July 23 (Bloomberg) -- Investment banks should be transformed to more closely resemble private partnerships in which employees are responsible for losses before investors, according to James Chappell, an analyst at German private bank Berenberg Bank.
Variable compensation should be paid in long-term capital adequacy buffer securities, or CABS, which would mean losses for bankers and traders if their decisions backfired, Chappell wrote in a July 20 client note. That, combined with an increase in capital, would help restore confidence in the industry, he said.
“CABS would fulfill two main purposes,” he wrote. “Firstly, they would align employees’ interests with those of other stakeholders, and secondly they would add to the capital buffer.”
Investor confidence in the financial industry has fallen after regulators announced probes into the manipulation of benchmark interest rates including the London interbank offered rate, the basis for $500 trillion of securities.
“In their current form, we do not believe that the investment banks should be owned by long-term equity shareholders,” wrote Chappell, an analyst at Goldman Sachs Group Inc. in London from 2001 to 2009 before joining Hamburg, Germany-based Berenberg Bank, the world’s oldest private bank.
Ideally, banks should be split up into retail and investment banking operations though that may not be possible considering “investment banks have hard-wired themselves into the system and remain too big to fail,” Chappell said.
Even if economic conditions improve, investment banks will struggle to achieve returns sufficient to attract investors because revenues have been permanently dented, Chappell said.
The 43-member Bloomberg Europe Banks and Financial Services Index is down 8.3 percent this year. Credit Suisse Group AG and Deutsche Bank AG are among firms that could see their share prices fall another 20 percent as they struggle to cut costs and raise capital, Chappell wrote.
Planned regulation that forces over-the-counter derivatives to be centrally cleared could reduce revenues by 25 percent, Berenberg estimated, because of a jump in transaction costs and the requirement for additional collateral by clearing houses.
One solution would be to pay bankers’ bonuses in CABS, which would leave employees responsible first in the event of losses, Chappell wrote in the note. If CABS had been in place in 2007, capital ratios would be double where they are, he said.
Firms should cut costs by 30 percent and staunch all bonuses until capital levels are boosted. That can only be assessed using a simple leverage ratio, rather than relying on banks’ internal risk-weighting models, Berenberg said.
On this basis, Deutsche Bank has a capital shortfall of 20 billion euros ($24.2 billion), Credit Suisse 20 billion Swiss francs ($20.2 billion) and Barclays Plc 5 billion pounds ($7.8 billion), Chappell estimated.
“We believe the Basel capital rules have now become a mathematical odyssey,” he wrote. “An outside observer has no way to fully understand their impact on a bank, and we remain deeply skeptical of them.”
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