Financial markets are undergoing generational changes, requiring institutions to adapt or risk their demise, yet banks cling to obsolete business models such as universal banking and originate to distribute.
The universal banking model has been revived during the credit crisis by regulators and institutions like Citigroup Inc. among others. They believe that stability of earnings and deposit funding, compared to the stand-alone investment bank model, are the keys to success. Unfortunately, they have drawn the wrong lessons from the demise of stand-alone investment banks. The latter failed because of a toxic combination of high leverage, short-term funding, and large, disastrous bets on housing rather than because they were not universal banks.
Universal banks combine investment and commercial banking activities in a one-stop, financial supermarket framework. During the last credit cycle, they also incorporated the originate-to-distribute model as a supposedly steady fee income source.
Proponents believe that cross-selling opportunities more than justified any increased costs or complexity. Actually, though, the universal banking model has never worked.
Banks, including Wachovia Corp. and Citi in the United States and UBS AG and Fortis NV in Europe, effectively failed despite their universal banking models. Even during the boom, universal banks traded at significantly lower earnings and book-value multiples compared with more focused institutions, reflecting investor doubts about the model.
In practice, the universal banking model is a complex, capital-intensive, and costly vertically integrated conglomerate strategy. Cross-selling remains an illusion as customers object to overpriced or subpar services. Frequently, fee-based products were cross-subsidized, usually by an underpriced credit product. This became evident with originate-to-distribute activities that required open markets to distribute securities. Once the markets closed, the fees become credit assets. Other supposed benefits proved illusory as well.
Banks' deposits are stable and have a lower cost because of the government guarantee and are available to all banks regardless of their business model. Diversification creates complexity, which causes banks to be not only "too big to fail" but also "too big to manage." Complexity hinders capital allocation, performance evaluation, risk management, and governance. Institutions deemed too big to fail eventually find a way to be both big and to fail. Essentially, management becomes an off-balance-sheet liability.
The universal bank's touted diversification-related stability will also prove illusory. Systemic risk is unaffected by diversification. Consequently, universal banks are the regulatory equivalent of the super senior tranche of a structured bond, which is long on correlation risk. The risk may look smaller but is more concentrated and more dangerous in universal banks.
Regulators are encouraging even larger future systemic crises as they encourage the growth of universal institutions. This is likely to produce a Detroit-like ending for these banks. Many of the current hastily arranged and potentially poorly integrated mergers will undoubtedly end up like those at Citi and Wachovia. Proponents argue that the problem is with the model's implementation, not with the model itself. Executives just need more time to correct the problem. Unfortunately, time is up for many institutions.
The way forward requires recognition that the credit crisis is a secular not cyclical event. It reflects the end of a 25-year bull run in financial markets. Things will not return to "normal," or at least not to the old normal. Financial services profitability will be hurt by lower leverage and higher funding costs. And former growth activities like structured finance will contract.
The key factor in this new market environment is adaptability, not size. The future belongs to specialists, not bloated conglomerates. The specialists will enjoy lower capital intensity and operating costs. They also will have less complex, more focused, strategies. This will reduce management as an off-balance-sheet liability but will require breaking up many complex institutions built up during the past two decades.
Existing management will see breaking up as an admission of failure. Thus, absent a survival crisis, they will resist breaking up regardless of shareholder pressure. Citi's refusal to consider break-up calls and insistence on staying the course is an example. One can hope that the Citi rescue will embolden directors to become more active.
Current market conditions make divestitures at reasonable prices problematic. Nonetheless, institutions can get a start by spinning off separate operations. Spinoffs involve distributing subsidiaries' shares to the parent's shareholders. Management changes, but ownership remains the same. The current shareholders get to participate in the upside once markets stabilize. And more important, the smaller, less complex, and more focused companies will enjoy an immediate value increase as the off-balance-sheet management liability shrinks.
Institutions must adapt to prosper in the new environment. Bloated universal and originate-to-distribute business models are questionable in the new market. The key to healthy institutions is smaller, more focused business models. A first step in that direction is to begin dismantling financial conglomerates through spinoffs.