Wall St banks wonder if they are shrinking for good


Posted at Nov 22 2011 08:51 AM | Updated as of Nov 22 2011 04:51 PM

NEW YORK - Wall Street bankers are used to vicious swings in fortunes - it is in their DNA. Make a killing in the good times, they say, because markets may turn against you tomorrow.

The job losses, bonus cuts and clampdown on the size of trading books this time around, though, seem different. It's not just the euro zone crisis, weak loan demand and volatile trading that has hurt profits, but a raft of new and proposed rules aimed at curbing risk and its sometime partner, reward.

Bankers say they can wait out the cyclical economic forces, but they're choking on fears that the new rules will fundamentally change their business models.

"We are constantly reassessing whether we're experiencing something that is secular or cyclical and under what conditions we would act to shrink or change businesses," Morgan Stanley CEO James Gorman said in a quarterly earnings call last month, adding: "We're not myopically focused on our size."

An admission from the head of the second-biggest U.S. investment bank that he's okay with shrinking is an extraordinary recognition of regulatory and market realities, said Roy Smith, a former Goldman Sachs partner who teaches management practice at NYU's Stern School of Business.

A shrinking bank model has huge implications for many things in business - from how speculative and liquid the world's capital markets will remain to whether thousands of freshly minted MBAs -- not to mention veteran bankers -- will find or keep Wall Street jobs.

Gorman didn't expand on what he may do, but Morgan Stanley has joined other banks in outsourcing business functions, firing employees and slimming bonus pools.

He has also been trimming the bank's reliance on capital-consuming capital markets businesses by expanding his bet on the more stable world of old-fashioned retail brokerage. Fees from advising rich people on investments now fuel more than 40 percent of Morgan Stanley's revenue and should grow as the firm acquires full ownership of a joint venture Gorman engineered in 2009 with Citigroup's Smith Barney wealth unit.

UBS AG has gone further. Following some $50 billion of trading losses during the financial crisis and a rogue-trading scandal earlier this year that cost it $2.3 billion, the Swiss banking giant is reverting to a model in which investment banking and trading are becoming adjuncts to its wealth management operations.

Last Thursday, UBS said it will slash risky assets by almost half and cut its return-on-equity target to 12 to 17 percent for 2013 from its earlier 15 to 20 percent range in the face of tough new capital rules and turbulent markets.

"We have chosen to substantially reduce the risk profile of the bank by exiting and downsizing businesses which are not value added to our client franchise or deliver unattractive risk-adjusted returns," said UBS boss Sergio Ermotti.

Capital constriction

The number of new rules confronting banks is substantial.

Under new global capital rules, banks have to raise higher levels of equity to absorb potential losses from their risky assets. That can be achieved by either issuing stock and diluting current shareholders, or by reducing those risky assets, or a combination of the two. Either way, the chance of big returns (and big losses) is reduced.

For the biggest the restrictions are most onerous. Global regulators earlier this month named 29 banks so important to the world's financial system that they must have more capital and closer surveillance than rivals. The list, led by 17 lenders from Europe and eight from the United States, includes Goldman Sachs, JP Morgan Chase and Citigroup.

The Volcker Rule embedded in last year's far-reaching U.S. financial reform law, the Dodd-Frank bill, is also reducing banks' profit potential by curbing trading for their own accounts, and limiting both their derivatives operations and ability to own private equity investments.

Banks with big retail lending operations face added constraints from recent rules restricting some credit card charges and capping "swipe fees" that merchants pay banks every time a customer buys something with a debit card.

Yet another threat is the "living wills" that big banks operating in the U.S. will have to write by the middle of next year. They will be used as blueprints for guiding regulators on how to break up the firms if they get into severe trouble. If unsatisfied with a plan, regulators can tell a bank to reorganize or even sell off certain lines of business.

Altogether it's a new world of lower risk and lower potential for reward for almost all banks.

"If you return banks to more fundamental products and edge away from risk, it likely means lower income," said Derrick Cephas, a partner at Weil, Gotshal & Manges LLP who served as superintendent of banks in New York from 1991 to 1994.

Behind the scenes, banks are telling policymakers that the new regime could make them more like low-risk utilities, which would reduce their ability to lend to businesses and consumers and keep global markets liquid.

Of course, Wall Street is no stranger to saber-rattling when government threatens more constraints, but veteran bank advisers say it's more than posturing this time.

"Banks are supposed to be financial intermediaries and risk takers, but it's almost impossible to conceive how they are going to be able to do that or return to former levels of profitability," said Robert Tortoriello, a partner at Cleary Gottlieb Steen & Hamilton who specializes in banks' securities activities. "The weight of thousands of pages of new statutes and rules adds layers of cost and complexity that I haven't seen in 37 years of practice."

The new regulatory regime affects not only big firms but also regional and even community banks whose capital conditions are being closely scrutinized.

For the big Wall Street players, the Dodd-Frank derivatives regulations are another major profit vacuum that is expected to lower fees charged for derivatives trades and increase competition.

"I've never seen anything like this," said Thomas Vartanian, a partner at law firm Dechert LLP, who was general counsel of the Federal Savings and Loan Insurance Corp, an agency that backed savings bank deposits, during the thrift crisis of the early 1990s. "The convergence of regulatory, government and economic forces is unprecedented."


Critics say big banks have only themselves to blame for the new order. For thirty years, with encouragement from central bankers such as former Fed Chairman Alan Greenspan, the banks built massive trading inventories and profits on the misbegotten theory that they were the "real" economy, said Richard Bernstein, former chief investment strategist of Merrill Lynch.

"Wall Street sort of lost its way," Bill Gross, co-founder of Pacific Investment Management Co., said at a Charles Schwab conference this month. "Investment banking became a function not of allocating capital properly, but levering capital and levering the returns on capital as opposed to transferring capital to productive industries."

Sallie Krawcheck, who was fired as Bank of America's wealth management chief in September, minced no words at a securities industry conference two weeks ago. "Years and years ago, the markets went from being arenas for capital allocation to being betting mechanisms," she said. "We need to step back."

And while a slump in bank share prices can be partly pinned on the euro crisis, the much more restrictive playing field the banks face has been discouraging investors.

The world's ten largest banks that are involved significantly in capital markets activities such as trading have lost about $250 billion of market capitalization since March 30, according to NYU's Smith, as their stock prices have plunged to an average of half book value. Large banks for most of the past decade have traded at a premium to book value.

As of Sept. 30, Bank of America was changing hands at 29 percent of its book value, Citigroup at 42 percent, Morgan Stanley at 43 percent and Goldman Sachs at 72 percent.

Uneasy bank investors are not biting at the values but instead questioning "the core earnings power for the industry," Guy Moszkowski, head of Bank of America Merrill Lynch's financial institution equity research group, said at the company's annual bank conference last Tuesday.

Cutting the core

Whether the problems are systemic or cyclical, banks are resorting to a familiar short-term solution: cost-cutting.

Bank of America Corp, saddled not only by new capital and consumer protection rules but a warehouse of bad loans and lawsuits, has been selling "noncore" businesses such as credit card operations outside the U.S. and begun a program to excise 30,000 jobs.

"We continue to focus our franchise greatly, narrowing in scope, making sure that everything we do is core," Brian Moynihan, chief executive of Bank of America, the second biggest U.S. commercial bank, said at last Tuesday's conference. "It won't be quite the same as it was at Bank of America and around the industry."

Some bankers, to be sure, say the setbacks won't be as enduring as their colleagues fear.

"We're managing our costs, obviously, but we're not thinking necessarily that there's such a radical, structural change," Goldman Sachs Group Chief Executive Lloyd Blankfein said at the Merrill conference. "We think these businesses are cyclical."

Goldman, which boasted eye-popping returns on equity of more than 33 percent in 2006 and 2007, had a net loss last quarter that shaved its return to shareholders over the first nine months of 2011 to 6 percent. It is now seeking to cut $1.4 billion of annual expenses and is laying off about 1,000 of its 34,000 employees.

Blankfein insisted at the Merrill conference that Goldman can still thrive by using its advisory and market-making skills to help its clients.

Even banks like Goldman and Morgan Stanley with strong advisory muscle, however, are bracing for change.

"The business model is changing and everyone has to figure out how they'll make money in the future," said Vartanian, the former regulator. "Many old avenues of income and capital have been shut off."