Character: The Fundamental Basis Of Business And The Future Of Finance

House of Morgan

Observations Concerning the Future of the Financial Industry

This article is the first in a series analyzing competitive trends in the financial services industry. Among these articles, I may feature specific banks or call out general trends. I have no current relationship with any of the banks I will highlight, though I have spent time working at a large commercial bank. I will note when I hold a position a company or ETF or plan on taking a position.

On Banking

In the 2011 Berkshire Hathaway letter to shareholders, Warren Buffett outlined the simple but universal rule: “buy commodities, sell brands” is one of the best ways to run a profitable business over the long term. This is the fundamental principle underlying finance. Banks are brands and finance – money and credit – is the ultimate commodity. What separates Goldman Sachs (GS) and Morgan Stanley (MS) from bucket shops (other than billions of dollars in shareholder equity)? The difference between them is their brands and the confidence and implied competence that these provide.

As interstate banking barriers have fallen and technological innovations allow greater scalability of retail and commercial footprints, I contend that we will see market divergence in commercial banking. As large banks are able to invest in new technologies that reduce costs and improve customer service, it is likely that the emphasis on brand and experience will create a strong competitive moat. A handful of large national banks will dominate commercial banking (with small community banks and credit unions maintaining a significant niche) and will play a powerful role in the investment banking world. Furthermore, the traditional broker-dealer/ investment bank business models will continue to diverge.

Commercial Banking

Net Interest Margin ((NIM)) based business are poised to thrive should the Federal Reserve raise interest rates significantly over the next 3-5 years. This is due to the simple mechanics of interest spreads in commercial banking. The cost component of efficiency ratios among regional banks and balance sheet reliant money centers will likely to improve as well – the financial crisis allowed banks to justify trimming their staffs and geographic footprints while technological changes have reduced the cost to service customers.

Large money center institutions (JPM), (C), (WFC), and (BAC) have been dealing with the aftermath of their acquisitions during the Global Financial Crisis (reducing waste, legal ramifications, increased regulatory scrutiny, etc.) and are generally limited to organic growth. While there may be some appetite for more acquisitions, in the near term they are limited to digesting their most recent takeovers. Indeed, it is unlikely that regulators would allow anything more than small bolt-on acquisitions. No transformational acquisitions here.

However, large regional banks – super-regionals or universal regional banks – are on the rise. While others use the term super-regional (which in many cases is apropos) I prefer the term universal regional banks to describe this growing trend in regional banks. Regional banks tend to have strong consumer presences, even more so super-regionals. However a universal regional bank aspires to function much like a universal bank with a strong consumer franchise, commercial franchise, and investment banking and securities franchise.

These banks maintain decent efficiency and those that survived the crisis were generally more conservative, better managed banks. As such, they were often able to grow organically or through acquisitions. Many have strong wealth management businesses and have bought or grown small investment banking practices.

A prime example of the transformation from a regional to universal regional to universal bank is that of Bank of America (BAC). Once a small regional bank in the Southeast, Bank of America grew by leaps and bounds, gobbling up wounded competitors at opportune moments (and sometimes inopportune moments). Perhaps the most notable actors in the bank consolidation drama of the 1980s-2000s are Sandy Weill and Jamie Dimon whose actions led to the creation of both Citigroup and what is now JPMorganChase (JPM). C and JPM will be discussed further in this series.

US Bank (USB) is generally seen as one of the best managed banks in the business (though they are also helped by their company’s product mix). Their return on equity and efficiency ratio are consistently among the best in class (most recently the return on average common equity was 14.5% and the efficiency ratio was 52.4%). However, given their recent integration of Charter One in the Midwest, USB is unlikely to make any large acquisitions in the near future. USB will be discussed further in this series.

Others, such as PNC (PNC) or SunTrust (STI) have strong franchises and advantageous footprints that have benefited from the recent recovery in the American economy. Both banks have strong commercial presences, good consumer brands, and even small investment banking businesses. Both of them are on the verge of being universal regional banks. Other examples of potential universal regional banks include M&T Bank (MTB) and BB&T. In fact, since the original writing of this article, BB&T has announced its intent to acquire Susquehanna Bancshares, a strong move into the upper mid-Atlantic market.  STI, PNC, and BBT will be discussed further in this series.

Some regional and aspiring universal regional banks have truly taken advantage of the crisis to grow or transform their businesses. Banks with the potential to become super-regionals and perhaps even universal regional banks include Bank of the Ozarks (OZRK) and BankUnited (BKU). These banks have transformed their businesses over the last 5 years. They have done an excellent job of leveraging their brands and they may have significant room for organic and inorganic growth in the future. BKU and OZRK will be discussed further in this series.

Suffice to say that with increased regulation, small regional banks and even large community banks face increased costs and may fall prey to growing universal regional banks that seek to rise in the food chain. As the need for a national brand grows in importance over the next decade, these universal regionals may feel forced to grow, lest they find themselves prey to organic declines or acquisition.

Investment Banks

Investment Banks on the other hand are dealing with a changed landscape after the Global Financial Crisis. Limitations on proprietary trading, regulatory requirements such as new minimum capital ratios, and new Fed oversight impact both the top and bottom line. Investment banking, perhaps even more so than commercial banking is built upon brand and trust.

M&A advisory only thrives if companies can trust their advisor. Prime brokers have trouble drumming up business if they cannot convince their institutional clients that they will be solvent the next Monday. Investment banking is in the trust business and the trust of many stakeholders was shaken during the Global Financial Crisis. As a result, there have been tectonic shifts in the business models of the major investment banks.

M&A advisory groups in bulge bracket investment banks, though still profitable, face increased competition from boutique advisory companies such as Moelis & Company (MC), Evercore (EVR), Centerview Partners, Greenhill & Co (GHL), and smaller traditional investment banks such as Lazard (LAZ) and NM Rothschild. With Paul Taubman’s success with a kiosk-style advisory business (and his imminent move to lead Blackstone’s (BX) soon to be spun-off advisory business) there are several competing business models challenging the bulge bracket one-stop shops. I may include an article or two about trends in the M&A boutique market in this series.

The industry seems to be realizing that there is only so much room in the ecosystem for apex predators. Most large investment banks are scaling back operations in one area or another to de-risk. Most are emphasizing lines of businesses where they have relative strengths. Goldman Sachs and Deutsche Bank are among the few to maintain an emphasis on trading (though in recent quarters Morgan Stanley has done well in FICC as well). Others are refocusing on asset-management and reducing their FICC and even M&A groups.

For example, Barclays has been shrinking its investment bank (the remnants of Lehman Brothers). UBS has done the same with its investment banking operations (the remnants of SG Warburg and several others) to capitalize on its leadership in the asset management space. Morgan Stanley’s completion of its acquisition of the SmithBarney franchise from Citi has strengthened its brokerage business and has reduced its overall risk. These are likely to be smart strategic moves for these businesses as they must both reduce risk and maintain profitability. 2007-2009 showed the investment banking world the danger of banks being all things to all people.

What has become clear is that there is plenty of room for niche players in the businesses that comprise investment banking. There is the possibility that we will see proliferation of firms and greater specialization of firms such as was seen in the 1950s and 1960s rather than the universalization of investment banking franchises as was seen in the 1970s and 1980s. There may be more firms starting in the mold of Donaldson, Lufkin & Jenrette ((DLJ)), Cogan, Berlind, Weill & Levitt ((CBWL)), and Keefe, Bruyette & Woods ((KBW)) over the next few years as the costs of doing business in a universal bank increases and sell-side research shrinks. Investment research is becoming privatized and brought in house for most institutional investors while also being democratized with small investment banks focusing on small caps and non-traditional outfits such as Zacks, the Street, an even Seeking Alpha provide individual (and occasionally institutional) investors a place to go for research.

There may be room for a few small firms to shine that provide high caliber research as did many of the smaller firms started in the post-war era.  I will likely include an article or two on the middle-market investment banking space as well as a number of the industry specific investment banks. As such the trends to be considered in the investment banking industry includes specialization among larger bulge-bracket investment banks and proliferation of smaller businesses focused in advisory, restructuring, trading, and research.

The aforementioned trends in commercial banking and these trends in investment banking seem to be on a fascinating collision course. As larger regional banks aspire to become universal regional banks (a transformation that was only fairly recently taken by both Wells Fargo and Bank of America) they will likely try to build or bolster their investment banking practices through selective hiring or the acquisition of small but reputable firms. Therefore, while the investment banking industry will likely become more fractured over the next 5-10 years, there will likely be consolidation in the commercial banking industry.  In fact, there may be several acquisitions of investment banking practices by aspiring universal regional banks.

Conclusion

Banking is built upon trust. J.P. Morgan said this over a century ago in a hearing before the Pujo Committee. When asked about what was most important when loaning money, he said character. When asked why trust mattered more than assets, Morgan said, “Because a man I do not trust could not get money from me on all the bonds in Christendom.” He continued, “I think that is the fundamental basis of business.”

The trust deficit in the financial industry and the growing importance of national brands in finance is going to be a driving force over the long duree of American finance. Throughout this series of articles, I will examine these trends in more depth and seek to elucidate upon their tangible effects on American business and finance.

Disclosure: I am long BX, LTS, UBS.

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