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LESS IS MORE
J.V. Rizzi
December 5, 2008
Financial markets are undergoing generational changes. This requires institutions to adopt or
risk their survival. Yet, Banks continue to cling to obsolete business models including universal
banking and originate to distribute. The universal banking model has been revived during the
credit crisis by regulators and institutions like Citi among others. They believe the stability of
earnings and deposit funding, compared to the standalone investment bank model, are the keys to
its success. Unfortunately, they have drawn the wrong lessons from the demise of standalone of
investment banks. They failed because of a toxic combination of high leverage, short-term
funding and of a large disastrous bet on housing, rather than not being universal banks.
Universal banks combine investment and commercial banking activities under a one-stop
financial supermarket framework. During the last credit cycle, they also incorporated the
originate-to-distribute model as an alleged steady fee income source. Proponents believe cross
selling opportunities more than justify any increased costs or complexity. Actually, the universal
banking model has never worked. Banks, including Wachovia and Citi in the United States, and
UBS and Fortis in Europe, effectively failed despite their universal banking model. Even during
the boom, universal banks traded at significantly lower earnings and book multiples compared to
more focused institutions reflecting investor doubts with the model.
In reality, 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 which
required open markets to distribute securities. Once the markets closed, the fees become credit
assets. Other alleged benefits prove illusory as well.
Banks deposits are stable and have a lower cost because of government guarantees, and are
available to all banks regardless of their business model. Diversification creates complexity,
which causes banks not only to be “Too Big to Fail”, but also “To Big To Manage”. The
complexity hinders capital allocation, performance evaluation, risk management, and
governance. Institutions deemed too big fail eventually find a way to be both big and fail.
Essentially, management becomes an off-balance sheet liability.
Regulators will also find universal bank diversification related stability also illusory.
Systemic risk is unaffected by diversification. Consequently, universal banks are the regulatory
equivalent of a super senior tranche of a structured bond, which is long on correlation risk. The
risk may look lower, 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 the problem is with the model’s
implementation and not with the model itself. They just need more time to correct the problem.
Unfortunately, for many institutions, their time is up.
The way forward requires recognition that the credit crisis is a secular not cyclical event. It
reflects the end of a 25 year financial markets bull market. Things will not return to normal, or at
least not to the old normal. Financial services profitability will be impacted lower leverage and
higher funding costs. Additionally, former growth activities like structured finance will contract.
The key factor in this new market environment is adaptability, not size. The future belongs to
specialist’s not bloated conglomerates. The specialists will enjoy lower capital intensity and
operating costs. Also, they will have less complex more focused strategies. This will reduce
management as an off-balance sheet liability. This requires breaking up many large complex
institutions built up over 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 stay the course is an example of the problem. Hopefully, the Citi rescue
example will embolden directors to become more active. Additionally, current market conditions
make divestments at reasonable prices problematic. Nonetheless, institutions can begin the
process by spinning off separate operations. Spin offs involve distributing subsidiary shares to
the parent’s shareholders. Management changes, but ownership remains the same. Existing
shareholders get to participate in the upside once markets stabilize. More importantly, the
smaller, less complex and more focused firms will enjoy an immediate value increase as the off
balance sheet management liability is reduced.
The future has already happened. Institutions need to adapt to prosper in the new
environment. Existing 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
spin-offs.