The truth about universal banking
Reports that Citi is considering selling off business units may be the final nail in the coffin for a system that failed to recognise the inherent risk in putting banks, brokerages and investment banks together as a one-stop-shop.
US reports of talks between Citigroup and Morgan Stanley about a deal that would see Citi sell its Smith Barney brokerage business into a joint venture controlled by Morgan Stanley make sense at a number of levels. If consummated, the deal would provide a further questionmark over the future of universal banking.
Citi and Morgan Stanley are said to be negotiating a deal under which Citi would vend Smith Barney into a joint venture 51 per cent owned by Morgan Stanley. Morgan Stanley would pay Citi up to $US3 billion and gain options to acquire Citi's interest over time. The deal could also enable Citi to book a $6 billion gain in the value of Smith Barney.
Such a deal would represent something of a backflip for Citi's Vikram Pandit, who had previously rejected calls to break up the sprawling Citi group. Circumstances have, however, changed.
Citi has lost about $US20 billion in the past year and has been forced to access the US government's bank bail-out program, obtaining $US45 billion of capital from the US Treasury. Morgan Stanley, while it has retained its independence, has been converted from an investment bank to a bank and also tapped into the bail-out funds, gaining $10 billion.
Citi had already announced plans to merge its investment and corporate banking businesses. Distancing itself from the brokerage and private wealth management businesses within Smith Barney would represent a significant unravelling of the 'one-stop-shop' or universal banking strategy that Citi had pursued since the repeal of the Glass-Steagall Act in 1999.
Glass-Steagall was the Depression-era legislation that separated US banks, investment banks and brokerages. Anticipating its repeal, the architect of the expansion that turned Citi, for a time, into the world's biggest banking conglomerate, Sandy Weill, acquired the Travellers insurance group in 1998. The acquisition brought with it Salomon Smith Barney.
Apart from the financial impact of selling out of its brokerage business and a time when Citi is still struggling to cope with the fallout from the credit crisis, a sale would reflect the changed nature of the times and changing structure of the sector.
Critics of Citi have always charged that the group was too big and too complex to manage. The global financial crisis has not only revealed the flaws and perils in the universal banking model, which directly imported financial market volatility and losses into the core of the banking system, but has dramatically reduced the appeal of a commercial bank owning non-bank businesses.
The concept of the universal bank was built around the logic of using a bank balance sheet and low cost of capital to support the advisory and trading businesses of investment banks and brokerages and capture more of the value chain and enlarge the distribution capabilities for both sets of businesses. The strategy was very appealing and rewarding during the credit bubble.
UBS has best described (and has experienced) the downside of giving investment bankers access to a bank's cost of capital without properly recognising that investment banks generate high returns because they take a lot of risk. As it has said, that created a perverse incentive for investment bankers (chasing big short term incentives of their own) to take the low-cost capital and pursue short term risks without regard for longer term consequences for the parent bank.
Quite apart from the fact that the banks now better appreciate the need to price the capital they transfer to their non-bank businesses on a basis that better reflects the risks being undertaken with it – which will deflate the returns of the non-bank businesses – the evolving regulatory context is going to make it much less appealing for commercial banks to own large non-bank financial services businesses.
The amount of regulatory capital the banks will have to hold against structured credit and securitised assets and to support the trading books of securities businesses will severely reduce the appeal of maintaining a financial conglomerate built around a bank while leveraging off its balance sheet.
JPMorgan's acquisition of Bear Stearns and Bank of America's acquisition of Merrill Lynch might appear to contradict that conclusion.
It remains to be seen, however, whether they can make a better fist of effectively managing a full-service financial conglomerate than Citi or UBS, particularly in an environment where those banks that have taken US government money won't be able to deliver their star investment bankers the bonuses they have become accustomed to.
Also unknown at this stage is the extent to which they are prepared to use their balance sheets to support non-banking activities and the impact of the looming new bank regulatory regime on banks pursuing a universal banking model.
There may, perhaps, be universal banks in future but they are unlikely to look anything much like the pre-crisis versions pioneered by the Europeans and emulated by Citi – the inherently conflicted model with its incentives for risk-taking that almost brought the global financial system undone.
Citi and Morgan Stanley are said to be negotiating a deal under which Citi would vend Smith Barney into a joint venture 51 per cent owned by Morgan Stanley. Morgan Stanley would pay Citi up to $US3 billion and gain options to acquire Citi's interest over time. The deal could also enable Citi to book a $6 billion gain in the value of Smith Barney.
Such a deal would represent something of a backflip for Citi's Vikram Pandit, who had previously rejected calls to break up the sprawling Citi group. Circumstances have, however, changed.
Citi has lost about $US20 billion in the past year and has been forced to access the US government's bank bail-out program, obtaining $US45 billion of capital from the US Treasury. Morgan Stanley, while it has retained its independence, has been converted from an investment bank to a bank and also tapped into the bail-out funds, gaining $10 billion.
Citi had already announced plans to merge its investment and corporate banking businesses. Distancing itself from the brokerage and private wealth management businesses within Smith Barney would represent a significant unravelling of the 'one-stop-shop' or universal banking strategy that Citi had pursued since the repeal of the Glass-Steagall Act in 1999.
Glass-Steagall was the Depression-era legislation that separated US banks, investment banks and brokerages. Anticipating its repeal, the architect of the expansion that turned Citi, for a time, into the world's biggest banking conglomerate, Sandy Weill, acquired the Travellers insurance group in 1998. The acquisition brought with it Salomon Smith Barney.
Apart from the financial impact of selling out of its brokerage business and a time when Citi is still struggling to cope with the fallout from the credit crisis, a sale would reflect the changed nature of the times and changing structure of the sector.
Critics of Citi have always charged that the group was too big and too complex to manage. The global financial crisis has not only revealed the flaws and perils in the universal banking model, which directly imported financial market volatility and losses into the core of the banking system, but has dramatically reduced the appeal of a commercial bank owning non-bank businesses.
The concept of the universal bank was built around the logic of using a bank balance sheet and low cost of capital to support the advisory and trading businesses of investment banks and brokerages and capture more of the value chain and enlarge the distribution capabilities for both sets of businesses. The strategy was very appealing and rewarding during the credit bubble.
UBS has best described (and has experienced) the downside of giving investment bankers access to a bank's cost of capital without properly recognising that investment banks generate high returns because they take a lot of risk. As it has said, that created a perverse incentive for investment bankers (chasing big short term incentives of their own) to take the low-cost capital and pursue short term risks without regard for longer term consequences for the parent bank.
Quite apart from the fact that the banks now better appreciate the need to price the capital they transfer to their non-bank businesses on a basis that better reflects the risks being undertaken with it – which will deflate the returns of the non-bank businesses – the evolving regulatory context is going to make it much less appealing for commercial banks to own large non-bank financial services businesses.
The amount of regulatory capital the banks will have to hold against structured credit and securitised assets and to support the trading books of securities businesses will severely reduce the appeal of maintaining a financial conglomerate built around a bank while leveraging off its balance sheet.
JPMorgan's acquisition of Bear Stearns and Bank of America's acquisition of Merrill Lynch might appear to contradict that conclusion.
It remains to be seen, however, whether they can make a better fist of effectively managing a full-service financial conglomerate than Citi or UBS, particularly in an environment where those banks that have taken US government money won't be able to deliver their star investment bankers the bonuses they have become accustomed to.
Also unknown at this stage is the extent to which they are prepared to use their balance sheets to support non-banking activities and the impact of the looming new bank regulatory regime on banks pursuing a universal banking model.
There may, perhaps, be universal banks in future but they are unlikely to look anything much like the pre-crisis versions pioneered by the Europeans and emulated by Citi – the inherently conflicted model with its incentives for risk-taking that almost brought the global financial system undone.
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