Why uni­ver­sal banks are fail­ing

The Pak Banker - - OPINION - Damian Chu­ni­lal

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.

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