Making the positive case for capital markets

PuzzleThis article is effectively a manifesto for the new think tank I have set up called New Financial. It’s all about making the positive case for capital markets – but also making the case for better markets and encouraging the industry to raise its game and embrace reform.

Investment banks and asset managers need to start making a more constructive and positive case for what they do and the valuable role that capital markets can play – before it’s too late.

A few billion here, a few billion there, and pretty soon you’re talking serious money. If you combine the apparently limitless capacity of the financial markets for misbehaviour with the regulatory appetite for ever tougher sanctions, you quickly get to some very big numbers.

For European banks, the fines could add to up to more than $100bn , according to a recent report by Credit Suisse. The final bill for the big US banks could be closer to double that.

In the context of this relentless scandal and bad press – whether it’s Libor-rigging, the manipulation of FX rates, sanctions busting or tax evasion - it can sometimes be hard to remember the positive case for what goes on in the financial markets.

As a result, there is a real danger that the vital role that healthy capital markets can and should play in driving sustainable economic growth is being overlooked and possibly even undermined – at a time when the European economy needs capital markets more than ever.

‘The purpose of capital markets is not primarily to enrich the people who work in them’

New Financial aims to address these challenges head on, by making the positive case for what capital markets do, and by simultaneously making the case for better markets. In other words, encouraging the industry to rethink the way it does business, to raise its game, to embrace reform where necessary, and to help make markets work better for the poeple they are supposed to serve.

Back to basics

It may have been lost over the past few decades, but the purpose of capital markets is not primarily to enrich the people who work in them or the shareholders of the banks or asset management firms that employ them. Instead, it is to allocate capital as efficiently as possible into productive investment, and to allocate risk to those parties most able to deal with it. In short, capital markets move money from where it is, to where it is needed.

And they move lots of it. Last year in Europe, the capital markets helped connect thousands of companies, institutions, and governments in need of capital with a giant pool of nearly €20 trillion of assets managed by more than 5,000 different asset management firms of different shapes and sizes looking after the savings, insurance policies and future pensions of hundreds of millions of people. In doing so, they helped raise more than $2 trillion in debt, roughly $1tn in syndicated loans, and a few hundred billion dollars in equity.

While there may be question marks over the social or economic utility of some aspects of the business, secondary markets provide liquidity to investors and in doing so help generate economic growth by encouraging competition for capital and investment in both the public and private sector. The trillions of dollars of bonds, currencies and stocks traded every day helps companies, governments and individuals manage their risk and future liabilities, and underpins global trade. In developing economies, this translates into helping to lift billions of people out of poverty.

For good measure, the capital markets industry in Europe employs hundreds of thousands of well paid staff, whose much vilified pay and bonuses translate into high levels of consumer spending and tax receipts (although this has to be offset against the risk of perverse incentives and the distorting effects that this may have on other parts of the economy).

Making the case

Despite this prima facie case, it is hardly surprising that no-one is making the positive case for the capital markets right now. Some sectors of the industry think it best to wait for the anger to simmer down. Others hope that if they keep their heads down, this will all blow over. Where the case is being made, it tends to be from the narrow perspective of one sector defending its own vested interest against a particular piece of legislation, rather than making a collective case for capital markets as a whole.

Unpopular though the capital markets may be – and that unpopularity is largely self-inflicted – this disjointed and half-hearted response is concerning. Not least because the answer to a lot of the long-term economic problems in Europe is probably more capital markets, not less.

Europe’s battered banks are struggling to deleverage and shrink their balance sheets, and are in no position to help companies borrow their way out of trouble. As people get older they will need mechanisms to save for their retirement that do not involve mattresses, and governments need to find ways of funding infrastructure investments and future pensions liabilities that do not rely solely on tomorrow’s tax receipts.

‘Instead of shouting at the waves, the capital markets industry needs to adopt a more enlightened approach’

Capital markets can play an important role in helping address these challenges. They are not going to replace bank lending altogether, but they can supplement it and provide access to alternative pools of capital with a more diverse range of investors. This should help reduce the negative feedback loop between markets, bank balance sheets and the real economy that has dominated the past five years. A shift from bank-led to markets-led financing would also help reduce the political interference and patronage embedded in some European banking systems, particularly at a local level.

Embracing change

Of course, capital markets are not perfect and making the positive case for them is not a one way argument. ‘More capital markets’ is a deeply unpopular message at a time when the word ‘banker’ has become a generic term of abuse for everyone who works in finance.

The industry needs to address and respond to the growing body of research that shows you can have too much of a good thing, that questions the assumed benefits of ‘financialisation’ and that beyond a particular point (long since passed in most Western economies) finance act as a drag on economic growth rather than as a catalyst for it. Markets overshoot in both directions and access to them can be volatile.

Yet too many people working in the industry still don’t get what all the fuss is about and still think that that things will return to normal. They ignore the need to rebuild what Mark Carney recently called the ‘social capital’ on which much of the industry is based.

Instead of shouting at the waves, the capital markets industry needs to adopt a more enlightened approach. In order to regain the trust of its clients and of policymakers, different sectors of the industry must work not only with each other and but also with policymakers to come up with constructive solutions to common problems. Coming up with a renewed sense of purpose for the capital markets would be an excellent start.

Only by making a more compelling and more positive case for what they do – while embracing the need for significant reform of the way they do it – can capital markets hope to break out of the painful and potentially damaging cycle of having that reform done for them.

Category: Bonuses & compensation, Capital, Conflicts, Finance, Investment banking, Regulation, Uncategorized |

Barclays and the great restructuring that wasn’t (quite)

The bank’s retreat from investment banking is not quite what it seems.

JenkinsLooks can be deceiving. Antony Jenkins, the quietly-spoken chief executive of Barclays, may not look like much of a bruiser, but last week he appeared to demolish in one Powerpoint presentation the investment bank that his predecessor Bob Diamond had spent a more than 15 years trying to build.

At a stroke, he appeared to halve the size of the investment bank, folding £100bn in risk-weighted assets into a ‘bad bank’ and cutting roughly one quarter of the staff in the division. By 2016 the investment bank will consume just 30% of the group’s capital, compared with more than half today.

Radical stuff. But on closer inspection, not quite as radical as it first appears, for at least three reasons. First, the cuts are not as deep as they look. Second, at the end of this restructuring Barclays will still be more exposed to its investment bank than many of its shareholders might be comfortable with. And third, the bank is likely to find that it is easier to announce its new strategy than it is to achieve it.

Let’s start with shrinking the investment bank. RWAs in the investment bank will drop from £222bn at the end of last year to £120bn. This looks like a reduction of 46% until you note that it includes nearly £50bn of RWAs in the investment bank that were held in something called the ‘Exit Quadrant’ – a bad bank in all but name – and which had already been scheduled for exit.

Window dressing?

In other words, nearly half of the announced reduction in the scale of the investment bank at Barclays had already been decided. Moving these ‘bad’ assets from the investment bank into a non-core unit is little more than window dressing. Sure, an additional £50bn or so in RWAs are going to be cut – a bold move in anyone’s books. But a better way of thinking about it is that Barclays had already decided to reduce its investment bank by one quarter, and has now decided to reduce it by another third.

It’s a similar story with the job cuts. On the face of it, 7,000 job losses add up to 28% of the headcount in the investment bank of 26,200. But don’t expect the number of staff to fall by 7,000 anytime soon. First, the cuts are staggered, with 2,000 coming this year and the remainder by the end of 2016. And second, Barclays was careful to describe the cuts as ‘gross headcount reductions’. This means that it will aim to eliminate the positions, but will continue to hire and replace staff in the rest of its business.

Even if Barclays manages to identify 7,000 jobs to eliminate over the next three years – and that’s a big if – it will lucky if it reduces its net headcount by half that over the next three years. Just ask Credit Suisse: it has cut thousands of jobs in its investment bank over the past few years, but the total number of staff in the division is proving remarkably stubborn.

If you assume that in the normal course of business headcount will increase by 5% a year – other businesses such as equities and investment banking may want to grow, while IT and compliance staff breed like bacteria – the investment bank will employ roughly 22,500 staff by the end of 2016, a net reduction of roughly half the headline figure.

And don’t forget that the assets in the non-core business will need lots of people to manage them. The non-core unit at UBS, for example, employs roughly 1,500 staff to look after £40bn in assets, so you might assume that the division would need to have more than 2,000 staff at Barclays. This means that many of the jobs are not being cut – like the ‘bad’ RWAs, a lot of them are just being shuffled from one division to another.

Are you sitting comfortably?

For good measure, even after these radical cuts, Barclays will still be more exposed to investment banking than it looks. Barclays reckons that in three years the core investment bank will represent just 30% of the group’s RWAs, capital and revenues.

But on its own numbers, it will still rely on the investment bank for 40% of its total pretax profits. And in 2016 there will still be £50bn in RWAs – mostly from the investment bank – sitting in the non-core division, dragging down returns for shareholders. Just because these assets are in the bad bank doesn’t mean they have disappeared: at UBS, losses on the legacy assets from the investment bank wiped out all of the profits made in the core investment bank last year.

This means that in total, RWAs across the good and the bad investment bank – shareholders don’t get to choose between the two – will add up to roughly 43% of the group total, compared with 51% today. In other words, by 2016, the investment bank will have shrunk by one quarter in terms of RWAs and by a lot less than that in terms of staff.

A big shift in direction for Barclays? Yes. A break with the past? Indeed. But not quite the demolition job that Barclays would have you believe – or that its shareholders had in mind.


Category: FICC, Finance, Reporting & Disclosure | Tags: ,

Saving the financial markets from themselves

The industry has undermined itself by failing to practice the gospel of free market capitalism that it preaches. My latest (and last column) for Financial News.

FOG-2915526You don’t have to be a rampant anti-globalisation bank-bashing socialist to think that sometimes capitalism doesn’t work quite as well as it should. And one of the main reasons for that is that capitalists can get in the way.

Take this, for example, from two of the most free market economists you are ever likely to meet: “The greatest political enemies of capitalism are not the firebrand trade unionists spewing vitriol against the system, but the executives in pin-striped suits extolling the virtues of competitive markets with every breath – while attempting to extinguish them with every action”.

That quote comes from the book Saving Capitalism from the Capitalists, a paean to financial markets written a decade ago at the height of market triumphalism by two Chicago economists, Raghuram Rajan and Luigi Zingales (although Rajan may find it a little harder to put his views into practice in his new role as governor of the Reserve Bank of India).

If you replace “capitalism” with “financial markets”, and “trade unionists” with “regulators” or “members of the European Parliament”, you have a pretty good summary of the paradox in the capital markets and investment banking industry today.

In their book, Rajan and Zingales argued forcefully that capitalism – and in particular the free market-based variety – is the best mechanism that mankind has yet devised to allocate finite resources in the most productive and efficient way. But a decade before the revelations of Libor-rigging and price-fixing in the foreign exchange market, the authors warned that in any capitalist system, “incumbent industrialists” would eventually seek to protect their position by rigging market structures and even subverting free markets altogether.

Pulling up the ladder

The problem with this desire of incumbents to pull up the ladder behind them is that it detracts from the valuable role that capital markets play in fuelling the economy and undermines public and governmental trust in free market principles.

In the financial markets the “incumbent industrialists” are not American oil barons or Victorian factory-owners but investment banks, private equity firms, asset managers and other market participants who are less keen on open competition and market forces than you might expect. They are not necessarily actively seeking to rip off customers, but a lot of the danger signs that Rajan and Zingales flag up are on display.

For example, having benefited from technological change on the way up, large parts of the market have fought tooth and nail to stop new technology stealing their lunch (think of the resistance to centralised clearing and trading in the $600 trillion over-the-counter derivatives market, or open access clearing between European stock exchanges).

In the same vein, the industry resists efforts to make itself more transparent, often using cost or commercial sensitivity as a cover for keeping the sunlight out. If you work at a pension fund, try asking your fund managers to provide a full breakdown of the fees they charge. Just for a laugh, you might suggest the fund manager put the same question to his or her broker.

You could even be forgiven for thinking that the complex structures in the industry might have been designed to confuse clients (and regulators) and ward off competition. Why else would big banks have thousands of legal entities? Why would there be as many as two dozen market participants in the chain between Mrs Smith wanting to buy some shares and them actually finding their way into her pension scheme?

Poor corporate governance at some banks – such as odd decisions about bonus awards to chief executives who double up as chairmen – provides evidence not just of a technical breakdown in governance structures and processes, but of a more worrying reluctance to embrace competition and market forces.

And, of course, the industry has turned its economic power into enormous political clout, which it deploys to protect itself. Expensive lobbying helps to delay or dilute new regulations that could challenge the existing dominance of incumbent players (even if some rules such as Vickers or Volcker have got to the finish line despite fierce industry opposition). This political clout often blurs with regulatory capture: think of the revolving doors between regulators and Wall Street, or of how the Labour government of Tony Blair was captivated by the City of London.

Bad economics

But perhaps the most obvious indication of the “incumbent industrialists” in the financial markets is the persistence of bad economics throughout the industry. Loss-making investment banks that pay billions of dollars of bonuses to people who will jump ship at the drop of a hat. Or the curious consistency of new issue fees in the US.

Or the dog’s breakfast of the economic relationship between brokers and fund managers, in which neither side knows the cost, let alone the value, of the services they are producing and consuming. Or the strangely uniform fees at asset managers and wealth managers, despite vast disparity in performance. Or the failure of most fund managers, hedge funds and private equity firms to deliver net outperformance over any sustainable period.

This breakdown in economics is a sign of an industry that does not apply to itself the market discipline that it preaches and for which normal rules – for example price elasticity – no longer seem to apply. A simpler way of putting it, as one wise old chairman said last week, is that it is “an inertia that is guarded jealously by people who make a lot of money from it”.

The danger of this defensive behaviour by the “incumbent industrialists” in the financial markets is that it undermines faith in the market system itself. The inevitable economic concentration that comes from financial markets comes to be seen as oligopolistic. Healthy income distribution is instead seen as pernicious inequality when pay loses touch with basic economics – particularly when profits are privatised but losses socialised. While there will always be winners and losers in any free market capitalist system, the system relies for its legitimacy on the belief that market structures will be fair, even if market outcomes may not always seem so.

From this perspective, the blunt decision by the European Parliament to impose a cap on bonuses, French President François Hollande’s 75% tax on earnings over €1 million, or even the policy of the Labour Party in the UK to freeze energy bills for 18 months after the next election, are easier to understand (even if you don’t agree with them).

They are not attacks on the financial industry (or its new rival bogeyman, the energy industry) for extolling free-market principles. Instead they are being targeted precisely because they appear not to be applying those principles.

So what can be done? Most obviously, the industry needs to make a better argument for what it does and of the value that it provides. When was the last time you heard about how much investment banks had raised for companies and governments in the debt and equity markets? Or how many millions of people in Europe rely on fund managers for their future savings and pensions?

It also needs to invest some time in making the case for why it deserves to be paid such large sums of money in exchange. At the same time, the industry collectively could take a long hard look at itself to work out how and where it could be improved, reformed and simplified for the benefit of its clients. How could it deliver more with less? And how it might look if you were to invent it today.

How, in other words, can the investment banks, asset managers, hedge funds, the private equity firms, and everyone else in the industry, get together to help save the financial markets from themselves.

On a more personal note, this is my last weekly column at Financial News. After nearly 20 years of writing about the industry, I am signing off with some sadness. But I am also optimistic: I am setting up an organisation to promote the role and growth of capital markets – and encourage the reform and simplification of the industry at the same time.

I would very much welcome the thoughts and input of anyone involved in the capital markets as to how we can improve the industry for the benefit of all users and market participants. Please get in touch on

–This article first appeared in the print edition of Financial News dated February 24, 2014

Category: Bonuses & compensation, Capital, City, Conflicts, Ethics, Finance, Investment banking, Management, Money, Regulation, Reporting & Disclosure |

Too big to fail and Pascal’s Wager

The only way to tell whether the problem has been solved would be to allow – or even encourage – a big bank to fail. My column for Financial News.

Simples: how  a European bank would be resolved over a weekend...

Simples: how a European bank would be resolved over a weekend…

Talk about hedging your bets. In what became known as Pascal’s Wager, the 17th-century French philosopher Blaise Pascal argued that the only rational response to the question of the existence of God was to assume that he exists and live your life accordingly. If it turns out that God does not exist, your downside is pretty limited. However, if he does exist and you chose not to believe in him, your downside is almost infinite. So it is with the debate over “too big to fail”.

The potential consequences of a big bank failing if the problem has not been properly solved are so catastrophic that it makes logical sense to assume that the problem is alive and well.

Over the past few years, regulators around the world have been frantically working on plans that would allow a failing bank to be wound down in a hurry without causing another financial crisis and without leaving taxpayers to pick up a multi-billion-dollar tab. But, ultimately, the only way to know whether the problem has been solved is for a bank to fail and to see what happens.

Many people in the industry argue that the problem has been solved, or is at least very close to being solved. Big banks, they say, are more resilient and less likely to fail. Tougher regulation and improved supervision mean that banks are less risky and less likely to make big losses. Meanwhile, stiffer capital and liquidity requirements have reduced leverage and created a buffer that would make any losses less catastrophic.

A huge amount of progress has been made on developing “resolution mechanisms” to enable regulators to wind down a failing bank without causing a ripple, which has been helped by the development of “bail-in debt” that converts into loss-absorbing equity if and when capital levels fall to agreed thresholds. In principle, this would stop a bank from tipping over the edge, or allow regulators to contain the damage if it did.

Supporters of this theory point to the credit ratings of US banks, which imply that the US government would not step in again to rescue a failing bank (although there appears to be some persistence of a “too-big-to-fail” subsidy in the credit spreads of the biggest banks). Sir Paul Tucker, the former deputy governor of the Bank of England, now a fellow at Harvard Business School, recently argued that “in extremis” even the biggest US banks could be wound down in an orderly way without government support (although Europe was some way behind).

The less optimistic counter-argument is that for all of the planning and progress, if a big bank went pop tomorrow – particularly in Europe – policymakers wouldn’t know what had hit them and we would be cast back to 2008 again.

There is plenty of evidence to support this thesis. Most obviously, for all of the progress in reducing risk, many of the biggest banks have got bigger since the crisis, and they are still highly leveraged. The 3% simple leverage ratio proposed by global regulators as a backstop represents gearing of 33 to one.

Besides, critics say, it is hard to know what numbers to believe. The asset quality review by the European Central Bank will be an important step in providing a once-and-for-all answer as to which European banks have holes in their balance sheets and which do not. But nearly six years on from the financial crisis, it makes you wonder why such an exercise should be necessary. And that’s before you even begin to talk about whether risk-weighted assets are worth the spreadsheets they’re calculated on.

This, perhaps, explains why some people, like the head of the monetary and capital markets department at the International Monetary Fund, think it is “astonishing” that governments are still so ill-equipped for the collapse of a complex international bank, and that there is “a lot of heavy lifting still to do”.

Another senior banker recently likened the response to something between Sisyphus and medieval physicians, who don’t really understand what the problem is.

Few people have faith in the “living wills” that banks have produced on how to resolve themselves in a crisis (which run to tens of thousands of pages for the largest), and the faith shown by some politicians in things like the European single resolution mechanism at least shows that European policymakers have a sense of humour (see the simple flowchart from German MEP Sven Giegold). As ex-professional boxer Mike Tyson said, everyone has a plan until they get punched in the face.

A dilemma

This leads to a perverse dilemma: the only way to find out which side of the debate is right is for a big bank to fail. The challenge here is in selecting a suitable guinea pig. Perhaps, you could start with a smallish regional bank like, say, BancWest (with $80 billion of assets), before graduating to something bigger like US Bancorp ($350 billion) and, ultimately, someone like Wells Fargo or even Bank of America. In Europe, the order might run something like the Co-operative Bank (done), through a mid-sized bank like ABN Amro, before tackling someone like Barclays or Deutsche Bank (For the record, I’m not suggesting these banks are close to failing.)

The mechanics of how to choose which bank will fail – a ballot of bankers and regulators or maybe drawing straws – and how to decide when the bank will fail, would have to be agreed, perhaps by the Financial Stability Board or the IMF.

Even then, there is no guarantee that the experiment would teach us anything we could use in a future crisis. One of the few things of which we can be certain is that the next crisis is unlikely to look like the last, and whatever resolution mechanism works for one bank in one crisis may not work for another in another.

On that basis, if you really want to think that the too-big-to-fail issue has been solved, then I have some miracle cures and guarantees of eternal life that I can sell you as well.

This article was first published in the print edition of Financial News dated February 10, 2013

Category: Capital, Finance, Regulation, Reporting & Disclosure |

Banks shoot themselves in the foot (again) over bonuses

The banks’ reaction to the bonus cap shows that it may take longer than expected for them to regain the trust they have lost, because they seem not to appreciate why they lost it in the first place. My latest column for Financial News.

money-12-1When it comes to pay, the only time investment banks open their mouths is to change feet. In their recent efforts to get round the cap on bonuses in Europe they have managed to shoot themselves in the foot at the same time.

In doing so, they have shown that it may take longer than expected for banks to regain the trust they have lost, because they seem not to appreciate why they lost it in the first place. It also suggests that instead of using the past five years as an opportunity to have a fundamental rethink about pay in the industry, banks have instead just been counting down the days until normal service can be resumed.

Over the past few months, banks have been working frantically to come up with ingenious ways of getting round the new rules that limit bonuses to being equal to fixed pay (or twice the level of fixed pay if shareholders give their explicit approval). The majority seem to have adopted some form of “role-based allowance” that sits somewhere between a salary and a bonus and that would be paid monthly to help top up any shortfall in income for bankers or traders.

It’s probably not quite what the European Parliament had in mind when it voted the cap into law last year. To many people outside the industry – and some inside it – it all looks a little squalid.

You may well think that the bonus cap is mad (and there is plenty of evidence to support that view). And you may think that the public’s interest in what banks pay their staff is little more than intrusive titillation (ditto). But you can also look at pay as a barometer of how the industry thinks about itself in relation to shareholders and to society.

One wise old banker said recently he was dismayed that the banks’ efforts to get around the rules were “a slap in the face” to policymakers that could trigger another regulatory backlash or at least prolong the banks’ public purdah.

If you ask most people inside the industry what this manoeuvring looks like to outsiders, you are likely to get roughly the following response: it’s unfair of European legislators to pick on banking and it’s unfair to put European banks at a competitive disadvantage by imposing rules that don’t apply to their US and Asian rivals.

To keep pay at competitive levels, banks will have to increase fixed pay, which will reduce their cost flexibility. If they don’t, their top staff will migrate to the shadow banking sector or move to the US or Asia.

And finally, the argument goes, pay has already come down faster than most people think, more of it is deferred than before and for longer, and more of it can be clawed back if things go wrong. Besides, there is nothing illegal with the allowances, so what’s the problem?

Some of these arguments have some merit. The cap was always going to lead to an increase in fixed pay: base salaries for the top staff at investment banks in the UK including Bank of America, Goldman Sachs and JP Morgan would have to more than double if overall remuneration were to remain at the same level while complying with the rules on capping. It is, indeed, “unfair” that Europe has gone much further than the US in reforming bankers’ pay (although a large part of that is down to the success of the bank lobby in the US at arguing down reforms on pay that were supposed to have been implemented globally).

And it will, indeed, reduce the banks’ flexibility on costs, but not by as much as some scare stories suggest.

I wonder, however, if the overall thrust of the banks’ argument doesn’t display something more worrying. First, as any politician knows, the moment you have to start explaining your position, you have probably already lost the debate.

And second, regardless of the validity or otherwise of the argument, their approach betrays a dangerous lack of self-awareness and context. There is no awareness, for example, of the thinking of the shareholders who have yet to vote on the level of the bonus cap at each bank, or what the policymakers might think of them breaking the spirit of the rules.

It betrays a mindset that still sees regulations as a challenge to be overcome instead of a set of rules to be followed and that doesn’t see the irony in paying billions of dollars in bonuses to bankers and traders at loss-making banks in the name of retaining talent, or in paying a chief executive $1 million for every $1 billion in fines and settlements that he agreed to pay out of his shareholders’ pockets last year. This is an industry that believes it is time to move on and stop being beastly to bankers, instead of one that really believes what it says in public about taking a generation to restore trust.

There are lots of ways the industry could have reacted. It could have taken the opportunity to be much more transparent about pay. It could have decided to stick to the spirit of the rules (if only for a year or two), or to fundamentally rethink the division of rewards between staff and shareholders.

Maybe it could have gone back to the future in bringing pay down to the level of other high-end professions – or even to move away from bonuses altogether in favour of a career-long process of wealth accumulation. Instead, the industry has deployed its brains and attention on preserving the very bonus system that signals its resistance to change.

Perhaps, the real problem is that everyone’s terms of reference are framed by their own experience. In the few decades before the crisis the numbers at investment banks were artificially inflated by leverage, innovation and deregulation.

Now that all three of those have slammed into reverse, it is time for pay to go the same way. It is entirely understandable that many people don’t want that to happen and, while pay has come down, it has a long way to go before it falls to a more sustainable level.

On the evidence of the past few months, banks clearly also have a long way to go in terms of thinking about how and what they pay their staff, and what that says about the way they run their business and how that business fits into society. Let’s hope they give it some more thought – before they shoot themselves in both feet.

–This article was first published in the print edition of Financial News dated February 3, 2014

Category: Bonuses & compensation, Conflicts, Ethics, Finance, Regulation, Reporting & Disclosure |

Investment banks and the law of unintended consequences

Not all of the ‘unintended consequences’ from the reform of financial regulation are as unintended, as consequential or as negative as you might think. My latest column for Financial News:

dominoesThere are a handful of laws in the financial markets that never change. The customer always pays, even when it’s free. The market is always right, except when you disagree with it. And every time regulators introduce a new reform it is followed by negative unintended consequences.

Critics would argue that these unintended consequences are undermining often well-intended efforts to make the financial system safer and prevent a future crisis. At a time when companies and governments need access to a stable banking system and efficient capital markets more than ever, the critics lament, reforms from Basel to Brussels and from Vickers to Volcker are doing their best to make them riskier and more expensive.

But on closer inspection, not all of these consequences are as unintentional, as consequential, or as negative as the targets of the reforms would have you believe. In fact many of them point to a brave new world, which market participants should embrace rather than resist.

At first glance, the law of unintended consequences seems to be as pervasive as the barrage of regulatory reform itself. Most obvious are the increases in direct costs for market participants that will ultimately be passed on to customers. Increased capital requirements are driving up the cost of loans to small businesses, and forcing banks out of some business lines (such as securitisation or commodities) altogether, reducing competition and increasing prices.

The wave of new rules is forcing market participants to hire thousands of compliance staff and invest millions of dollars in IT systems. Taxes such as the financial transaction tax or the bank balance sheet levy quickly add up.

These direct cash costs pale alongside the increased indirect costs from regulation, in particular the fall in liquidity in many markets that has been triggered by capital requirements. Reform of the derivatives market is causing a global liquidity squeeze, we are told, creating a shortfall of trillions of dollars in high-quality collateral. In the corporate bond markets, the collapse in inventory held by investment banks has blown trading spreads wide open and could increase volatility.

Hiding in the shadows

Meanwhile, in their efforts to reduce risk, regulators often concentrate it or merely push it into the apparently unregulated shadows. The bonus cap will increase fixed pay and reduce the flexibility of banks to manage their cost base. The reform of derivatives trading may concentrate risk in clearing houses, and forcing banks to raise capital could cause a vicious circle as they are forced to sell assets at a loss.

Over-regulation or unpredictable taxation risks driving activity, organisations and highly paid staff overseas. Or it merely drives activity into the regulatory equivalent of a dodgy casino in Macau.

Of course, some degree of unintended consequences is inevitable. The financial markets are complex and the scale and speed of the reform process is bound to throw up some problems. The Financial Stability Board, which orchestrates global financial reform, has 73 working groups, and the European Banking Authority has 409 tasks on its regulatory to-do list this year. Inevitably, regulators are almost always playing catch-up. But regulators seem alive to this risk and are prepared to be flexible.

More flexible, that is, than many market participants, who often use unintended consequences as an excuse to block or delay, and who often seem to ignore the context: how the entire industry benefited from the highly lucrative unintended consequences of the deregulation of financial markets over the previous few decades, before feeding into the mother of all unintended consequences in the form of the financial crisis. From that perspective, many of today’s unintended consequences of regulation seem trivial.

Very much intended…

Indeed, many of the consequences of recent regulation are not “unintended” at all. Stefan Ingves, the chairman of the Basel Committee on Banking Supervision, could not have put it more clearly when he said that the reform process is “designed to fundamentally reshape the banking industry… and obviously will have consequences for the cost of financial intermediation”. (In other words, costs are suppose to go up but this is more than offset by the benefits of increased financial stability). “A degree of deleveraging and increased risk premia are intended consequences of reforms,” he said.

For example, the fall in trading inventory and transfer of risk from banks to investors are an intended outcome of the desire to derisk banks, not an accidental by-product. The increased cost of doing business for banks and asset managers is a deliberate part of raising compliance standards and disincentivising bad behaviour. The aim of the bonus cap was ultimately to reduce what bankers get paid and it may yet achieve that by forcing banks to justify an increase in fixed pay or awarding convoluted allowances to their senior staff.

In many cases, the phrase “unintended consequences” has become a lazy shorthand for a threat to the status quo. For example, bond investors have complained that a financial transaction tax would dent the performance of active asset managers (although they are more than capable of denting their performance on their own). The potential shortage of collateral in the derivatives markets is seen by dealers as a cost problem, instead of as potential indicator that derivatives markets got too big too quickly with compound annual growth of more than 20% in the decade before 2008.

And, in the same way that you never hear about rogue traders making huge profits, you rarely hear about the positive aspects of unintended (or intended) consequences. Higher spreads and the scarcity of loans represent an overdue repricing of credit risk that imposes a positive dose of discipline on lenders and borrowers alike. The reduction in trading inventories is a welcome transfer of risk away from banks funded in part by taxpayer-backed deposits. The bonus cap will focus the minds of shareholders on pay.

It may also help trigger behavioural change: the widening of spreads in the corporate bond market should be a prompt for investors to embrace more efficient ways of trading, such as trading less (the surest way to improve performance) or trading electronically.

The overall – and very much intended – aim of regulatory reform is to shake up the financial markets and make them safer and more transparent. Market participants who think it is the end of world can keep shouting at the waves if they want. Or they can embrace the opportunities that such radical change will present.

In doing so, they will fulfil that other basic law of financial markets: if there is money to be made doing something, sooner or later someone is going to start doing it.

– This article first appeared in the print edition of Financial News dated January 27, 2014

Category: Conflicts, Ethics, Finance, Regulation, Reporting & Disclosure |

Exactly how global are global investment banks?

Behind their apparent decline, European banks are punching above their weight outside of their home markets.

World Series Rays Phillies Baseball

World series: how well does it travel?

It’s funny how American teams always seem to win the World Series . The competition in global investment banking may be a little more international, but the apparent world domination by US investment banks might be equally misleading. Perhaps the US banks will find out that, a little like their home-grown sports, they don’t travel so well.

That sounds absurd when you consider how the big Wall Street banks flattened their European competitors in investment banking last year. They filled the top five slots in the ranking of global investment banking fees for the first time since 2009 and their combined market share of 34% reached its highest level since before the financial crisis, according to Dealogic. The top five European banks could scarcely muster 20% between them (as per this chart):

Top 20 Global

In their home market, the big five US banks took the top five slots as well and in Europe they hammered the local competition, filling five of the top eight slots with their highest market share in a decade.

It looks like what a US banker might call a “shutout”, an American word for a “clean sheet” in football, or possibly a “slam dunk”. Whatever you call it, US banks appear to be tightening their grip on the world of investment banking as, one by one, their European rivals are forced to retire hurt.

But the closer you look, the less convincing this global domination becomes: once you strip away the huge in-built home advantage that US banks enjoy they seem far less confident playing away from home. In fact, on away form, it’s the Europeans banks that are punching above their weight. This poses presents both a threat and an opportunity to US and European banks alike.

Home sweet home

A huge part of the US banks’ global success is their dominance of their own very large backyard. They have a combined market share in the US that is twice that of their European rivals (44% vs 21%) in a market that is twice the size (generating nearly $38bn in fees last year compared with $18bn according to Dealogic).

That’s always going to give you a good headstart. The top five US banks made more than $16bn in investment banking fees in the US last year, or roughly four times as much as the European banks made from fees in Europe.

Playing away

Strip the US numbers out of the picture and you quickly get a sense of how reliant the big Wall Street firms are on their domestic business. On average the big five make little more than of their investment banking revenues outside of the US (ranging from just 27% at Bank of America Merrill Lynch to 43% at Morgan Stanley).

Here’s what happens when you rank the same 20 investment banks by fees earned outside the US:

Top 20 ex US

While JP Morgan is still top of a revised ranking of investment banking fees in the rest of the world with $2.1bn, the Europeans start to fight back: Deutsche Bank leapfrogs its US rivals to second place, just ahead of Goldman Sachs. Credit Suisse, HSBC and UBS all climb the rankings while BAML and Citi are left propping up the top 10.

Take this a step further, and calculate the fees earned by investment banks outside of their home region, and the global domination of American banks is turned on its head (in this chart, BAML is highlighted in grey and Credit Suisse in yellow to highlight the trend):

Screen shot 2014-01-24 at 16.12.47

Credit Suisse tops the rankings on away form, with $3bn of fees earned outside of Europe. Remarkably, Barclays and Deutsche Bank complete a European clean sweep with JP Morgan demoted to a lowly fourth place.

On this measure, every big US bank slips further down the league tables. The top five European banks earned $10.8bn between them outside Europe last year, while the big US banks made just $9.2bn. For example, BAML (which last year ran an advertising campaign with the slogan “the power of global connections”) has an 11% share of US investment banking fees, but just little more than 4% in Europe and less than 3% in Asia.

This presents an opportunity for European banks: if they can hold on to their existing market share at home, their business should improve as and when the European and Asian markets recover. They should also be able to squeeze out a little more share in the US as US banks run out of domestic growth. The threat for them – matched by the opportunity for their American rivals – is that the US banks continue to use their dominant position at home to subsidise their overseas business and tighten the screws on their struggling European and Asian rivals in their home markets.

In the investment banking World Series, the big question is not whether international teams will be allowed to play – they already are, and with greater success than US banks would like you to think. Instead, it’s whether the European banks will be able to hold on long enough for markets to recover – or whether they’ll be forced to throw in the towel in the middle of the innings.

Category: DCM, ECM, Investment banking, M&A, Uncategorized | Tags: , , , , , , ,

What investment banks pay their most senior staff and how it is changing

A few days before the start of the annual season of bonus baiting, here is a quick look at one of the few ‘known knowns’ in the debate over pay: what investment banks pay their senior staff in the UK.

Nearly a year ago, I wrote that it might be a little awkward – embarrassing, even – if it turned out that pay for the most senior staff at investment banks was going up, even as overall pay across the board was falling.

That conclusion was based on filings by European banks showing what they paid to their most senior staff in 2012. In the past few weeks, the big US investment banks have filed the same disclosures, and they appear to confirm that original thesis:

‘…In other words, banks are being more discerning about how they pay bonuses. Good performers – people who make more money for the bank than you might expect for someone sitting in their place – are getting proportionately more.

Mediocre performers and middle level staff, who are useful for heavy lifting but are eminently replaceable, are getting proportionately less. Juniors or bad performers are getting nothing. This is, of course, exactly as it should be…’

Here are five charts that tell you everything you ever wanted to know about pay for senior staff at European and US investment banks in the UK:

1) How much…?

Senior staff at investment banks are not struggling to pay the gas bill: there is no such thing as an average senior banker (ask them: they all say they’re way above average), but the 2,138 most senior senior staff (or ‘code staff’) in the UK at a sample of 11 banks earned an average of $2.05m in 2012 (that’s about £1.3m). Their average fixed pay was $506,000 and their average bonus was three times that at $1.54m.

There is a surprisingly wide variation in what different banks pay their top staff in the UK. This chart shows the total pay for the most senior employees at US and European banks in 2012 (in millions of dollars and with the number of staff included):

Screen shot 2014-01-15 at 09.25.23

The top 115 staff at Goldman Sachs received an average of $4.7m in 2012 (roughly £3.0m). That’s more than double the average earned by their peers and nearly triple what HSBC and RBS pay their top staff (about $1.7m each).

Note: the data for those banks marked with an asterisk is their group wide pay disclosure for senior staff and include a lot more staff as a result (Credit Suisse 523 staff, Deutsche 1,215, UBS 501). the figures have been included for illustrative purposes and have not been includes in the overall averages.

2) Tinkering at the edges?

Perhaps counterintuitively, at a time when most people might assume bankers’ pay is falling, pay for lots of senior staff is actually rising. This chart shows the change in total pay in 2012 compared with 2011:

Change vs 2011At Goldman Sachs, pay for the top staff in the UK leapt by a staggering 77%, and pay also increased for senior staff at Citi, Credit Suisse, HSBC, Nomura and UBS. On average, across more than 2,100 senior staff in the UK, pay increased by 6%. The only big investment banks that paid their senior staff significantly less in 2012 than the year before were JP Morgan, Barclays and Deutsche Bank.

If you convert the numbers at constant exchange rates, the overall average increase in pay was 8%, and all of the US banks except JPMorgan increased pay. Even if you strip out the surge in pay at Goldman Sachs, pay for senior staff at the other banks was flat on 2011.

3) …or a step change in pay? 

It looks like there is more of a step-change in pay when you rewind and compare the 2012 numbers with 2010:

Change vs 2010Average pay for the most senior staff in the UK fell by an average 26% between 2010 and 2012, and it halved at Credit Suisse. Now, 2010 was hardly a vintage year for the industry, and sadly the disclosure doesn’t go back any further. But it is a reasonable bet that average pay for the most senior staff in the UK is down by between one third and one half since before the crisis.

4) The wrong incentives

Of course, it’s not just the amount of money that gets people so worked up: it’s the ratio of bonuses to salaries as well. This chart show the variable / fixed ratio for senior UK staff at banks in 2012, with the equivalent ratios for 2011 and 2010:

RatioSeveral points stand out: first, the variable / fixed ratio has come down sharply from an average of more than five to one in 2010 (shown in red) to ‘just’ three to one in 2012 (possibly under the threat of the European Union bonus cap).

Second, there is still huge variation between different banks: the ratio at JP Morgan, Bank of America Merrill Lynch and Goldman Sachs is still above five times, while senior staff at Morgan Stanley and Citi have to get by on a bonus that is little more than twice their salaries (talking of salaries, fixed pay fell in 2012 compared to 2011, but has increased for senior staff by about one sixth since 2010 to an average $506,000).

And third, if you look closely, you can see that the ratio of variable to fixed pay increased slightly from 2011 (shown in blue). With the bonus cap looming, this could be storing up trouble…

 5) Unintended consequences

In order to meet the bonus cap of two times salary (with shareholder approval), most banks are going to have to conduct radical surgery on their pay for senior staff. This chart shows by how much banks would have to increase fixed pay for senior staff to bring their pay into line with the EU cap, or by how much they would have to cut their bonuses to achieve the same ratio (I suspect that won’t happen):

ImpactThe figures speak for themselves: banks on the left hand side of the chart will either increase salaries significantly or make up the difference with ‘allowances’.

But the right hand side of the chart is more interesting. Citi, RBS and Lloyds already comply with the EU cap (at least for their senior staff), and could afford to cut salaries or raise bonuses and still comply. Who says bankers are paid too much…?

Category: Bonuses & compensation, Ethics, Regulation, Reporting & Disclosure, Uncategorized |

Too early to call the winners and losers in investment banking

For the first time in years investment banks are adopting different strategies and business models – my latest column for Financial News.

BankersA few years ago a senior investment banker was on holiday on a remote Scottish island. With no mobile phone reception and desperate for news from the City, he walked for miles to the island’s only post office to buy a newspaper. When he finally got there, he found that the only newspapers available were a day old. “I’d like to buy today’s newspaper, please,” he said to the shopkeeper. “Well I’m afraid you’ll have to come back tomorrow,” she replied.

So it is with gauging the pecking order of investment banks. After more than a year of perpetual restructuring, the dust has yet to settle on an industry that is still struggling to identify a sustainably profitable business model. The only way to really understand where each investment bank stands today will be to come back tomorrow – or ideally in a few years’ time.

More than five years on from the financial crisis, you might have thought that the winners and losers had already been decided. On the one hand, monster banks like JP Morgan and Citi have hoovered up market share and Goldman Sachs has staged an impressive comeback. On the other, once-upon-a-time contenders like Barclays and Deutsche Bank have struggled to get to grips with the new world.

In between, it is less clear which of those investment banks that have engaged in furious restructuring have come up with a realistic strategy, which are clinging to past glories, which have managed to delude themselves again, and which have merely postponed the inevitable. However, the closer you look the more you realise that there are several reasons why it is still too early to identify the longer-term winners and losers.

First, for the first time since long before the financial crisis, competing strategies and business models have emerged across the industry. When everyone was trying to be JP Morgan or Goldman Sachs, when the entire industry had access to virtually free funding, and when almost everyone was printing money, it was easier to spot the winners and losers.

But there are now at least three competing strategies (universal bank, full service investment bank, and a sort of pick’n’mix investment bank) overlaid with different levels of geographic ambition (global, regional and national). This relatively recent development, dubbed “The Return of Strategy” by McKinsey, will take several years to play out.

This is partly because – second – it is still early days for most investment banks and their relatively inexperienced management teams. It may feel like the industry has been having its teeth pulled for several years, but the reality is that it is only relatively recently, over the past 12 to 18 months, that banks have really got to grips with their problems.

What had passed for fundamental restructuring – and pretty brutal at that – had instead been an industry-wide exercise in cutting the most visible costs out of the business and taking the obvious tactical decisions. With each quarter, as the recovery never came, these decisions became harder and harder, and looked more and more strategic, but it is only since late 2011 that most banks have started to ask fundamental questions about their purpose.

This has been compounded by the high turnover of the most senior executives running the business. Of the 15 biggest investment banks, 10 have changed their chief executives or co-chief executives in the past two years, according to my analysis, and their median experience at the very top is a mere 17 months.

Turning the screw

The third reason for it being premature to declare the winners is that the pressure for change from regulators and shareholders is only beginning to bite. Credit Suisse and UBS provided an early warning of how a determined regulator can dictate the shape of a bank’s investment banking business, and the UK government gave a masterclass in how not to run an investment bank in its treatment of RBS.

But it is only recently that the boards and shareholders of several aspiring European universal banks seem to be querying the trade-off between the high absolute profits that their investment bank subsidiaries might generate in future versus the risk and capital drag that most probably will accompany them as regulators tighten the screw on leverage.

Fourth, the industry is still adjusting to a new world in which success is measured by risk-adjusted returns instead of the top line.

One senior banker said recently the industry had previously been run by “revenue junkie product heads” who are struggling to adapt to a more austere and disciplined world. Entire businesses that used to generate huge absolute profits find themselves on the naughty step as banks drill down into the fully costed profitability of individual clients, teams, and business lines.

Banks are finding that loss-leading businesses that had been retained for the sake of “optionality” (a smart-sounding word for not wanting to take a decision too soon and look stupid if the business comes roaring back) or because of synergies and cross-selling, are instead just a jumble of losses.

This means that an important determinant of the winners and losers over the next few years will be which investment banks have the most sophisticated management teams and reporting processes.

Deliberate confusion

And finally, the picture has been clouded by the confusion over reporting and disclosure at the different investment banks. While it would be scandalous to suggest that any of the big investment banks would deliberately ferment confusion over the state of their business, most of them are remarkably tight-lipped about how they fund their business and what regulatory regime they apply to which parts of the business.

How much of the US banks’ business is still run on the basis of Basel I (they never quite got the hang of Basel II and sort of skipped Basel 2.5)? When a bank says it is Basel III compliant, what exactly does it mean and can it provide comparable historical numbers to enable investors and analysts to make up their own minds?

When a bank tidies up its investment bank business by throwing the nasty stuff under the bed (or into a non-core business), for how long can it pretend that its investment bank is in tip-top condition? How do individual banks apply transfer pricing between different divisions, and what would happen if everything were properly costed? And what would the banks’ risk-weighted assets (and therefore capital and leverage ratios) look like if they all used the same methodology to calculate them?

It has never been easy to compare one investment bank with another, but right now it is like trying to complete a jigsaw puzzle in the dark with too many missing pieces. Gradually, over the next few years, these pieces will fall into place. But for now it’s still too early to say.

- This article was first published in Financial News on January 6th 2014

Category: FICC, Investment banking, Management, Regulation, Reporting & Disclosure, Uncategorized |

The 10 big themes from last year that will continue to dominate 2014

As the investment banking industry heads nervously into 2014, here is a quick guide to 10 of the big issues that dominated the industry last year – and which will continue to define its success (or otherwise) this year…

1. How to solve the impasse in regulatory reform

escherThe well-intended process of regulatory reform is in danger of grinding to a halt – not least because of the delaying tactics and obfuscation deployed by the banks. One way of getting things moving again would be to shift the burden of regulatory proof from policymakers to banks.

2. Banks take the ‘Big Tobacco’ approach to lobbying

A big part of that blockage is that the big banks are using diversionary tactics and deliberately misleading arguments to drag out the process of regulatory reform – whether it is chipping away at the Volcker Rule and the possible resurrection of Glass-Steagall, or muddying the waters on capital requirements.

3. Counting the real cost of financial regulation

Regulatory authorities around the world have puny budgets compared to the institutions they regulate and task they are expected to perform. It’s time to spend a lot more money on far smarter regulation.

4. Meet the new kids on the Wall St block

Experience can be overrated – but the high turnover and relative inexperience of executives at the most senior on Wall St could be storing up trouble ahead: two thirds of investment banks have changed their chief executive in the past 18 months, which is also the median number of months that the heads of the big investment banks have been in office.

5. Where is the growth going to come from?

9m revs 2009 to 2013Perhaps the most pressing question for the relative novices running investment banks is how to address the fact that revenues are flatlining and showing no sign of improvement. An industry that has become used to easy double-digit growth is struggling to adapt to zero.

6. Time for a more radical approach to cost-cutting at investment banks

With the topline flatlining, investment banks are only just beginning to explore more imaginative ways of reducing their costs. This means thousands more jobs will go in the next few years and 2014 is likely to see some bold structural changes.

7. Investment banks and their giant game of Jenga

As investment banks struggle to work out how the different parts of their business fit together and how profitable they are, they may find that many of the links, cross-subsidies and loss leaders are really just ‘losses’. But as they try to unpick things, it could all come crashing down.

8. Is there a third way to measure bank capital?

Meanwhile, the debate over bank capital requirements – particularly between the leverage ratio and risk-weighted assets -  could get lost in its own complexity. Here’s a simple suggestion to clarify matters: banks should disclose their capital requirements in three separate ways.

9. Memo from banks to shareholders: mind your own business

FOG-2915526This sort of approach would help address the woeful levels of transparency across the investment banking industry that are undermining its relations with regulators and shareholders.

10 . When will investors lose patience with investment banks?

But perhaps the biggest question of all is whether the extraordinary patience shown by  shareholders in investment banks over their dire performance over the past few years will snap – and what will happen when it does?


Category: Bonuses & compensation, Capital, DCM, ECM, Ethics, FICC, Investment banking, Management, Regulation, Reporting & Disclosure |