[DEBATE] : Is it the end of the world for big banks?

[Riaz K. Tayob]

Is it the end of the world for big banks?

They wanted to be global titans. Now, as the most powerful finance 
houses stagger under the weight of losses and write-offs, a 
once-unthinkable idea is gathering strength: it's time they were broken up
           o Heather Connon
           o The Observer
           o Sunday November 11 2007

Will the sub-prime crisis mark the breaking point for the global banking 
model? There are some early signs that it might.

Citigroup, the world's biggest bank until last week's write-offs and 
management departures, will have to split to survive, according to 
leading analysts. HSBC, which has taken the top slot, is being pressed 
to do the same by a vociferous activist investor. Swiss bank UBS could 
well face a similar shareholder campaign after a series of sub-prime 
write-offs and hedge fund losses have raised questions about the 
legitimacy of combining its investment banking division with its - much 
more robust - private banking operations.

Add in the speculation that Bear Stearns could succumb to a bid, 
widespread speculation about the risk of more write-offs, dividend cuts 
- and even the warning that at least one big US bank could go bust - and 
the global banking model is suddenly starting to look rather vulnerable.

The attractions of that model are straightforward enough. The bigger the 
bank, the more capital it has to win business; the more regions and 
businesses operations are spread across, the less impact a dip in one 
area or business will have on the overall results; and the more 
diversified the operations, the more opportunities there are to 
cross-sell services to clients.

For the last few years, this model looked a surefire winner as profits 
across the industry soared: Morgan Stanley's earnings rose by 66 per 
cent in the three years to the end of 2006 while Goldman Sachs, the 
doyen of all the so-called 'bulge bracket' banks, doubled its earnings 
over the same period - and our own Barclays Capital, part of the high 
street banking group, did even better, albeit from a much lower base.

It now appears these spectacular results have been built on sand. 
Citigroup, Merrill Lynch and Morgan Stanley between them have written 
off more than $22bn relating to US sub-prime mortgages, and the City is 
braced for more. Goldman Sachs has made no write-offs so far and BarCap 
and Royal Bank of Scotland - the two UK banks most exposed to the credit 
crisis - have not yet said anything, but the pressure from the City for 
statements about their exposure is growing daily. And many analysts 
think even those banks that have already come clean could be forced to 
make further bad-debt provisions before the crisis is over. That will 
load yet more pressure on the global giants to justify their business 
models.

Indeed, even before Citigroup chief executive Charles Prince departed 
last weekend, investors were questioning whether its global strategy was 
working. The global diversification that should have been a key selling 
point was, in fact, a handicap as Citi got embroiled in virtually every 
scandal going - from bond trading in London to ate banking in Tokyo - 
tainting its reputation among both regulators and clients. Nor have its 
results reflected its supposed strength: Meredith Whitney, an industry 
analyst who is said to have attracted death threats earlier this month 
after predicting the bank would need massive write-offs, points out that 
its income has stayed relatively flat for the last three years. She 
believes a break-up is now the only solution.

Pointing out that the current write-offs had already undermined its 
balance sheet, she says: 'We believe that... the bank will have to raise 
over $30bn in equity. To do that, it could cut its dividend, raise 
capital, sell assets - or a combination thereof.'

On the face of it, HSBC's problems are far less severe. While it did 
take a write-off of more than $10bn in 2006 because of its sub-prime 
lending, it still made a record $22bn profit; its relatively small 
investment bank does not have trading arms of the type that are causing 
the swingeing sub-prime write-offs elsewhere; and it has not been as 
accident-prone as Citi. But Knight Vinke, the activist investor that is 
campaigning for change, questions whether it has benefited from its 
global spread. While its US, British and European business markets are 
supposed to supply the capital for its faster-growing emerging markets 
businesses, in fact, Knight Vinke says, returns in developed markets are 
pedestrian while the emerging-markets investment lacks focus.

Simon Maughan, banking analyst at MF Securities, says HSBC claims to 
have six products, in lending, savings and life insurance, that will 
have attractions across its empire. But, says Maughan, when you ask what 
they are, 'it says it does not know yet. To a degree, it has found the 
answer and now wants to find the question. It is trying to justify its 
global scale'.

He thinks that UBS will also face pressure for a break-up if there is 
not a significant improvement in performance from the new management 
team installed during the summer: 'Shareholders are likely to say they 
want a bank with a narrower focus.'

Derek Chambers, a banking analyst at Standard & Poor's, agrees there 
should be benefits from global banking - such as efficiencies in 
payments processing, the ability to ride out problems, and delivering 
the benefits of scale to customers. But, he adds, 'there are questions 
about whether any of these add value'.

Certainly ABN Amro - one of the few banks with a global payments system 
and operations in South America and Asia as well as Europe and the US - 
failed to secure any advantage from them. Its performance was so poor 
that it was targeted by activist investors and eventually fell to Royal 
Bank of Scotland, after a battle with Barclays. While RBS has an 
enviable reputation for cost-cutting, secured following its takeover of 
NatWest, there is considerable scepticism that it will manage an 
international banking empire any better than ABN did.

Goldman Sachs - so far at least - is the key exception to the 
underperforming trend, despite the fact that it also has the biggest and 
most aggressive trading desk. That, says Chambers, is down to 
management. 'Banks are IT-driven businesses to a large extent. Any fool 
can spend on IT; it takes good management to spend on IT and deliver 
results.'

But Maughan says its good performance reflects its focus: 'A long time 
ago, people were saying that it was just a large hedge fund. Clearly 
they believe they can make sustainably good returns from proprietary 
trading [that is, trading on their own account rather than for clients]. 
To date, they have been very successful, but no one else has got the 
risk appetite to do it.'

The current travails make it likely that the banks will start to think 
about the range of services they offer - and the chances are that they 
will all start paring back their operations. There are also likely to be 
mergers - Bear Stearns, one of the earliest sub-prime victims, is seen 
as particularly vulnerable but there could be others. And Ken Murray, 
chief executive of Blue Planet, a fund manager that specialises in 
financial companies, has reiterated his belief that at least one US bank 
will collapse as the crisis plays out. The threats to the global banking 
model will not go away quickly.

Jury still out on Barcap

Two decades ago, Barclays was one of dozens of banks with the ambition 
to be a global full-service investment bank. Having snapped up brokers 
and jobbers like De Zoete & Bevan and Wedd Durlacher in the run-up to 
the Big Bang restructuring of the City stock market, it set about a 
hiring spree of specialists in mergers and acquisitions and equities, 
such as the late Bill Harrison. Like many of its rivals, however, its 
ambitions evaporated in the harsher climate of the late 1990s, when the 
Asian crisis sent the appetite for risk plummeting.

Bob Diamond, brought in to run the rump of the business - effectively a 
debt capital markets, derivatives and Treasury operation - has made a 
virtue of the fact that it has steered well clear of the supposedly more 
cyclical parts of the market like mergers and acquisitions and the 
low-margin equities business. The business has grown so rapidly that, in 
2006, it was almost as big as the core UK banking operation.

While there have been no acquisitions, BarCap has expanded its staff 
aggressively. Diamond insists BarCap will be a net beneficiary of the 
sub-prime crisis, but many in the City are sceptical about its future, 
given that so much of global investment banking business depends on 
cheap money and securitisations. He still has a lot to prove.