Why universal banks are failing

SCARCELY a day goes by without news of disappointing financial resultsor top-level leadership changes at universal banks -- those all-purpose financial institutions that were supposed to benefit from synergies and economies of scale among their many businesses. Their model is clearly breaking down. And without some crucial changes, their future looks increasingly in doubt.

With a few notable exceptions, the recent performance of these banks has been poor. Even controlling for the effect of reduced leverage, return on equity has fallen. Many universal banks haven't returned their cost of equity for years. Many would like investors to focus on their "core" businesses, defined by them to exclude past mistakes and problematic "non-core" areas. All too often, the fundamental performance metrics that drive shareholder returns -- such as operating margin and return on assets -- have deteriorated, in some cases progressively. The resulting effect on banks' valuation, in terms of price to tangible book value, has been severe. Many universal banks are now trading at less than half their valuation of 10 years ago.

The temptation is to blame regulatory headwinds. But this is too simplistic. Although return on equity and valuations have fallen at nearly all universal banks, the impact differs greatly between institutions. Why, for example, have some organizations that have significantly reduced their leverage post-crisis not seen a commensurate fall in their return on assets, whereas others have seen a collapse? Why have some universal banks, such as JP Morgan Chase, and some more focused institutions, such as Wells Fargo, managed to maintain or improve their operating margin, offsetting the headwinds to return on equity, whereas many others haven't?

Numerous factors are at play, but it's important to focus on the underlying drivers of value. First, many universal banks lack an economic "moat" -- that is, the ability to sustain a competitive advantage over their peers in a core area. They're still operating in too many markets or businesses where local or purer-play competitors are better placed and have consistently superior returns. Second, many of these banks lack adequate information-management systems to properly price transactions and value their range of businesses. That's why so many have persisted in areas where returns don't exceed the true cost of doing business once the price of funding, capital and risk (including counterparty and operational risk) is properly factored in.

Third, many banks are staffed and led by teams with the more-is-better mentality of a market-share culture, rather than one where capital is treated as a scarce resource and allocated according to the appropriate marginal rate. In a world where the biggest producers typically move to leadership positions, the flaws of the current model become ingrained. Finally, many universal banks simply have weak leadership and management, leading to frequent and contradictory changes in strategy and a failure to execute needed reforms.

As a result, the whole model of global universal banking is being challenged. The cost and revenue synergies that were expected -- from combining functions such as compliance and information systems, and from selling financial products across businesses -- often haven't materialized. In contrast, many of those banks have proven costly and unwieldy to manage, excepting only those few with truly talented leadership teams. At several banks, the better businesses have simply subsidized the weaker ones, and cost-of-capital discipline has been weak or nonexistent.

The new leadership teams being put in place -- at institutions such as Barclays, Credit Suisse and Deutsche Bank -- have their work cut out for them. Many are embarking on company-wide restructurings and cost-reduction programs with the aim of reducing riskweighted assets and increasing return on equity. Some are attempting to reshape their businesses to focus on areas that offer a higher return on capital, such as asset management and wealth management. Some are withdrawing from specific businesses or regions.

But to avoid repeating the mistakes of the past, the new leaders of these banks should also think through some core principles. Strategy must be framed in the context of an organization's economic moat, to emphasize core areas of strength. This will require more focus, more downsizing and less tolerance for marginal businesses. Execution should follow a clearly defined strategy that isn't subject to frequent change.

More radical steps will be required for several weaker performers who should arguably give up the universal banking model altogether. Individual transactions and businesses need to be judged on their contribution to enterprise value, properly measured after all costs and risks are factored in. Many organizations still don't have reliable ways to measure this. Silos between divisions, and within divisions, still need to be broken down.