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John Mack was brought
in as CEO three years
ago to cut costs.
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When John Mack (pictured right) was brought in as CEO to turn around Credit Suisse First Boston more than three years ago, he offered a simple diagnosis. "We don't have a revenue problem, we have a cost problem," he said. That might have been so then. But in trying to cut costs, has the former Morgan Stanley CEO created a revenue problem that wasn't there before?
A rising tide lifts all boats. And in common with the rest of the investment banking industry, CSFB's profits are expected to have risen in 2003. But it has dropped behind its peers. The bank has lost market share in several of its key franchises, and its position relative to other heavyweight investment banks has slipped. This applies in European, US and Asian M&A, as well as in convertible and equity issuance. Only in bond issuance and foreign exchange has it maintained its rankings. True, CSFB's profits are up on 2002. But total income is forecast to have fallen by about 13% last year.
To be fair, some of this has been a result of calculated action. Mack hasn't just cut costs, he has also cut the bank's risk exposure. This has involved pulling back from activities that could blow a hole in CSFB's balance sheet. In a year when many banks made pots of cash from risky proprietary trading, that meant CSFB missed out on the bonanza.
There is no doubt that Mack has attacked the cost base. Staff expenses have almost halved from SFr12 billion ($9.6 billion) to an estimated SFr6.6 billion since 2001, as he has hacked out guaranteed bonus packages and cracked down on people with special remuneration deals – the most notorious of whom was technology banker Frank Quattrone.
The question is whether Mack has in fact gone too far – and chucked the baby out with the bathwater. In slashing back costs, he might not only have cracked down on overpaid staff, but also on those who were actually worth the money. CSFB has certainly kissed goodbye to a number of employees it would rather have kept, such as John Walsh from its fixed-income team. And arguably the bank is still feeling the absence of Kenneth Moelis, the former DLJ corporate finance chief who defected to UBS.
And while it has damped down risk, CSFB appears to have been pretty inconsistent in the way it has done so. Trading profits boomed in the second quarter, but fell by 95% in the third quarter, with "value at risk" down by two-thirds in fixed income and by a half overall.
CSFB says it pulled back from the market in a calculated decision based on the uncertainty of the interest rate environment. But another explanation is that this was a knee-jerk reaction to trading losses. Either way, the bank could be criticized for having retreated too far. Other banks made a decent fist of trading in the same period without cutting back on value at risk. CSFB lost out.
Unfit to face the bears
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CSFB is ill-suited to a bear market, when fixed
income and commodities desks rule
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There are other explanations for CSFB's lacklustre performance. The firm's business mix is particularly ill-suited to a bear market, when fixed-income and commodities desks have been raking it in. CSFB's franchise is stronger in equities and M&A. Even its fixed-income business is equity-like, since its forte is high-yield instruments. So perhaps its day is yet to come.
Still, the bank's top brass have made it plain that the present situation is not acceptable. Barbara Yastine, the chief financial officer, has warned that the solution to low profitability needs to be "structural". What this means is unclear. But it is not hard to see what it should mean. CSFB needs more investment – and probably more risk-taking. The question is whether Mack has made CSFB a business that Credit Suisse, its parent, wants to invest in. Or indeed, whether Few have yet made their intentions explicit. But it is possible to get a sense of where things are headed from HSBC's recent announcement about its equity business. The international banking group said it was scaling back agency brokerage in order to focus on the trading side of the business. It is not alone in heading down this route.
It isn't clear what will take the place of the full-service big players. But the market's new structure might bear more than a passing resemblance to the one the City abandoned in 1986.
Before Big Bang, the stock exchange operated on what was called a single-capacity system. That separated traders – known as "jobbers", who provided liquidity to the market – from "brokers", who bought and sold stocks on behalf of investors.
This system was swept away at Big Bang in favour of dual capacity, which stuck everything under one roof. The argument was that the dual system offered sufficient economies of scale to compensate for the loss of transparency. Moreover, economies were needed because Big Bang also swept away that other mainstay of the old market – fixed commissions.
The new system entrenched itself further when banks found that there were synergies between broking research and investment banking. Having a star analyst helped them to win capital markets and M&A mandates.
In a short space of time, big integrated houses came to dominate the research landscape. The high-water mark came in about 2000 when just two of the biggest firms, Merrill Lynch and Deutsche Bank, employed nearly two-thirds of all top-rated analysts according to that year's Extel survey.
Since then, the tide has ebbed. Integrated firms have laid off analysts and salesmen – the front-line troops of the agency broking business. This process is continuing. Firms are focusing on providing liquidity to the market, through block and programme trades, while using their knowledge of the market flows to trade for their own account. In short, they are becoming like old-fashioned jobbers.
The most striking example is the agreement that UK funds manager Gartmore struck last year with Goldman Sachs and Merrill Lynch. This allowed it to split the commissions it paid between trading and research. The benefit for Goldman and Merrill is that they got more of Gartmore's trading business.