Don’t count the bankers out yet
Dec 05 2012
How did investment banking become so big? Because, apart from wealth management fees, the rates of return earned on investment bank activities far exceeded those on retail banking, which had essentially become commoditised with the spread of securitisation in the major banking nations. As wafer thin profits were made on each financial transaction, banks had to expand their balance sheets enormously if they wanted to beat their rival’s performance. And they certainly competed. As Chuck Prince, then CEO of Citigroup, said in July 2007 “But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Bank CEO’s found it hard to retrench without risking losing their jobs.
The fact that the bounce back after previous financial crises had been so fast probably encouraged bank executives to postpone retrenchment for as long as possible. Surely markets would again recover quickly and it’s off to races! This time around, however, despite huge injections of funds into the banking system in the forms of bailouts and from central banks, easy money didn’t yield high profit levels.
Ultimately bank executives began to succumb to two pressures. First, long-suffering shareholders were fed up with the mounting losses created by investment banking divisions, losses that often came to light at the most unexpected times. Some of those losses arose because of illegal trading behaviour by bank staff, further compounding distrust between shareholders and bank management — after all, the latter were supposed to be responsible for risk management!
The second source of pressure came from bank regulators, who kept pushing for banks to increase their capital levels. Given that only limited funds could be raised from private financial markets to rebuild bank balance sheets, then only by limiting or abandoning dividend payments could banks accumulate more capital. Unsurprisingly, sustained lower dividend payments further antagonised shareholders, reinforcing pressure to change course.
Still it’s too soon to say that the bankers have really changed their stripes. After all, not every major bank has abandoned large shares of its investment banking activities. Those banks with greater reserves and other sources of profits are still biding their time, hoping the go-go years return. Their incentive to hold on is even greater now that it appears that more rivals are exiting investment banking.
But the recent announcements aren’t complete withdrawals from investment banking. Some activities remain and it begs the question whether UBS and Barclays might be tempted to reverse course should financial market circumstances markedly changed. It would definitely take time — and possibly a lot of money — to rebuild the teams of talent necessary to succeed in investment banking, but the option remains.
Furthermore, the past six months have seen bank regulators soften then harden their treatment of banks. Over the summer, there were several reports that UK bank regulators were slowing down their implementation of new, tighter requirements on banks. Similar dynamics were at work in the US before the presidential election there — plus previously legislated rules (such as the so-called Volker rule that sought to separate investment bank functions from others) were watered down. Furthermore, recently considerable opposition has emerged in Europe to a proposed banking union.
Set against these developments have been demands from the Bank of England that UK banks hold more capital and similar demands have been made elsewhere. If bankers can successfully blame sluggish economic growth in industrialised countries on tighter bank rules that discourage lending to the private sector, then it will be the bank regulators that find themselves as political scapegoats. The cat and mouse game between banks and their regulators is far from over.
It is tempting to ask just how much has really changed in banking since the crisis began in 2007? In the world’s larger financial sectors at least the answer is almost certainly “not much.” Research has shown that the relative compensation premium for those working in the financial sector grew substantially in recent decades, providing a very strong incentive for bankers and the like to resist change vigorously and for as long as possible.
Even if the formal banking system did fundamentally change its corporate strategy, those concerned about fostering financial stability still need to be vigilant. As many experts have begun to realise, many functions of banks and the massive levels of leverage created by them can be replicated by other financial institutions. The latter — known as shadow banks — fall outside the system of bank regulations and to date have been subject to far fewer reforms. What we may be seeing, then, is not the demise of the super-compensated banker, but rather the transformation of bankers into shadow bankers!
(The writer is a professor of international trade and economic development at University of St Gallen, Switzerland)