The Bear’s Lair: Behemoths should give up merchant banking

“The mood’s always depressed in Deutsche” said one of that bank’s Singapore traders (not being laid off that day) to the FT. That reflects my experience at Citigroup and is contrast to my experience at the genuine merchant bank Hill Samuel where we were pretty cheerful. Surely now, a quarter century after the demise of the London merchant banks, it has become utterly clear: the behemoths like Deutsche, Barclays and Citi simply can’t do merchant banking competently, and should abandon it to smaller, nimbler houses.

Much of Deutsche Bank’s trouble derived from business that was not strictly speaking merchant banking. Media memory being so short, most of the recent commentary on Deutsche’s problems claims that the bank got into investment banking with its 1998 purchase of the New York commercial bank Bankers Trust. That is incorrect; its far more significant move into true merchant banking came with its 1989 purchase of the top-tier British merchant bank Morgan Grenfell.

Morgan Grenfell, which had started life in the 19th Century as the London arm of the J. Pierpont Morgan banking empire, was the London leader in the mergers and acquisitions business and a fairly important asset manager, although it had failed to build a substantial equities trading and issue business, having closed its trading arm in 1988. Nevertheless, it was a very solid base on which Deutsche could build; if large banks could become major “universal banking” houses, it seemed that with Morgan Grenfell Deutsche was well on its way. However, in 1995 a minor scandal, involving a fine of a mere $3 million, caused Deutsche to abandon the Morgan Grenfell name and strip the firm of its autonomy, thus losing whatever remained of the merchant banking culture.

Bankers Trust was much larger than Morgan Grenfell ($10 billion acquisition cost versus $1.5 billion) and much less central to true merchant banking, having been a New York commercial bank that had bet big on the derivatives business. At the end of 1998, it was faced with huge losses on its holdings of Russian government bonds, and deep suspicion from derivatives counterparties in the wake of the Long-Term Capital Management collapse/bailout. It was therefore happy to be acquired by Deutsche and could almost certainly have been bought more cheaply. It brought Deutsche a premier position in the derivatives business and a major if somewhat gamey investment management business, but no significant position in U.S. corporate finance or equity sales/trading, the businesses Deutsche needed to build up to become a full-line house.

Over the following two decades, Deutsche suffered under a number of CEOs, and was zapped repeatedly by several regulators, but never managed to build an investment banking business with satisfactory returns. In equity trading, where it brought in high-price staff from outside, it was still losing $600 million annually in 2018, by press accounts. It is surprising that Deutsche did not seize the opportunity to acquire capability in this area by buying a chunk of Lehman Brothers at that unhappy institution’s bankruptcy in 2008. Equally, the dismal post-acquisition history of Barclays, another behemoth commercial bank that did buy most of Lehman’s, suggests that the problem is structural rather than simply a question of making the right acquisitions.

From the quote above, it is clear that morale problems alone prevent Deutsche from ever succeeding as an international investment bank. Equally, its domestic retail banking business, greatly expanded with the purchase of Deutsche Postbank in 2008-10, is unable to earn adequate returns, even though it is dominant in the large and economically successful German market. Still, a retreat to the business of serving the German corporate and upmarket retail sector, ideally including an investment management capability, would seem the best way forward.

More interesting than the simple question of what Deutsche should do is the overall question of why large behemoth commercial banks cannot run investment banking businesses, and what “secret sauce” would enable an investment/merchant banking business to operate successfully in the future. There are two very separate businesses to consider here: the large trading business, including bonds, foreign exchange, equities and derivatives, and the much smaller advisory, new issues and mergers/acquisitions business, the “high-IQ” end of finance that was dominated by the true London merchant banks.

Much of Bankers Trust’s business came from the high risk, high margin end of the derivatives sector, where Bankers Trust was a pioneer. For the traders involved, the main joy of this business was the ability to “up-front” fees, receiving bonuses thereon, for transactions with maturities of 7-10 years or more. Indeed, we are told that one of Deutsche’s current problems arises from the need to allocate balance sheet space for old derivatives transactions with maturities of 20-30 years, which still have decades to run, yet whose profits were recorded a decade or more ago and paid out in bonuses long since spent.

Another problem with trading businesses is the management of their risks. Kevin Dowd and I wrote on this problem at length in our 2010 book “Alchemists of Loss;” suffice it to say that Wall Street’s risk management practices still suffer from the same underlying flaws that they did in the years prior to the 2008 financial crisis. The underlying assumption is made that risks are “Gaussian” with very thin “tails” in which the risk can become much larger than the standard “Value-at-Risk” calculation.

Experience has shown that this is not the case; in addition, clever quants can design new structures that “game” the risk management system, having much larger risks (and consequently much larger profits) than the risk management system shows. Examples of such products are credit default swaps (CDS), which have risk “tails” much longer than is calculated by the models and collateralized debt obligations (CDOs) which in many cases have risk “tails” much “fatter” than is calculated in the models. (Long-tailed risks lose you much more money when they go wrong than the Gaussian-based system calculates, while fat-tailed risks go wrong much more often.)

Gigantic trading operations based in banks with deposit insurance are essentially gambling casinos financed with taxpayers’ money; this should be stopped, for the security of the banking system. In any case, the risk incentives in such a case are so poorly aligned that the large bank (and its shareholders) is simply asking for trouble in the long run. Trading operations need to be placed in hedge funds, where their inevitable bankruptcies hurt nobody but their suppliers of capital. Oh – and special interest whining for bailouts, such as took place with the Long-Term Capital Management debacle of 1998 must be firmly resisted. The short-term damage to the system from a large hedge fund bankruptcy may be considerable, but the long-term damage to the entire economy from bailing it out is much more pernicious – for one thing it will push all the capable and greedy young people into financial services, as before 2008, starving the overall economy of talent.

Finally, we come to the highest intellectual-value-added sector of finance, the pure merchant banking “advisory” business. This involves the best and brightest brains in finance advising major corporations and governments about finance raising, the financial aspects of strategy, acquisitions and long-term financial management. It was pioneered by the Florentine bankers of the fourteenth century. The last major Italian example of such “consigliere,” the banker Enrico Cuccia of Mediobanca, was active right up till his death at the age of 93, in 2000.

Advisory work was the main business of the classic 19th Century top merchant banker. The specialized lending, capital raising, merger advice and commodity trading businesses were added to this business to increase the stability and size of the partnership’s income flow, as well as training the middle-level people who assisted the top merchant bankers and in some cases graduated into partnership themselves. It naturally included the business of advising the finance ministries of independent countries on how to raise money for long-term projects and how to budget on a sound basis. From Alexander Baring’s assistance to the Royalist post-1815 French government on financing the Allied indemnity, this advice was invaluable, and was properly appreciated by the recipients.

The merchant banks’ country advisory function was usurped by the 1944 Bretton Woods Agreement, which created unnecessary public-sector monopolies, the International Monetary Fund and the World Bank, which since that time have provided the advisory function on a very much less competent and disinterested basis.

You only have to look at the chaos in Argentina in the last few years. The reforming Mauricio Macri government after 2015 was first allowed to raise its entire borrowing capacity in one year from the international capital markets, then rewarded the following year with a $50 billion bailout loan from the IMF. This combination has overloaded the country with debt, while allowing the Macri government to avoid the utterly essential budget cutting needed to restore economic health after the wild public sector bloat of the Fernandez years. As a result, the economy is being forced into austerity just as another election looms, probably resulting in the return of the loathsome leftist Cristina Fernandez and further poverty and misery for Argentina’s citizens.

Lord Ashburton, Lord Revelstoke, Lord Kindersley or Lord Bicester, were they advising it, would never have allowed Argentina to behave so foolishly. The cost, to Argentina and the world, of having the IMF in charge, rather than one of their Lordships, has been incalculable, in both the short- and long-term. It is no coincidence that Argentina’s long economic decline began after 1931, when the London merchant banks were forced to withdraw from this business.

The best merchant bankers will not work for behemoths – why should they subject themselves to the power-mad drones who run them? For this reason alone, the merchant banks should be re-created as independent entities, the IMF and World Bank run down and closed, the world returned to a Gold Standard, and international finance allowed to restore its traditional standards of soundness and probity.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)