How European investment banks can achieve a 12% return on equity
The answer involves a 'shareholder spring', a return to the old partnership model to investment banking and regulatory intervention, according to Société Générale, as shareholder fears grow that senior bankers are still living in a fantasy world.
The cyclical weakness of European investment banks – low balance-sheet yields and feeble credit demand – combined with structural headwinds – higher funding costs, stigmatisation of leverage and tighter regulation – is now an all-too familiar truth.
Here are some depressing stats from Société Générale, in a research report on the sector, that add fuel to the fire. In short: cut costs, cut costs, cut costs.
"We see an opportunity to cut compensation costs by 29%, as pay levels are still 35% above historical relative means and headcount reduction to date stands at just 7% versus 19% in 1987 and 16% in 2001. For the first time since 1998, industry revenues are below the long-term mean by 10-15%, but the cycle appears broken and structural growth opportunities – euro DCM [debt capital markets], competitor exit – are looking slow to assert themselves."
In a post-Lehman era, where investors look past Basel III risk-weighted-asset calculations, leverage ratios and the capital side of Basel III, more generally, reign supreme in investor calculations of banks' financial strength. Against this backdrop, “investors are best served focusing on I-banks with capacity and intent to cut costs aggressively, a broad revenue base with less gearing towards a return of the cycle and lower leverage,” SocGén advises.
European investment banks face a more disorderly shift to profitability than their US counterparts, since “the European banks still operate on an average balance-sheet yield of 1.44% versus US banks at 2.41%. As a consequence, European banks have had to be more levered to achieve similar RoE [return on equity] – 28 times versus 14 times in the US."
To achieve a 12% return on equity - compared with a new 7% normal, according to McKinsey - European investment banks need to do the following, according to SocGén:
- Increase balance-sheet yields by around 40%
- Reduce cost-income to around 65%
- Bring down leverage to 27 times allocated capital
Relative to the long-term earnings cycle compared with equity markets, European investment banks are under-earning by just 10-15%. Meanwhile, structural revenue-growth opportunities are thin on the ground, with the exception of rising corporate bond issuance, in Spain and Italy in particular, amid vanishing lending appetite from banks. As a result, to achieve this magic 12% RoE, banks need to resolutely cut costs.
SocGén analysts proffer the following advice about where the axe should fall:
""Industry headcount dropped 19% in 1987, 16% in 2001 and by just 7% this time round, leaving ample room for more and deeper cuts. There are three key ways that pay will be cut. First is regulatory intervention into product profitability, which in the case of equity analysts in 2002 lead to a 50% cut in pay. We also see a return to the old 'partnership model' in investment banking as exists in BTG Pactual, an investment bank with a 23% compensation ratio but huge dividend payouts to 'partners'. Lastly the 'shareholder spring' provides management with the justification to cut expenditure. Deutsche Bank is best positioned to cut compensation costs amongst the three banks given lower base salaries and an awarded compensation ratio of 33% versus 47% and 51% at UBS and CS [Credit Suisse] respectively."
SocGén analysts conclude:
“Deutsche Bank is best positioned to benefit from the scarce structural-growth drivers due to broad product mix and strength in DCM, whilst UBS and in particular CS are heavily geared towards a return of the cycle.”
In summary, a developed world balance-sheet recession, the euro crisis, asset-class correlations, regulation – proprietary trading curbs, Volcker, Dodd-Frank – still-strong banking competition, in fixed income, commodities and currencies in particular, and stubbornly high costs have slammed the brakes on RoE growth.
SocGén analysts have charted a way for European investment banks can cut costs. For shareholders, it’s do or die. But, on the basis of current expenditure trends, there is scant evidence banks' management are willing to enact the savage cuts required.