Consulting » BANKING – Troubled investment bank seeks sugar daddy for long,

It is not a coincidence that British banks, with their comparatively low exposure to the volatile investment banking industry, rank as the most profitable in Europe. The likes of Barclays and NatWest took fully a decade to climb out of the investment banking sand trap, after spending billions of their shareholders’ money on disastrous forays into the high-risk, low-reward world of equities and debt underwriting. Lloyds Bank decided from day one – that is, from the launch of Big Bang in 1986 – that it would have nothing to do with investment banking. In the words of one senior Lloyds executive, it is a business that produces nothing but “crap profits”. So is there any justification for retail banks, which have shown themselves capable of achieving returns of 20% or more on their core activities, to retain investment banking operations that, with few exceptions, are struggling to squeeze 10% profitability out of the business? Probably not. “There are a number of cultural problems involved in putting together retail and investment banking operations,” says Gael de Pontbriand, a partner in PricewaterhouseCoopers’ financial advisory services division in Paris. “On the one hand, investment banking is about quick reactions to market conditions and high value-added products. Retail banks, on the other hand, are more technology and marketing driven. It is a difficult combination.” PwC has been developing its own investment banking business over the past 10 years or so. “It is an attractive niche for us, given our high level of internal competence and international resources,” says Pontbriand. “Some 70% of our deals are cross-border.” But PwC is not involved in areas such as underwriting debt or equities. Retail banks are generally risk-averse, while investment banks are risk-prone. In its simplest terms, therein lies the culture clash. A number of British banks learned this lesson the hard way: Barclays with BZW, NatWest with NatWest Markets, TSB with Hill Samuel. There is some irony in that last example: TSB is now part of Lloyds Bank, largely because of the disastrous acquisition of Hill Samuel in 1987. If there was one bank that had no business dabbling in the capital markets it was stodgy, traditional-to-the-core TSB. But it had £1bn in flotation proceeds burning a hole in its pocket and it followed the pack, a move that inflicted a fatal wound in its capital base and drove it straight into the arms of the arch-enemy of investment banking. Investment banks are fond of retail banks. Each looks upon its parent organisation as a sugar daddy, oozing stability to offset its volatile operations and stuffed with capital resources to fund high-risk transactions. US and European retail banks are not pushed to the brink by an Asian currency collapse, a Russian default or a Brazilian devaluation. The need to find a sugar daddy is particularly acute for middle-ranking investment banks, since, in this business, they need to be global and require access to vast amounts of capital. The returns of these smaller banks are generally lower than among the bulge bracket banks such as Morgan Stanley Dean Witter or Goldman Sachs. But like their giant rivals they have to pay a hefty premium to attract top quality staff. “In M&A work, quite often prior to obtaining a mandate, a bank has to invest heavily in expensive research, and this has an impact on the bottom line,” says PwC’s Pontbriand. “In Europe, several retail banks will not be able to maintain their commitment to investment banking. The market will not accept low returns versus the risk involved.” Pontbriand cites Banque Paribas and Deutsche Bank as two cases of banks that are having difficulty in achieving the sort of returns expected. Banking analyst John Leonard at Salomon Smith Barney says an investment bank’s success depends largely on being semi-dominant in its markets or, alternatively, a niche player. “The returns are generally low, except in some markets like the US where Morgan Stanley Dean Witter has been making more than 20% ROCE and Goldman Sachs is up there at a similar level,” he says. “This is because the strength of the US has boosted the fortunes of the investment banks. It is pretty hard not to make good returns in that market.” Exceptions to this are NatWest and Barclays, which never achieved critical mass in the US and failed to become global players. They also failed to develop a niche, unlike a medium-sized house such as Schroders, the only UK investment bank left in the FTSE-100. The others – the likes of SG Warburg, Morgan Grenfell, Barings – met their fate in different ways, but each ended up under the umbrella of a European retail bank. The Germans, French and other continentals seem to have an insatiable appetite for troubled British investment banks. Rumours have recently been flying about Robert Fleming falling into the arms of Commerzbank in a £4bn deal. “European shareholders are used to low returns so the banks can get away with it,” says a UK banker. “But even French and German shareholders are beginning to wake up and the situation cannot continue much longer.” Not that the huge US investment banks have had such a smooth ride. Travelers Group’s $9bn takeover of Salomon Smith Barney is riddled with management clashes. This is making it difficult for the merged group to get its synergies to work and it is causing disaffection amongst staff. And at Deutsche Morgan Grenfell, doubts over the German bank’s long-term commitment to its UK investment banking subsidiary has touched off a stampede of top-flight staff in recent months. Both these problems are potentially disastrous for the organisations involved, because investment banking is first and foremost a people business. Putting an investment bank under the umbrella of a brokerage, as was the case in Morgan Stanley’s $10.5bn merger with Dean Witter, seems to be a more viable prospect in terms of minimising culture conflicts. Jules Stewart is a freelance journalist.