|Capital Markets: Tough sell (April 2007)|
Investment banking has had minimal penetration among even large and regional banks, eight years after Gramm-Leach-Bliley. Bankers, analysts, and others weigh in on why few banks have made it high up on the league tables, and what the future holds.
Only a small handful of banks has been willing to do what it takes to crack investment banking’s ranks. Cleveland’s two regionals like the challenge
It’s been eight years since the Gramm-Leach-Bliley Act lifted the restrictions keeping commercial banks from directly engaging in investment banking. But other than an initial flurry of activity after the passage of the act by the largest global money center banks (and before passage in the case of Citicorp), the mid-tier and regional banks have mostly shied away from capital markets.
In a September speech at the Financial Services Roundtable Leadership Lunch, Securities and Exchange Commission Chairman Christopher Cox told attendees, “All in all, the seven year stretch from enactment of Gramm-Leach-Bliley until today is a disappointing record of indecision and inaction. We’ve made several efforts to cross home plate, but all our runners have been left stranded on base.”
“Banks haven’t been getting into capital markets and understandably so: it’s a very different beast in terms of culture, compensation, and fundamental business economics,” explains Alenka Grealish, managing director of the Banking Group at Celent, Boston. “It’s a volatile business that won’t necessarily improve their total shareholder return.”
There are exceptions, of course, and some banks, such as $1.4 trillion JPMorgan Chase and Citigroup ($1.8 trillion) have a thriving capital markets business. Others that entered investment banking have exited: $6.4 billion BankAtlantic Bancorp, Fort Lauderdale, Fla., recently announced completion of its sale of Ryan Beck Holdings, Inc., to Stifel Financial Corp., St. Louis. Minneapolis-based US Bancorp spun off Piper Jaffray & Company in 2003.
Lack of synergies
Investment banking can be a hugely profitable endeavor (think Goldman Sachs). In addition, the synergies between commercial banking and investment banking seem obvious: a bank’s loan customer is doing very well and decides to take the company public. Because it already has a relationship with the company and knows its credit worthiness, a bank should be able to manage the process more easily than an outside firm.
So are banks missing an opportunity by not entering investment banking? Not necessarily, says Tim Yeager, associate professor of finance and the Arkansas Bankers Association Chair in the Sam M. Walton College of Business in Fayetteville, Ark.
Yeager, a former economist with the Federal Reserve Bank of St. Louis, studied the financial performance of financial holding companies for two periods: the four years preceding the Gramm-Leach-Bliley Act and four years after. He found only minor performance differences between the time periods. “Banks became financial holding companies in spirit but not in practice, deriving most of their earnings from standard bank offerings such as deposits and loans,” he notes.
Cream of the crop
Minus a few exceptions, those that are in, are in. Those that are not in seem content to stay that way.
“The banks that are getting into investment banking have already gotten in to it,” says James M. Schutz, director of the Financial Institutions Group at Sterne, Agee & Leach, Birmingham, Ala.
Part of the difficulties in entering investment banking is that the market is extremely competitive and reputation is important. There are the firms that are the cream of the crop: the Goldman Sachs and Morgan Stanley’s of the investment banking world—and companies wanting to go public naturally want to be associated with a big-name to maximize their offering price. The second-tier investment banks can still make high profits, but “let’s face it, no one wants to go with a third-tier firm,” explains Yeager. Some third-tier firms (however that may be defined) may dispute that, but the consensus clearly is that getting and staying at the top is difficult and too expensive for most banks except the very largest. Even some of the biggest banks acknowledge this, at least in part.
In talking about being in the investment banking business, Ken Thompson, chairman and CEO of Charlotte, N.C.-based Wachovia Corp. admitted, “Frankly it’s not an easy model to execute, but if you can knit disparate businesses together in a way that brings greater value to customers, you will undoubtedly also deliver exceptional value to shareholders.”
Indeed, large banks such as Wachovia and Bank of America have worked hard in investment banking but have yet to match the cache of Goldman Sachs or JPMorgan Chase. “The large banks are clearly in the institutional side of the business, but you’re not going to see the next tier of banks really get into that business,” says Jim Reichbach, national industry director of the Banking and Finance Sector at Deloitte, New York.
There are a handful of large banks that could get into this business—Yeager names San Francisco-based Wells Fargo as an example—but adds that it would require buying an investment banking firm and ramping it up: a significant investment that would take a few years to pay off.
Large banks can be successful, agrees Gary Townsend, senior vice-president and analyst, Friedman, Billings, Ramsey Group, Arlington, Va., but they need to be committed to this business. He names Bank of America as an example of a bank that is successful in capital markets because they are ambitious, they’re big, they’re capable, and they generate lots of revenues, says Townsend.
Even if they are successful in capital markets, these large banks are not going to drive the standalone investment banking firms out of business, as there will always be a need for niche players, says Yeager.
“Goldman says they have no plans to do commercial banking. If it were so important to be affiliated with a bank, Goldman would be scrambling to buy one,” he notes.
Celent’s Grealish agrees it’s unlikely that banks (other than Citi and JPM Chase) will ever wind up at the top of the league tables. “The incumbents rule the roost,” she says. The table at left bears this out.
Townsend points to BankAtlantic selling Ryan Beck as an example of a smaller bank perhaps getting in over its head. “Bank Atlantic really is a small community bank that bought Ryan Beck with great expectations, but it didn’t work out well enough for them.
It’s an example of the difficulty in making a go of things. Competitors are very strong and one needs a solid earnings base and franchise to be competitive against the strongest in this space,” he says.
Cleveland’s two success stories
The different cultures of investment and commercial banking can be challenging to blend, but it can be done. Cleveland-based Key Bank, for example, which owns McDonald Investments, is one of a few financial services providers in its market with integrated teams of commercial and investment bankers specialized in certain industry groups. “Our corporate clients benefit from seeing all their alternatives for raising capital, whether that be bank, private, or Wall Street financing from a single advisor who understands their company and industry dynamics,” says a spokesperson for the $92 billion-assets Key Banks.
“Areas such as investment banking, capital markets, research, public finance and fixed income have added valuable expertise—and revenue—to Key’s corporate and institutional banking areas,” and has been a competitive advantage. (Key recently sold the retail brokerage office network of McDonald Investments to UBS, but kept the institutional business.)
Another Cleveland-based bank, National City Corp. ($140 billion in assets), which owns NatCity Investments, announced the acquisition of SSG Capital Advisors, Philadelphia, this past summer. This is the first acquisition for NatCity Investments, which is focused on middle market transactions, says Sean Dorsey, senior managing director of NatCity. The SSG acquisition adds about 15 people to NatCity’s roster of about 35 investment bankers, he says.
Dorsey calls NatCity’s approach to growth “calm and measured.” “We focus on building slowly in a way that is durable for the long run. We want to be culturally consistent, so we are looking to hire organically or hire groups of people who can provide some specialty–whether that’s an industry specialty or a product specialty that is middle-market focused consistent with our bank,” he says.
For banks such as National City, slow and steady appears to be working. Julio Gomez, vice-president of Capital Markets and Financial Markets Investor Research for Financial Insights, Framingham, Mass., says that having management bandwidth is critical.
“The importance of very smart and capable management talent cannot be underestimated, particularly when you integrate investment banking/trading with commercial banks,” says Gomez. “Investment bankers have very strong personalities with highly independent natures and their completely different pay scale causes natural tensions. That has to be managed.”
Few attractive acquisitions
For mid-tier banks interested in acquiring an investment banking firm, there just aren’t that many that are attractive to acquire, says Richard Bove, financial strategist with Punk Ziegel & Company, New York. Not that they are that expensive—the larger investment banks charge ten or eleven times earnings—but regional banks can’t afford to run them, he says.
“I think most banks have become somewhat unhappy with their brokerage subsidiaries,” adds Bove. “They are not producing what had been hoped because they don’t know how to run them. They run it through the retail branch system when you have to run it through a wealth management system and most banks haven’t figured that out yet.” (See “Wealth management: Worth a second look?” March 2007, p.36.)
Technology integration is another issue for banks acquiring an investment bank since the systems used in investment banking and trading are very different. “It’s almost impossible not to have major conversion challenges, says Gomez.
Deep financial pockets help. “The larger institutions that can afford to transform themselves and reap the benefits of technology will be in the best position to provide universal banking,” says Rembert de Villa, global practice leader in MasterCard Advisors’ Strategic Services Practice.
But even the biggest banks have a tough row to hoe. BofA is a case in point.
“The platform that Bank of America is using is not as strong as Goldman Sachs’ or Morgan Stanley’s,” says Townsend.
“But over time the bank hopes to narrow the gaps and become even better and more competitive and take more market share at higher ends of the customer segment. But it’s probably a decade of effort or more.”
Vertical, not horizontal growth
It’s not that banks are standing still. They are certainly morphing and offering new products and services, but these are still under the auspices of banking rather than capital markets.
Christine Barry, research director with Aite Group, Boston, says, “We’re seeing banks going beyond their core competencies but they are still sticking to banking products and expanding into products and services such as accounts payable or electronic invoicing.”
There are still a lot of opportunities within banking to grow, notes Barry. “Banks are very focused on their ability to cross-sell so they are trying to expand on existing offerings. A lot are doing so by making acquisitions. A few years ago we saw them trying to increase their reach. Now we see firms such like JPMorgan Chase acquiring trade management solutions provider Vastera to do more of the working capital management for their customers.”
Most of the analysts we spoke with agreed that sticking to their knitting rather than venturing into the capital markets business is a good idea for the vast majority of mid-sized banks. “I think they are right to expand along the supply chain and look vertically to better serve their corporate customers,” says Barry. BJ
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