the empire-building synonymous with Goodwin’s regime. Where Goodwin was obsessed with expansion, Hester is focused on consolidation. But RBS’s banking and markets division, which caused the massive losses and damaged its reputation, remains crucial to its survival in the post-crisis environment.
In the first half of the year, RBS limped to a profit at group level, but operating profits from its investment banking division more than quadrupled from the same period a year ago. Booming activity across its interest rates trading and credit market businesses helped reverse the losses of last year.
Stellar revenues from sales and trading in interest rate and money market products, as well as in credit markets, helped propel operating profits in global banking and markets from £1.12bn last year to £4.87bn (US$7.9bn). Revenues from RBS’ global banking and markets were £7.83bn – up 113% on last year – with fees and commissions rising 13% to £728m, although revenues from the division’s trading activities provided the bulk of the total income at £5.73bn.
It would be generous to ascribe the success of the bank’s trading activities to Hester’s new strategy: all banks with strong trading arms reported huge profits from their fixed-income businesses in the first half.
Nor is Hester, who worked at Credit Suisse First Boston before becoming chief executive of UK property group British Land, under any illusions. He warned good results, buoyed by fixed income, could be "unsustainable" and are unlikely to be repeated in the second half of the year.
Instead, Hester will be judged on how quickly he can complete the asset disposal plan, and whether the new management team he put in place in the markets and banking division can deliver and make the acquisition of ABN live up to the promises made when the deal was done in 2007.
The new-look markets and banking division is led by John Hourican. Peter Nielson runs markets and Marco Mazuchelli, who worked with Hester at CSFB, is in charge of banking. Other important lieutenants are Frank McKirgan, a former ABN Amro executive who runs the cash equities business and Richard Bartlett, who runs the combined DCM and ECM divisons under the financing umbrella
At its first half results, RBS broke down its results by "core" and "non-core" divisions, to reflect a strategy announced in February to rebuild its balance sheet by running down or selling assets and business lines that carry too much risk, or otherwise don't fit in. Its core units made an operating profit of £6.3bn in the first half, compared with £4.71bn in first half 2008. But non-core units lost £9.6bn, from £4.86bn in the same 2008 period.
Markets, cash equities, debt and equity underwriting and M&A advisory remain core business. It will stay in the sub-investment grade credit market, but it has pulled out of providing leveraged finance to private equity firms, and scaled back its overall client base and geographic coverage.
Bartlett said: “One consequence of driving into the wall is it forced us to restructure hard and fast. Because of what has happened and our involvement in the asset protection programme, we know how much capital we have, we know we have a clear organised machine to go out and do it.”
Bartlett believes the integration of ABN Amro is starting to bear fruit. “Our traditional trading business may have helped us through in the first half, but our financing businesses are now coming good,” he said. “Companies acknowledge they have to diversify their sources of funding away from traditional bank lending and with the addition of ABN’s business, we now have the full suite of capital markets products to offer our clients.”
The crisis, he argued, brought together the different factions, but it has taken a while. Legally, the two banks have still to achieve unity, with some staff on different contracts, but Bartlett said the firm now acts as one: “Three months ago, it was possible to see the different attitudes. Now we act as one.”
Rivals argue that, as a lender to many of Europe’s big companies, RBS can dictate where and how it can deploy its balance sheet, giving it a ready-made pipeline of equity and bond deals from companies needing longer-term financing. “Financing in the capital markets will be the mainstay,” said Bartlett. “In Europe, the bulk of financing comes from traditional bank lending. In the US, the majority come from the capital markets. We believe there will be a permanent shift in the direction of the US model.”
The bank’s role as bookrunner on the US$2.5bn bond issue by Dolphin Energy typifies the new strategy, said Bartlett. Mubadala was one of the bank’s core clients and RBS was an existing lender, but the bank was lead adviser on the structuring of the deal. “It would have been easy to drop out of the flow of activity, had we been distracted. But we thought hard about who our clients are,” said Bartlett.
Its top-five presence in all Thomson Reuters’ bond league tables by currency illustrates its all-round capability following the ABN deal, but its biggest benefit has been in equity capital markets. Bartlett said: “We had no presence in ECM prior to the ABN Amro deal. Of the £44bn in new equity issued by UK companies in the first six months of the year, RBS was involved in underwriting £39bn.” A big chunk of that was taken up with one deal – HSBC’s £15bn rights issue. RBS admits its decisions around clients and capital deployment have become highly selective. “Capital is available where we have made specific undertakings to make capital available,” said Bartlett.
Despite pulling out of leverage finance for private equity firms, RBS remains committed to non-investment grade. It was bookrunner to Sappi on its high-yield bond and did a similar deal for Virgin Media.
At the bank’s half-year results presentation, Hester complained it had suffered from rivals’ poaching raids. Banks that have not accepted government bailouts have been able to set more attractive rates of pay, although they have since been curbed, following an FSA ruling last month.
However, Bartlett said his business had not suffered. “So far this has not proved to be an issue for us. We are expanding in some areas, such as our business that helps clients buy back their debt. Headcount in our corporate bond business is up by 10% and we are also looking to expand in Russia.”
On the offensive
The financial crisis had an equally dramatic impact on Barclays Capital. But whereas RBS’ banking and markets business was transformed by government intervention, massive losses and a management shake-up, Barclays exploited the turmoil to accelerate its plans to become a full-service investment bank.
Barclays Capital signalled its intent when it bid for ABN Amro. After losing out to RBS, its ambition appeared to wane. Then, in early 2008, it hired a team of emerging markets M&A specialists from ABN Amro as part of selective move into traditional investment banking. This was territory it had avoided since vacating it ten years ago with the sale of its BZW subsidiary.
Its acquisition of the US and Canadian investment banking businesses of Lehman Brothers last September gave it a full-service presence in the world’s most liquid capital market. Since then the bank has won high-profile mandates, most notably providing advice and financing to US drugs giant Pfizer on its acquisition of Wyeth in March.
Larry Wieseneck, head of global finance and risk solutions at Barclays Capital said: “Nine months ago we were one of the few firms with a genuine plan in the aftermath of the crisis. In 2009, much of our focus has been on levelling the playing field across products in different stages of development. Barclays Capital historically had deep debt capital markets expertise in the sterling and euro markets and the Lehman acquisition significantly strengthened its dollar market expertise. The result is that today we’re one of the only firms ranked near the top in each of the major currencies.”
The bank argues that having a US presence is an essential pillar to building a global investment banking business. This was absent with BZW.
While BarCap had board backing to buy Lehman’s US business, it had no such mandate in Europe. It attempted to cherry-pick the bank’s best staff, but talks broke down because Lehman’s European management wanted Barclays to buy the entire business – something that Japanese bank Nomura pulled off.
Since then, BarCap has accelerated its expansion in Europe with a series of hiring raids on rivals, in one of the most ambitious expansion drives of recent years. The bank is building equity sales, trading and research, an equity capital markets business and a M&A advisory operation from scratch in Europe. It believes it is two-thirds of the way through its recruitment drive, but realises it cannot compete for the biggest mandates until the entire structure is in place.
“While our ECM business is fully-formed in the US, in Europe we are in build-out mode,” said Wieseneck. “Our expansion in sales and trading and banking continues apace and early next year we will be able to execute deals almost anywhere in Europe.”
It has completed the recruitment of the bank’s most senior managers. September saw the arrival of Sam Dean, whom BarCap poached from Deutsche Bank to become head of European ECM and co-head of European global finance with Richard Boath, reporting to Wieseneck. Jim Renwick has also arrived from UBS to run UK ECM, while Matthew Ponsonby and Mark Warham, formerly of Citigroup and Morgan Stanley, have started work running European M&A.
Rivals pointed out that BarCap has an immediate advantage because it can use its lending power with clients to win ECM and M&A mandates. While Wieseneck agreed the universal model is a distinct advantage, he is preparing to fight for market share. “We will have to prove to our clients that we can execute in ECM and M&A,” he said. “Clients will not use us just because we ask for their business. Rather, we have to earn their trust.”
Barclays Capital is building out is business at the bottom of the market, but missed out on a bumper pay-day that rivals like RBS enjoyed from the record levels of equity issuance in Europe this year. “If you look at the world as a short-term opportunity then we have missed the recent flood of equity issuance in Europe,” said Wieseneck. “But we are making decisions beyond that and are aiming to provide the full suite of products across the next cycle.”
BarCaps’s ability to lure talent from rivals that accepted taxpayer bailouts was possible because of its stubborn refusal to take government money. Barclays President Bob Diamond expressed frustration earlier in the year about its constant need to defended itself over its capital position. After both RBS and Lloyds fell into partial state ownership, analysts were convinced Barclays would follow.
When its share price nearly went into meltdown at the start of 2009, threatening to destabilise the bank amid fragile confidence in the barely functioning funding markets, BarCap came out fighting. In an unprecedented move, chairman Marcus Agius and chief executive John Varley published an open letter to shareholders, reassuring them that results for 2008 would be brought forward and show strong revenues. The bank absorbed £8bn in gross credit impairments and still turn a pre-tax profit.
More recently, it nearly had to seek insurance under the UK government’s asset protection scheme, a backdoor into partial nationalisation. It avoided this when it sold the iShares division of Barclays Global Investors, showing its ability to raise more capital. Not only did it enable the bank to avoid the APS, but it enabled it to continue its hiring spree. Sources at the bank said Renwick had been considering a move for months but delayed signing up until Barclays had avoided participating in the APS.
While questions still remain over bad assets, the scepticism has given way to acceptance by rivals that the bank is a winner from the crisis. Its recent results prove that Barclays Capital remains a strong growth engine.
In the first half, profits at Barclays Capital doubled to £1bn, accounting for 35% of overall group profits. Much of the bank’s success was down to higher customer volumes in areas like interest rates and currencies, and capital markets activity such as underwriting bond sales, said Diamond. But as the investment bank bounced back from a weak 2008, bread-and-butter lending to retail and commercial customers was hit by rising impairments on corporate and consumer loans. The biggest challenge facing Barclays’ management in the months ahead is not supporting an underperforming investment bank but how to break its reliance on Barclays Capital.
Still looking inwards
Lloyds’ capital markets business is relatively small and the bank has adopted a more cautious stance in investment banking, avoiding an extensive build-out. However, the forced takeover of HBOS has started to change that, while also handing the combined group a big restructuring and divestment challenge.
Lloyds acquired HBOS at the height of the financial crisis. Within weeks it needed a £17bn bailout, resulting in the UK government taking a 43% stake in its shares. Before making the acquisition, Lloyds was among the few banks to carry a Triple A credit rating. It had been lauded for focusing on traditional lending and deposits, while its peers loaded up on risky assets.
During the first half of the year, LBG recognised losses of £1.4bn on debt securities and available for sale investments, compared to £203m for the second half of 2008. HBOS legacy assets accounted for around 80% of the first half write down.
The corporate markets business, which includes its commercial real estate and specialist finance units, among others, reported a loss of £7.73bn from corporate impairments due to the deteriorating economic environment. The asset finance unit, which provides leasing and speciality finance, reported a loss of £250m – again from impairment charges.
However, total income from Lloyds’ wholesale banking division, which is being restructured following the HBOS acquisition, was up 37% to £4.65bn in the first six months. This was driven by the market dislocation, low interest rates, good transaction volumes on the capital markets and robust client demand for derivatives at higher spreads, the bank said.
LBG submitted a restructuring plan for Lloyds to the European Commission on July 15 and the EC has indicated that a condition of approving the state aid received by Lloyds could be the disposal of some of its operations. The bank has pre-empted the findings of this report and is understood to have put controlling stakes in both the equity and debt of HBOS’s integrated finance unit on the block, in an effort to accelerate the divestment exercise. The division is likely to be valued at just below £4bn. LBG declined to comment.