Yesterday JPMorgan research released a 328 page report arguing that global tier 1 investment banks were "un-investable," and today JPMorgan reported record first-quarter earnings of $1.59 per share versus $1.40 consensus, so I guess it sort of looks like there's a disconnect. But not really? Here are the analysts on banking regulation:
We believe Tier I IBs are un-investable at the moment and the right time to make a switch into Tier I IBs would be if we get more clarity on regulations providing us comfort around the ROE potential of Tier I IBs or we see IBs having to spin-off their businesses leading to capital return to shareholders. We believe Tier I IBs will continue to remain more exposed to the IB regulatory changes as they try to “defend their turf” while Tier II IBs have the option to step back more aggressively.
Jamie Dimon, meanwhile, responded to analyst questions this morning by more or less begging the analysts themselves to call their congresspeople and defend JPMorgan's turf, arguing that banks are safer than ever, that JPMorgan's size and scale and universality provides services that clients want and is good for the world, and that "I hope at one point we declare victory and stop eating our young."1
The analyst report is a fascinating bit of business. The claim is that global investment banking - by which they mean of course FICC trading - will see market share move toward top-tier banks, driven mainly by the commoditization of the FICC business with clearing and greater price transparency around derivatives, as well as higher capital requirements and more complex and Balkanized regulation around trading activities. The result:
In an FICC world which is becoming more cash-equity like, we see a scenario in which IB managements would have to make a decision on whether they have the appetite or ability to run a full-scale all-in-one business servicing clients in all the product areas globally or they are in a better position running a small-scale IB focusing only on flow businesses, and supporting their more profitable divisions be it Private banking or Retail banking.
In our view, winners in the new regulatory and revenue environment are Global FICC Tier I IBs, boutique houses and agency only-type IBs. Firms which are running institutional businesses which are not able to offer the whole range of client solutions need to focus on an agency-only business model or become much smaller i.e. concentrated to the domestic markets. Hence we expect Tier II IBs to be more pro-active and expect further restructuring to come.
"Winners," here, interestingly, means "losers," at least as the global tier I's go:2
In our view, Tier II Institutional IBs could end up targeting 12% ROE as an acceptable level of return to shareholders. We believe it is not possible for Tier II IBs in the restructuring mode to generate 15% ROE as it would mean unviable levels of compensation or staff reductions. Tier II IBs, in our view, could run their Investment Banks to support their Private Banking franchise, corporate clients or their retail client base – i.e. a more agency-like structure over time. This may lead to lower ROE but we believe more predictable IB earnings and lower staff costs from employees in execution type businesses with lower compensation levels. Hence we believe even with 12% ROE, it could become 1x BV business for Tier II IBs and also lead to PE rerating of the universal bank.
For Tier I IBs, however, we believe 15% ROE is the cost of equity plus a premium to shareholders for running a full-scale Investment Bank, with greater volatility in earnings compared to the Tier II Agency-like model and for taking on higher amounts of risk. Most importantly, our analysis in this report implies ROE could remain subdued with ongoing uncoordinated regulatory proposals and we see IBs struggling to make ROE above COE in the medium-term at least. As a result, we see Tier I IBs as un-investable, and do not see them re-rating to TBV.
They're not alone. Wells Fargo analysts argued this week that the biggest universal banks trade at 20-30% discounts to their sum-of-the-parts values, and shareholders real and imaginary are pressing banks to break up for reasons real and imaginary.3 The idea that the giant universal TBTF banking model, and its attendant regulatory uncertainty, is a little rough on shareholders is getting close to universally accepted.
So why do it? Oh you know lots of reasons, of which inertia is surely the leading one: even if Jamie Dimon thought that JPMorgan would be worth more to its shareholders sundered into a dozen pieces, there's no obvious way to get from here to there without a lot of intervening misery for all concerned. But of course there are various non-shareholder stakeholders who are better served by the universal model, too. Credit investors get their too-big-to-fail uplift, of course, whatever that is, but they also get diversified, heavily regulated, increasingly well capitalized, and actually kinda boring businesses. Since they still provide ~95% of the big banks' money, why shouldn't their preferences get some weight?
Other constituencies too. Jamie Dimon of course points to JPMorgan's cross-selling ability as being good for clients, "good for clients" of course has some feedback into "good for shareholders" and his Corporate & Investment Bank CEOs point to the ROE benefits:
But they are separate constituencies; you could imagine some customers being persuaded that keeping all their banking business in one place is a valuable convenience even if the shareholders of that place disagree.
Of course there might be one more constituency? Here are JPMorgan's analysts again:
Note a rough trend: being Tier II (UBS, CS, MS) and restructuring into a more agency-based investment bank seems to correlate with significantly reduced compensation expense. Being Tier I (DBK, GS, BARC) and defending your turf against interlopers and regulatory changes costs money. But at least some of the money goes to a worthy cause.
JPMorgan Analysts Say Big Investment Banks Are ‘Uninvestable’ [Bloomberg]
JPMorgan earnings release, presentation, supplement [JPM]
1.That paedophagy comment was the spunkiest Jamie got this morning. The London Whale has left him a changed man, and he showed unaccustomed restraint in an exchange that went roughly like this:
Analyst: This Brown-Vitter bill, with 10-15% capital requirements, do you have any idea where they got those numbers, or is it just an arbitrary attempt to break up the big banks?
Dimon: You'll have to ask them.
Analyst: That's fair, but just on the numbers - do you have a sense of where they came from?
Dimon: You'll have to ask them.
Analyst: Please say something outrageous.
2.Here's the classification by the way:
I get it, but still, a bit rough for Morgan Stanley no?
3.Here's the shareholder proposal demanding that Goldman Sachs sell itself. The single best part of it is this:
That the shareholders of the Company, assembled at the annual meeting in person and by proxy, hereby request that the Board of Directors immediately engage the services of an investment banking firm to evaluate alternatives that could enhance shareholder value including, but not limited to, a merger or outright sale of the Company, and the shareholders further request that the Board take all other steps necessary to actively seek a sale or merger of the Company on terms that will maximize share value for shareholders.
If only there were an investment bank with a strong FIG practice that they could hire! But the second best part is this:
As a committed investor in the Company, my focus is for the Company to enhance value for its investors. Therefore, I believe that the greatest value to the shareholders will be realized through a merger or sale of the Company. The Board should take advantage of the market for low interest rates by immediately seeking out opportunities to merge into a better managed and more competitive financial institution or find an opportunity for shareholders to sell their stock to a better managed and more competitive financial institution.
So: do you believe that his goal here is maximizing shareholder value? Or, like, "Other"? I want to set up a fund, call it the Annoying Fund, and get investments from people not that concerned with returns so I can buy small amounts of stock in various widely disliked public companies and submit irritating value-reducing shareholder proposals so I can get them included in the proxy. I think I'd be good at that, and I think some people would get utility out of the product.