A few weeks ago I took a group of visiting Chinese finance executives to visit two banks in London, as part of a Cambridge Judge Business School Executive Education course. Although technically both are described as banks, the two institutions were very different in scale, ownership, style, activities and location. But both are among the best in class at what they do.
One, JPMorgan Chase, is a giant in the world of banking, one of the leading investment banks, according to the usual rankings, the largest US commercial bank by assets, and based at Canary Wharf, the “new” City of London.
The other, Berenberg Bank, is small, privately owned and run as a partnership, focused on a limited range of activities and located very close to the Bank of England in the heart of the old City of London. Yet Berenberg, the older bank by far, may tell us more about the future than JPMorgan Chase.
Big is not necessarily better – at least for shareholders and taxpayers
JPMorgan Chase is the best (or if you prefer – and I often do – least bad) example of the western modern universal bank model. Not quite the world’s largest by market value (that remains Industrial and Commercial Bank of China) Morgan is one of the finest names in finance and came through the financial crisis in better shape than almost any other western bank. This reflected a wise (or lucky) strategic decision not to get into the structured mortgage finance business and a long standing heritage of managing risk well. The bank acquired Bear Stearns (an investment bank) and Washington Mutual (a retail commercial bank) through the crisis, building scale and completing its product suite (Bear brought hedge fund prime brokerage).
Yet the vast scale and reach of Morgan’s businesses makes me wonder if this is a viable model for the future. The argument for scale is doubtful. The Federal Reserve of St Louis did find in 2009 evidence of cost economies for US banks, many of which remain surprisingly small by the standards of other rich economies. But research by Ronald W. Anderson, Karin Joeveer at the London School of Economics suggests that there is no evidence of benefits to shareholders from economies of scale (though there are benefits to bankers). Other research suggests very big banks are just bad for the whole financial system because they may be too big to save.
But the real reason for achieving very large scale is that if a bank is perceived to be too big to fail, it enjoys a lower cost of wholesale funding because investors expect to be bailed out if things go wrong. This is simply an unfair and inefficient subsidy from taxpayers to bank shareholders and employees. Andy Haldane of the Bank of England suggests the subsidy to the world’s largest banks in the period 2002-2007 was of the order of $70 billion a year, or about half their post-tax profits. Moreover, once this subsidy is taken into account the economies of scale that previously appeared above a size of $100 billion of assets, disappear.
As for the argument for breadth, there is something to this on the pure investment banking side. A recent senior M&A speaker on the MFin made clear that the provision of financing can be a deal winner for banks competing against pure advisory boutiques. And the financing costs can be pushed up to allow a lower M&A fee to be charged, but the client is overall worse off. So there may be some commercial benefits to being a full service bank, though not necessarily for the economy as a whole.
But it’s harder to show that the combination of commercial and investment banking, as previously banned in the US until 1999 by the Glass-Steagall Act of 1932, has commercial benefits. JPMorgan Chase, Bank of America-Merrill Lynch and Citigroup all increasingly look as if they are too big and too complex to manage. As a (small) shareholder in JPMorgan Chase (I used to work there), I can’t help but wonder if the bank would be worth more broken up. Many people are saying that about the financial giants now, especially if the too-big-too-fail subsidy is withdrawn.
Partnerships: the past and future model?
JPMorgan Chase’s roots go back to 1799, when the Bank of The Manhattan Company was founded. The earliest version of what become JPMorgan was Drexel, Morgan & Co. , founded in New York in 1871. But compared with Berenberg, both roots of JPMorgan Chase are newcomers. Hans and Paul Berenberg founded their trading business in Hamburg in 1590 (the bank website’s history starts with the Reformation), which was converted to a bank in the seventeenth century to fund trading. Continental Europe was then the most dynamic part of the world economy, with a large and growing trade between Scandinavia, the far East, Italy, Russia, Portugal and the Netherlands. Antwerp was the richest city in Europe and Hamburg one of the leading ports. British commercial dominance didn’t start till the eighteenth century and the City of London was much less important till it imported Dutch expertise along with a Dutch king in the form of William of Orange in 1688.
Berenberg has a mere 1,100 people and assets of €3.8bn compared with JPMorgan Chase’s 240,000 and assets of $2.3 trillion. It is privately owned, with the Berenberg family still owning 25% of the equity. Partners are individually liable, as in the original sense of partner, before the US and UK invented the limited liability partnership concept. This is a big risk to take but encourages good decisions and careful risk management. Yet Berenberg made a 40% pre-tax return on equity in 2011 (down on the 45% of the previous year) so the incentives don’t simply lead to risk aversion (the high returns partly reflect the lower cost of labour, as people are paid in part through partner profit share).
Originally all of the US investment banks were partnerships, which converted to public company status from the 1970s ownwards, in order to raise more capital. Goldman Sachs was the last one to convert, in 1999. Goldman still retains the partnership title but these are not strictly partners in the original sense.
The logic of a partnership structure is that the partners are all in it together, though they may own different shares. They have their own net worth on the line and have an incentive to make prudent decisions, monitor each other and protect the value of the firm for the future, since otherwise they will not be able to turn their equity into cash. So the partnership structure should encourage appropriate risk taking and a long term perspective. These are just the features missing from most western banks in the last decade or so.
So could the big banks revert to partnerships? This is most unlikely so long as they remain giants. Partnerships don’t provide the sort of capital needed for a $2.3 trillion balance sheet. And even if JPMorgan Chase and the others are too big, some scale is needed. It’s hard to finance a project loan of $8.5 billion for a liquefied natural gas terminal on the back of a partnership.
But the economic incentives of a partnership could be adopted by even very large banks. In fairness, some do try to achieve this. Lehman Brothers and Bear Stearns had a high (around 30%) proportion of employee share ownership. So you might have thought they’d be more careful with their money. But their decision making was conventionally autocratic.
Most big banks pay their senior employees in deferred and contingent stock which has similar characteristics to a partnership interest but without the very long time horizon. But if your stock vests only after five years, you presumably are quite attentive to deals that may look profitable on day one but could sour in the future. Admittedly this doesn’t capture interest rate swaps that go out thirty years but these are not (so far) a major source of risk.
The insistence by the British Financial Services Authority that banks really do claw back bonuses from employees whose activities have been revealed to have cost money rather than made it is a good one. Shareholders would approve. But banks are not run by shareholders, they are run by senior management. The key missing ingredient is the alignment of shareholder and manager interest. Partnerships make this alignment automatic, since the senior managers are the owners. Other banks have only partially closed the gap, and this is partly the fault of shareholders, who put up with useless performance by the banks with only slight complaint. Since the big banks are pretty much impossible to take over at present, there is a lack of discipline on the senior management.
I don’t seriously think that JPMorgan Chase will come to resemble Berenberg any time soon. But Berenberg’s profitability and longevity are telling us something. As we muddle through the long process of reforming and rebuilding an economically useful western banking system, I suspect that Berenberg’s example will be increasingly relevant.
Interesting read as always; you note that “A recent senior M&A speaker on the MFin made clear that the provision of financing can be a deal winner for banks competing against pure advisory boutiques.” – I would strengthen that comment to say that in my experience, it has come to be the case that ALL clients in recent years would only consider hiring an M&A advisory bank if they could provide financing alongside.
I think this is both a symptom of three factors: large banks are covering so many products that they are true specialists in none – it is a commoditised product, with few real “rainmakers” who actually have the connections that are implied by their salesmanship.
Secondly, as there are lower rewards for bankers at the moment, clients are often able to hire competent professionals as internal M&A advisors.
Finally, many of the skills of M&A bankers are no longer such a mystery and are more easily copied, so the skill itself has declined in value, particularly if the negotiation aspect can be competently handled by legal counsel rather than the more expensive M&A advisor.
However, the current gloom should be offset by the fact that there are so few M&A advisors currently being trained following the cutbacks since late 2007, that future cadres will be both smaller in number and consequently better rewarded as the value of M&A expertise inevitably rises given limited supply, as with any business cycle.