Bankers in search of a new business model - By James Saft

“You’d probably have to go back to the 1930s to get something quite as bad.”
-- James Davis


Bankers in search of a new business model

Seismic shift coming in how banks make and sell loans; focus on underlying assets

By James Saft
April 4, 2008
Source

Reuters—However long or deep the credit crisis turns out to be, it will change the business of investment banking profoundly, probably for good.

Unsurprisingly, it won’t just be bankers who suffer.

The mortgage meltdown has led to a collective loss of faith in structured finance, credit ratings and the banking industry itself.

The upshot for banking: job losses, capital losses, balance sheets that need to be rebuilt, lower profit margins and an industry in search of a business model.

The upshot for the rest of us: besides the bill for what will be an ongoing bailout, expect more expensive and scarcer credit, perhaps even when the crisis is through, and possibly lower structural economic growth.

“We haven’t seen anything as bad as this in the 30-year period we looked at,” said James Davis at consultants Oliver Wyman, who recently conducted a review of investment banking with Nick Studer at Wyman and Huw van Steenis at Morgan Stanley. “You’d probably have to go back to the 1930s to get something quite as bad.”

The study takes as a base case that net revenue in investment banking falls 18% this year, but might fall as much as 45% in a “bear” scenario.

What’s more, it foresees a fundamental change in the way in which banks and investment banks manage the business of making and selling loans.

“We see a shift to emphasis on the underlying assets,” said Davis. “Investors will have to build up skills so they can look at the assets themselves.”

That’s a big change from the “originate and distribute” model we’ve followed in recent years, in which banks originate deals, get them stamped by a credit ratings agency and then sell them on to investors, many of whom bought on the strength of the credit rating and bank originators’ reputations.

Those reputations are now, shall we say, frayed, and it will likely be a lot more expensive if we all do our own credit analysis, just as it would be if we all grew our own food.

Look in any event for profits at investment banks to shrink, and not just due to the current crisis. Between 2000 and 2006, return on equity at investment banks averaged a whopping 17.5%, according to Oliver Wyman and Morgan Stanley, up from 15.4% in the previous seven years.

The problem is that almost half of the growth from 2003 was driven by increased borrowings, a strategy with risks that have become all too clear.

Gearing down

Expect use of leverage at investment banks, and banks, to fall as soon as they are able to manage it. Thus far they’ve been stuck with loans they made or committed to before the crisis.

But once a lower borrowing regime is in place, the banks’ share of what profits they do generate will fall. And even if managers at banks don’t cut back on leverage, regulators are very likely to force them to.

When the Federal Reserve intervened to help Bear Stearns and extended access to the discount window for borrowings to other investment banks, it opened up the way not just to emergency credit, but also to tighter regulation and tougher balance sheet requirements.

“There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks,” said Bill Gross, chief investment officer at Pimco in his April investment outlook.

“Leverage and gearing ratios of securities firms, therefore, will in a few years resemble those of commercial banks, resulting in reduced profitability for major houses such as Goldman, Lehman, and Merrill Lynch.”

Investment banks have only about half the capital base of standard commercial banks, he said.

The Treasury on Monday laid out a plan for the Federal Reserve to oversee investment banks and other financial companies more closely.

On top of that, it’s very likely that regulators ultimately increase commercial bank capital requirements, as well as forcing them to make better provisions for access to liquidity, leaving investment banks even more ground to make up.

A lot of the pain implied in all this will be borne by bankers and bank shareholders.

But not all.

A banking system with more capital and better provision for rainy days, leaving investors to do more work in analyzing credit, and probably requiring better collateral and less aggressive assumptions, should add up to fewer loans made at a higher cost.

That would mean lower economic growth than would otherwise be the case, even once the current storm has passed.

(James Saft is a columnist at Reuters)