Ahead of the second quarter reporting season – which kicks off with JP Morgan this Friday – here is the first article in a series that underlines the scale of the challenges facing investment banks.
For a summary of the perfect storm for investment banks over the past few years, it’s hard to beat this: across the industry, average pretax return on equity more than halved over the past year from 20.6% to just 9.6%.
Over the past two years it has collapsed by more than two thirds. If you assume a 30% tax rate, that’s a net ROE of less than 7% over the past year, compared to a probable cost of equity of around 12%. In other words, the investment banking industry is collectively destroying value for shareholders, and has been doing so for the past 18 months.
This chart, which tracks the weighted average pretax ROE at a sample of a dozen large investment banks over on a trailing 12 month basis (ie the most recent four quarters), highlights the problem:
The problem here is twofold: the downturn in activity (revenues are down by 16% over the past 12 months) has combined with relatively inflexible costs (costs have fallen just 4%) to trigger a sharp fall in pretax profits (down 50%). This has collided with regulatory pressure to increase the equity investment banks allocate to their business.
Over the past two years investment banks have increased the aggregate equity in their business by 10% (the burden here has fallen on European banks, which have increased their equity by 28% as they adapt to Basel 2.5, while US banks have flatlined).
This increase has been particularly marked at several firms which boosted their equity in the first quarter of this year: at Deutsche Bank it increased by 38%. With the same level of equity as last year, pretax ROE in its CB&S division in the first quarter would have been 19%, not the 13% reported.
Look hard enough and there is a an optimistic note: the recovery in the first quarter meant that pretax ROE recovered to 26% across the industry, but that is lower than in the first quarter of both 2011 and 2010. And, with the second quarter expected to be significantly worse than last year, profitability continues to head in only one direction.
There is a wide dispersion in ROE across the industry, with JP Morgan top of class with a pretax ROE of 22% over the past 12 months. Banks in the dangerzone over the past 12 months include Deutsche Bank CB&S (10%), Goldman Sachs group (7%) and Morgan Stanley’s institutional securities division (6%). The investment banks at UBS and Credit Suisse, which are sitting on trailing 12 month pretax losses, had negative ROE.
If you assume a tax rate of 30% and (generously) a cost of equity of 12%, investment banks would have to post a pretax ROE of around 17% to beat their cost of capital. On this basis, JP Morgan is the only investment bank to have done so over the past 12 months.
On the plus side, every investment bank posted a pretax ROE in the first quarter of this year that was higher than over the previous 12 months, and every bank except UBS generated a pretax ROE higher than 17%.
Investment banks may hope that things can only get better in the second quarter – except of course, that it looks like they will probably get worse…
Note: all of the above numbers exclude own credit / DVA, and have been converted into US dollars at prevailing quarterly exchange rates. The source is my analysis of the investment banks’ reported results.