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When Jamie Forese started out at Salomon Brothers in 1985, being an investment banker was not a guaranteed ticket to riches. “A career on Wall Street was considered a stable income, same as a lawyer, a doctor, an accountant,” he recalls.
What changed, he says, was banks’ addiction to leverage – the cheap debt that fattened profits and bonuses, financed mega-mergers and ultimately fuelled the global financial crisis. In the boom years, leverage convinced people that “banking was the gravy train”, he says.
Today, amid a regulatory clampdown and a turbulent global economy, the industry is contemplating a future that looks more like the lower-key profession Mr Forese remembers. Securities firms are cutting jobs. Bonuses are down sharply. The prestige of being a Wall Street banker has plummeted. And the profits that underpinned the heady years of the past are harder to come by. For Wall Street’s critics, these are not all bad developments.
This week, the Financial Times looks at the industry’s attempts to adapt to a post-crisis world. We investigate whether the spread of electronic trading is a threat or salvation, examine the competitive challenge from non-bank firms and report on the struggle of troubled European institutions to stay in the top tier of financial players.
Now aged 49 and the head of Citigroup’s investment bank, Mr Forese is one of the executives trying to determine the future of Wall Street. But many of the events shaping the industry are well outside his reach.
Four thousand miles from Mr Forese’s Manhattan office, regulators in Basel, Switzerland, have banned all banks from carrying as much debt as they did in the past. That changes the economics of the business, particularly in the fixed-income trading divisions that have been prized profit centres for the past two decades.
The big five US banks on Wall Street made more than $50bn a year in combined revenues between 2005 and 2010 from fixed income trading, with the exception of 2008. This was far more than in equities trading, underwriting or advisory work. Last year, according to Credit Suisse, their combined revenue fell 22 per cent. As the new Basel III rules are phased in, the business is set to come under further pressure.
Basel III enforces greater levels of loss-absorbent equity capital for the banks but also lasers in on the structured credit businesses at the heart of the last crisis, ascribing particularly punitive capital levels to those areas. With less leverage it is difficult, perhaps impossible, to make the returns on equity that banks used to enjoy – with the happier trade-off that it is also harder for them to fail.
When Goldman Sachs went public in 1999, it was able to boast an ROE of more than 40 per cent, although it was never again to reach such levels. Last year it racked up its worst ever ratio: 3.6 per cent.
Understandably, this affects shareholders’ appetite for the stock. In 2006 both Goldman and Morgan Stanley traded at more than twice their book value. Now Goldman trades at 0.9 times book; Morgan Stanley at about half. This means investors no longer believe the companies are worth more than the stated value of their assets.
On top of Basel III, US banks must contend with the Volcker rule, also aimed at limiting risk-taking in fixed income divisions. Banks contend that this will damage their traditional ability to act as market makers, bringing together investors wanting to buy with those who want to sell.
The banks are struggling to identify a new cash cow that grazes between the new rules. The equivalent of the junk bonds of the 1980s or the credit derivatives of the 1990s has not been discovered. “We’re waiting really for the unveiling for what the new bank models are going to be. I’m surprised that there hasn’t been more forced innovation,” says John Studzinski, who spent most of his career at Morgan Stanley and now runs the advisory group at Blackstone, the private equity firm.
Given some of the results of the last round of experimentation, there may be good reasons for the financial scientists to be held at bay. “Innovation? God, look where that got us,” says one hedge fund executive.
With no wizardry to rely on, banks are behaving like other mature companies in a straitened economy – they are cutting costs. But they also face a structural dilemma: is it possible to fine-tune the fixed-income divisions in the new environment or will it require a more radical overhaul?
Making savings will require cutting the headcount and reducing pay – which accounts for more than 40 per cent of revenues at investment banks.
Where there is innovation, it is in technology. While stocks, and much foreign exchange, are now electronically traded, most bonds and other fixed-income instruments remain opaque and reliant on human beings. Shifting from telephone to electronic trading offers a significant cost-cutting opportunity and a plausible route to increased revenue growth – but also, as greater transparency and efficiency leads to lower fees, to thinner margins. And then there is the risk someone will ask: why do we need the banks as a go-between?
At BlackRock, the asset manager, that conflict is already in evidence. The company is pioneering its electronic Aladdin Trading Network to match buyers and sellers of bonds without an investment bank standing in the middle. BlackRock stresses over and over again that the “dealer” banks are its “partners”, and it does not wish to sideline them. The banks are not sure it will be successful but are convinced BlackRock – despite its denials – is taking them on.
Banks and asset managers, though, have a mutual interest in electronic trading expanding to take over more business. According to the Federal Reserve, the volume of bonds held by the traditional dealer banks has fallen sharply, from $200bn in 2007 to $90bn in 2011 and $45bn today. Institutional investors complain that this is reducing liquidity in the market, and is part of the reason for them to expand their own trading platforms, allowing them to trade among themselves.
Gary Cohn, chief operating officer at Goldman, calls this decline “the most fascinating chart”. He and his peers are trying to decide how to satisfy their counterparties’ demand for liquidity while complying with new regulations, and what products can be traded electronically.
Not all businesses demand as much soul-searching as fixed-income trading. Goldman has the biggest mergers and acquisitions operation by revenues on Wall Street. In M&A, the problem is cyclical, not structural – corporate clients are too troubled by the world economy to do many deals.
But overall, particularly at Morgan Stanley, which is number two in M&A and also has a strong underwriting business, there is more radical surgery under way. The bank last month agreed to buy the rest of Smith Barney, the brokerage whose 15,000 advisers sell stocks and bonds to retail investors. It is also reducing its fixed income trading operation . . .
This shift from trading, combined with a push into advising retail clients, should help produce more stable revenues. It will also ease the bank’s funding costs: investors and credit rating agencies such as Moody’s prefer less volatile businesses.
The trading that remains, according to chief executive James Gorman, will be all about institutions servicing clients rather than making money on their own account. This produces lower margins than some of the trading Morgan Stanley undertook in the past, but it is also safer.
Goldman, on the other hand, appears to be fine-tuning, looking to profit from the surrender of its rivals in fixed-income trading. Risk, its executives say, will return.
“You go through periods of the cycle where clients want the most levered instrument they can possibly create,” says Mr Cohn. “We’re in the opposite part of the cycle now. You would think people want to get leverage back into the system, with interest rates so low, but clients have gotten more conservative.”
He is betting this will change, and that the decision to do nothing drastic will benefit Goldman. “As the cycle changes, cash will diminish in importance and leverage will gain in importance. A lot of firms have laid off expensive derivatives talent so they’re not tooled for that part of the cycle.”
Both Mr Cohn, whose background is in commodities and fixed income, and Mr Gorman, who cut his teeth in retail brokerage, seem comfortable with their very different strategies.
There is one area where senior bankers do agree, and it is surprising in the current environment: despite the onslaught of regulation, they say, officials will loosen the fetters if the rules restrict business too much.
Mr Cohn and Mr Forese note that securitisation, which allowed banks to shift mortgages from their balance sheets and write new loans, has dried up. Run amok, mortgage-backed securities turned into instruments such as the infamous collateralised debt obligations, whose risks were ill-understood by banks and their counterparties. But the first wave of securitisation brought down the cost of loans for ordinary Americans as well as generating profits for issuers.
“The securitisation business is closed,” says Mr Cohn. “It’s going to stay closed until central banks want to create more consumer-related credit.” Bank executives say that eventually those central banks will revise Basel III to make the job easier.
Meanwhile, Mr Forese is confident that either the Volcker rule will be less stringent than feared or that Congress will step in to change it. “It may prove to be workable as it’s written today or, if not, legislators will fix it if it needs to be fixed,” he says. “If there’s one thing that resonates in Washington it’s the competitiveness of our capital markets.”
So Wall Street today is divided on how drastic the job of reinvention will prove, and how much risk it is wise to take. But the banks are united in the hope that regulators, despite their tough post-crisis stance, will go the way of their predecessors and eventually heed pleas for leniency.
If the institutions adjust to the new financial landscape, the employees who remain are going to have to adjust, too. Their bosses insist that bonuses will have to fall if banks are to deliver a decent return for investors. Some bankers are finding it hard to adapt to the new Wall Street.
“I’m bemused when I hear about people getting upset with their $600,000 pay cheque because it’s down from $800,000,” says Mr Forese. “For banks, the greatest lever is compensation.”
This article is subject to a correction and has been corrected since original publication to reflect the fact that Goldman Sachs trades at 0.9 times book value
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