The two leading European banks in the global fixed-income markets, Deutsche Bank and Barclays, took divergent steps last month after announcing disappointing first-quarter results driven by hits to FICC revenues.
FICC revenues drove earnings mightily at these two banks in the era of balance-sheet expansion and easy leverage, but like all banks they have struggled to adjust to a new era of punitively high capital requirements cratering returns on retained market and counterparty credit risk. The immediate outlook remains dire. Deutsche Bank said in mid-May that, halfway through the second quarter, investment banking revenues look as if they might be lower than in the comparable quarter of 2013 by a similar or even greater magnitude than the year-on-year decline in the first quarter of 2014.
At Barclays, Tushar Morzaria, group finance director, says: “April was a month for us in which we saw weakness from the first quarter persist.”
With regulators and investors focusing on the two banks’ poor leverage ratios, the pressure was increasing on them to do something. The uncertainty was itself becoming destabilizing.
An older generation of Barclays investment bankers, including many that had joined during the acquisition of Lehman Brothers, began hitting the exits. At Deutsche Bank, the share price fell from €39 at the start of the year to just over €30 in May.
Plans
Each bank has now set out medium-term plans to achieve a 12% return on equity by 2016. But they will travel to that destination along very different roads.
Barclays went first. On May 8, chief executive Antony Jenkins told many outside the bank exactly what they wanted to hear: that he would rebalance Barclays by cutting back the markets businesses heavily.
“The investment bank is too exposed to volatility in FICC and the [Barclays] Group is too exposed to volatility in the investment bank,” he said.
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| Anshu Jain and Antony Jenkins: different strategies |
In the next two years, Barclays will cut leverage exposure at the investment bank in half, with its risk-weighted assets falling from £222 billion ($375 billion) in 2013 to £120 billion in 2016, with £90 billion of those immediately transferred into a new non-core unit to be run down.
Barclays will cut the proportion of group equity capital allocated to the investment bank from 51% to 28% and undertake that it will not grow above 30%. Fully 7,000 jobs will be cut in the investment bank, split roughly equally between front and back office.
Jenkins insisted that this major surgery was essential on the group’s signature business, the only one in which Barclays is a global leader. “It [the investment bank] consumes too much capital; it does not generate sufficient returns for shareholders; and it is too large as a proportion of the group. As currently constituted, it is an unacceptable drag on group returns.”
In place of the global ambitions once harboured by Bob Diamond and John Varley, Jenkins set new and more modest expectations: “In the future, Barclays will be a focused international bank.”
Over at Deutsche Bank, co-CEO Anshu Jain doesn’t do modest expectations. On a Sunday evening 10 days after Barclays had announced its radical rebalancing, Deutsche Bank announced an €8 billion equity capital raising.
It has brought in €1.75 billion from shares placed at a price of €29.20 to Paramount Holdings Services, a vehicle of the Qatari royal family – an echo there of Barclays’ highly controversial capital raising back at the height of the financial crisis in 2008 – which will be an anchor investor committed to take up all of its entitlement in a fully underwritten €6.3 billion rights issue expected to close at the end of this month.
Jain struck a bullish tone, apparently emboldened by the retreat of Barclays and others. “We are now the only true global universal bank based in Europe,” he said. “These actions are not a recalibration of our strategy, they are a reinforcement of our strategy.”
He talked up Deutsche’s intentions to seize “the opportunities we see from the dramatic shift in competitive dynamics here in Europe and from a number of mega trends that are quite substantial”.
Laggard
Long seen as a capital laggard, with a common equity tier 1 ratio of just 6% two years ago, Deutsche had taken that to 9.5% on the eve of the latest rights offering. Once the deal is completed it will boost Deutsche’s fully loaded CRD IV common equity tier 1 ratio to 11.8%.
“Deutsche Bank is now in a comfortable capital position,” notes Kian Abouhossein, analyst at JPMorgan. “Co-CEO Anshu Jain is putting Deutsche Bank on the right track.”
That extra capital gives Deutsche enough breathing room to absorb higher than expected litigation costs – most analysts have raised expectations on provisions against such hits towards €2.5 billion for this year from €1.9 billion previously, following the bank’s guidance – with a sizeable buffer to protect against further unforeseen regulatory demands that might follow the European Central Bank’s asset quality review and some capacity left over to invest in growth.
Analysts at Citigroup suggest that the capital raise has finally put Deutsche on the front foot. “We see increasing consolidation in the global FICC market, with Deutsche Bank emerging as one of the top five. Recent announcements by Barclays and RBS should accelerate these moves, with further pressure on Credit Suisse.”
Jain says: “This capital will allow us to expand RWAs selectively.” The bank will also pursue selective hires in its market businesses in the US. Jain argues that the bank’s FICC division has performed well through the worst times of declining customer volumes, low volatility and higher regulatory capital charges.
Deutsche might reallocate equity away from low-return, highly capital-intensive markets businesses, such as core rates, and flow credit towards better-returning ones, such as emerging markets debt and leveraged debt capital markets, but this is not the time to cut the division in half.
Different choices
“Different firms have made radically different choices in fixed income,” says Jain. He suggests that the raging debate around the industry over the extent to which recent declines in FICC earnings are secular or cyclical creates a false distinction. They are both.
“The changes on regulatory capital are structural. They’re here to stay. The drop-off in volumes, the drop-off in rates and low volatility, we believe to be cyclical.”
Deutsche, like other big players in fixed income finds itself waiting for a decisive turn in the rates market to prompt higher volatility and greater client volumes from which it can profit.
Jain believes that the needs of borrowers and investors hold out the prospect of much greater volumes in fixed income. “If you look at the longer-term outlook, deficits are not coming down in Europe as fast as anyone would like,” he says.
Deutsche suggests that borrower demand will support the debt markets, with new-issue volumes likely to grow by over 80% between 2010 and 2020. At the same time, the demand among key fixed-income investors such as US pension funds and European insurance companies to allocate larger portions of their assets to fixed income will also grow.
Which bank will turn out to have made the right choice in May 2014 only time will tell. Each has drawn a mixed response. Analysts grumble at why Deutsche has raised so much new dilutive equity at a year-to-date share-price low and are in no mood to accept its claims that it can still produce a 12% return on this swollen capital base, especially while cutting guidance for profits in its retail and transaction businesses.
A continuing commitment to fixed income means that the deal might dilute returns without doing so much to put Deutsche ahead of regulators’ demands on their new obsession: the leverage ratio.
Deutsche will move from the back of the pack at a 3% leverage ratio towards the middle of the European peloton at around 3.5%. “However it is still lower than the 4% leverage ratio being proposed by the Dutch and UK regulators, as well as the 6% level from Switzerland or FDIC-insured banks in the US,” notes Alberto Gallo, credit strategist at RBS.
Some analyst suggest Deutsche could have improved its total capital ratio by selling much more AT1 capital than its current €5 billion programme. However, sources say that Deutsche was pushed into an early announcement of the equity raising ahead of its AGM by mixed feedback from investors on the €3 billion AT1 deal it had been roadshowing who wanted it to bolster its pure equity cushion.
Cost of exposure
For Barclays, analysts are starting to calculate a lower cost of equity rewarding the reduced exposure to investment banking. The bank hopes to maintain its position in capital markets origination despite a shrunken markets business. “I’ve been surprised how well Barclays has fared in DCM this year,” says one rival, “almost as if Barclays was trying to make a statement in advance that that remains core to the reduced investment bank.”
But the fear remains that it might be throwing a jewel away under pressure from regulators and politicians.
Professor Jon Rushman, a former Barclays investment banker who researches finance at Warwick Business School, says: “Barclays acquired the US operations of Lehman Brothers for no more than the cost of a data centre and at a stroke became an investment banking colossus encompassing world-class equities and fixed-income capability.
“It would be an amazing act of self-harm to acquire such a great franchise and then not give it what it needs to succeed.”
