The post-Labor day period was supposed to be about jumbo IPOs and capital markets grinding into gear again – a chance for investment banks to regain their swagger. Instead, the headlines have been dominated by a disastrous investor day at Societe Generale – complete with a 12% one-day share price plunge – and a sweeping overhaul at Citigroup.
In an uncertain world, one thing remains constant: bank stocks are unloved by investors – particularly those weighed down by the more volatile and capital-consuming investment banking and markets businesses.
I am old enough to remember when banks felt it was a must to target a valuation multiple at least equal to their book value. Anything else was deemed unsustainable. After all, a market capitalisation less than a bank’s net asset value implies value destruction.
But depressingly few bank executives can pretend that’s a realistic goal anymore, looking at their share price in recent years. If anything, their dismal performance raises a fresh question: is 0.3x the new 1x book value?
It would certainly seem that way if you listened to SG’s new chief executive outline targets of almost zero revenue growth for the coming years and a return on equity only hitting 9%-10% three years from now, despite its share price languishing on 0.3x book value. Valuations are not much better for Deutsche Bank and Barclays. Even Europe’s strongest investment bank, BNP Paribas, trades at a significant discount to book.
The big US banks, barring Citi, look healthier thanks to their scale and home field advantages. But, apart from JP Morgan and wealth management-focused Morgan Stanley, they still face challenges. The hard truth is that rising interest rates have lifted the profitability of corporate payments and retail banking far more than investment banking.
The deal-making environment should turn at some point and ease some of the pressure on investment banks. But here’s the thing: the fantastic trading environment for macro trading desks is unlikely to get any better, while capital requirements are only going one way – and will land most heavily on markets businesses. Goldman Sachs’ David Solomon recently said he expects capital requirements to increase by slightly more than 25% based on the current proposal from US regulators. This will further increase the regulatory advantage of non-bank market makers like Citadel Securities and Jane Street.
Senior bankers often boast about their share of the industry revenue pool, or “wallet”, but this approach increasingly looks outdated. Entering and exiting markets is costly. Just ask Deutsche Bank with all those long-dated derivatives that weighed so heavily on returns over the past decade. Shrinking an investment bank balance sheet quickly and selling positions at huge losses can even bring down the whole house – as we saw at Credit Suisse.
These examples underscore how discipline has never been more important when running an investment bank and the need to focus on building businesses with moats, while maintaining profitability and strong risk management.
Let’s start with businesses with moats. Competition from electronic trading firms, investment banking boutiques and private equity has meant that some products just aren’t attractive anymore in a highly regulated banking world. A focus on captive flow is a must, whether it be the huge FX trading revenues that banks like Citi and HSBC generate thanks to their global corporate payments networks, the more localised franchises that regional champions have, or the stickiness of financing relationships in an increasingly commoditised markets business.
Zooming in on financing: the banks that have fared best in trading in recent years have either been market leaders in prime brokerage or have been investing heavily. This business is booming thanks to the breakneck growth of highly leveraged, multi-strategy and macro hedge funds that need financing for their positions. Goldman’s markets financing revenues are on pace to reach US$8bn this year – more than triple their level a decade ago. Financing has been similarly crucial to up-and-comers like Barclays and BNP Paribas.
Financing is balance sheet intensive but, in a world where electronic trading has shrunk margins in areas like equities and corporate bond trading, investment banks simply can’t afford to miss out. For proof of this, look no further than the complete collapse of Credit Suisse’s equity trading franchise after its exit from prime brokerage.
It’s also important to check regularly that those moats are still intact. Citadel Securities has been successful in cornering the US equity retail trading market and Jane Street has had a decade-long first-mover advantage versus banks in trading fixed-income exchange-traded funds. Banks can’t afford to miss the next big thing that could disrupt their core competencies, like credit trading.
Next up: discipline on costs and capital buys optionality. Investment bank executives are ruled by FOMO – fear of missing out – more than most. Follow the crowd to where the action is. Let’s not get out before our competitors. Again, Credit Suisse provides the best example with its half a dozen restructurings, cumulative profits of almost zero over a decade and ambitions of a mere 6% return on equity.
The problem is piecemeal actions often result in revenues falling quicker than costs and capital. A rare, successful resizing was Morgan Stanley’s 25% headcount reduction in fixed-income trading in 2015, where it was decisive in focusing on its strengths.
Finally, investment banks live and die by their risk management. The collapse of Archegos Capital Management was not just notable for Credit Suisse because of the size of the losses it suffered, but for the paltry revenues it was generating from this client and the fact that other banks moved quicker to offset their exposures.
Armies of compliance and risk officers are useless if a bank doesn’t have best-in-class risk managers on the trading desk and among senior management. Too often banks skim on costs there and the benefits can prove hard to quantify, favouring instead a focus on investing in client-facing deal teams where success is easier to measure.
The problem is you only miss having a great risk manager once it’s too late and you’ve dropped a few hundred million dollars on a bad trade or loan. It reminds me of the Second World War story of fighter planes coming back from battle where the parts of the plane that had been hit would be reinforced. It took the mathematician Abraham Wald to realise that actually the bigger dangers were the spots that had no bullet holes, because the planes hit in those areas never returned to be evaluated.
With financing growing in importance, not just because of hedge fund prime brokerage but also margin loans to founders and corporates, risk management will matter more than ever. The underwriters of Arm Holding’s recent IPO secured their underwriting fees in large part because of their willingness to provide huge margin loans to SoftBank. But this isn’t a free lunch and banks shouldn’t forget debacles like Steinhoff in 2017 when lenders sustained heavy losses on a margin loan following accounting irregularities at the South African company.
No doubt investment banking is a scale game. But the era of prioritising market share over building moats, return on equity and stability of earnings is gone. Only the banks that find the right mix of all these things can dream of returning to a world where 1x book value represents the bare minimum – rather than something to aspire to.
Rupak Ghose is a former financials research analyst