Dougan Lowers Returns Goal as Blankfein Clings to 20%
By cutting Credit Suisse Group AG (CSGN)’s profitability target last week, Brady Dougan acknowledged what some Wall Street bankers and investors are loath to concede: Tougher capital rules will mean lower returns.
Dougan, the Zurich-based bank’s chief executive officer, lowered the goal for return on equity, a measure of profitability, to more than 15 percent from more than 18 percent. Barclays Plc (BARC) said today it will aim for a 13 percent ROE, down from an average of 18 percent over the past 30 years. By contrast, Goldman Sachs Group Inc. (GS), the bank that makes the most revenue from trading, insists its target of a 20 percent return on tangible equity doesn’t need to be moved.
Profitability soared in the middle of the last decade as banks increased leverage, using borrowed money to bulk up on assets. The credit crisis exposed the risks of that strategy and resulted in $1.48 trillion of writedowns and losses worldwide. To generate the same returns while holding more capital, Wall Street firms can either discover fresh profit opportunities or reduce costs, including pay, analysts said.
“If the margins stay the same and the balance-sheet leverage drops, as we know it has, ROEs go down,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. “Your choice is pretty simple then: You cut compensation to your employees or you ask your clients to pay more. If that’s impossible, well then your targets are going to go down.”
Tougher Swiss Rules
New rules drawn up by the Basel Committee on Banking Supervision and endorsed by Group of 20 leaders last year will require lenders to more than triple the highest-quality capital they hold to cushion against losses by 2019. The regulations may trim the return on equity of European banks, on average, by 4 percentage points, and U.S. banks by 3 percentage points, according to estimates by McKinsey & Co. consultants.
Switzerland may ask UBS AG (UBSN) and Credit Suisse, the country’s largest banks, to raise capital to almost twice the new Basel levels while allowing them to make up for part of the difference by selling bonds designed to convert into equity when a lender’s reserves drop below an agreed-upon threshold. Credit Suisse said yesterday it agreed to sell about 6 billion Swiss francs ($6.18 billion) of contingent convertible bonds to shareholders in Qatar and Saudi Arabia in October 2013 at the earliest.
Dougan, 51, said on Feb. 10 that Credit Suisse looked at the rules and decided the bank’s old target was unrealistic. The company reported a 2010 return on equity of 14.4 percent. He also cut the dividend by 35 percent to build up reserves. Investors punished the stock, sending it to the biggest decline in nine months.
‘Among the Best’
“I think, over the next three to five years, we can make more than 15 percent,” the Credit Suisse CEO said in an interview last week. “If we do that, you and I will be standing here in five years time and you’ll say that was a very, very good performance, among the best in the industry. But a lot of people don’t think longer term like that.”
Goldman Sachs, the fifth-largest U.S. bank by assets, says its target for returns is still in reach. Chief Financial Officer David Viniar told investors at a conference in Florida last week that higher capital requirements won’t necessarily lead to lower returns because other circumstances can change, such as the rapid growth of emerging markets.
“We’re going to be Goldman Sachs in more places than we are now,” Viniar, 55, said. “And so hopefully there will be revenue opportunities that will rise along with our capital requirements.”
In its 12 years as a public company, Goldman Sachs has generated an average return of 23.9 percent on tangible common shareholders’ equity. Tangible common equity is total shareholders’ equity excluding preferred stock, goodwill and identifiable intangible assets. The firm has achieved its goal of attaining a 20 percent return on tangible equity over a business cycle, even though returns have zigzagged from a high of 39.8 percent in 2006 to a low of 5.5 percent in 2008.
“We’re not in a position now to say we have to adjust that,” CEO Lloyd Blankfein, 56, said of the New York-based bank’s profitability goal at a Nov. 16 investors’ conference.
While Goldman Sachs sets its return targets based on tangible common equity, the firm also reports a regular return on common shareholders’ equity. Over the last 12 years, the average for that measure was 20.2 percent, with a peak of 32.8 percent in 2006 and a trough of 4.9 percent in 2008.
Charles Peabody, a bank analyst at Portales Partners LLC in New York, said Goldman Sachs eventually will have to lower its targets, something shareholders already are anticipating.
Reasonableness a ‘Crime’
“The valuations for the investment banks and money-center banks have not been very high, and that’s because of this regulatory override that in many respects caps ROEs,” Peabody said. “The marketplace understands ROEs are coming down, even if managements haven’t admitted it yet.”
After the response by investors to Credit Suisse’s revised target, Dougan’s CEO counterparts may decide it’s best to leave their goals where they are, at least for now, said Dirk Hoffmann-Becking, a London-based analyst with Sanford Bernstein.
“Credit Suisse’s reasonableness seems to be a crime,” said Hoffmann-Becking, who described the new goal as “sensible.” His research shows that Credit Suisse’s average return on equity in the 40 years through 2000 was 8 percent, before rising to 27.5 percent in 2006.
Other banks have indicated they may need to cut targets or reorganize businesses because of higher capital requirements. Michael Geoghegan, CEO of London-based HSBC Holdings Plc (HSBA) at the time, said in August that the bank will “aspire” to achieve a return on equity at the lower end of between 15 percent and 19 percent and will review the goal “when the regulatory framework becomes clearer.”
UBS had an average return on equity of 9.2 percent in the 40 years through 2000, before that ratio rose to an average of 19.4 percent in the following six years, according to data compiled by Hoffmann-Becking.
While the Swiss bank set a target of between 15 percent and 20 percent in 2009 and hasn’t changed that range, CFO John Cryan said in November that returns in the industry will fall “unless we do something about revenue rates.”
Oswald Gruebel, UBS’s 67-year-old CEO, told reporters last week that the Zurich-based bank won’t shy away from slashing costs should it fail to boost revenue at its investment bank and may consider reorganizing to place businesses that use a lot of capital in locations with lower requirements. Cryan, 50, said the company will be more selective about which businesses to keep, based on their profitability and capital needs.
Deutsche Bank AG (DBK), Europe’s biggest investment bank by revenue, is sticking to a goal of 25 percent pretax return on average active equity and plans to boost earnings at the securities unit by reaping cost and revenue benefits from closer integration, CEO Josef Ackermann, 63, said at press conference on Feb. 3. The Frankfurt-based bank doesn’t plan to increase capital levels as much as some competitors because it doesn’t want to dilute returns, he said.
“It will only be maybe six months from now where you will start focusing more on the return on equity again,” Ackermann said. “We want to be well-capitalized, but we would like to meet the financial markets’ requirements in terms of return on equity.”
Robert Diamond, Barclays’s former investment-banking chief who replaced John Varley as CEO last month, is reviewing operations to see which units are generating insufficient returns. The strategic challenge for Barclays is that businesses consuming about 35 percent of group equity will probably be making returns in 2013 lower than the 11.5 percent cost of equity, the return shareholders expect from dividends and the stock price, according to the bank’s forecasts.
The London-based bank’s 13 percent ROE target is based on a core Tier 1 capital ratio of 9 percent, Barclays said, adding that there is “no certainty” that this level of capital will be enough in the future.
“The new environment will necessitate lower returns than the period just preceding the recent crisis,” Diamond, 59, said in remarks posted on Barclays’ website today. “We have already undertaken a strategic review of our operating model that should take out considerable running costs over the medium-term, and you should expect us to continue to act to adjust our business and asset portfolio mix as required to achieve our return goals.”
New Basel rules will hurt returns at banks’ fixed-income units the most, Morgan Stanley (MS) analysts led by Huw van Steenis wrote in a note last month. The stricter requirements would have cut the average return on equity by 5.7 percentage points to 8.3 percent in fixed-income businesses in 2010, they estimated. That would have compared with a 2.6 percentage point decline to 16.5 percent in equities, they wrote.
“We have been encouraged by UBS and Barclays’ decision to re-assess critically their portfolio, whilst Deutsche is also addressing costs in earnest,” Morgan Stanley analysts said in a separate note on Feb. 11.
JPMorgan Chase & Co. (JPM) is sticking to a target of 17 percent ROE at its investment bank, which it met in 2010, CFO Douglas Braunstein said at an investors’ conference in November. The New York-based firm is expanding in emerging markets, including Brazil and China, and in commodities to help boost revenue after increasing equity allocation to the unit by 21 percent, he said.
Jes Staley, CEO of JPMorgan’s investment bank, cut the unit’s ROE target to 17 percent from 20 percent in February 2010. While the investment bank posted a 21 percent return in 2009, Staley, 54, said the unit’s average over the previous five years was about 12 percent.
The cut came one year after Steven Black, then co-head of investment banking, said he wasn’t ready “to throw in the towel” on the target. The bank, which also has retail, asset-management and credit-card businesses, reported an overall return on equity of 10 percent last year.
Morgan Stanley CEO James Gorman, 52, said in October he expects return on equity to be in the “mid to high teens” through a business cycle. That’s higher than the 12 percent to 15 percent target the New York-based firm set in 2008.
The company will improve returns by investing in businesses that don’t require much capital, including its retail brokerage and asset management, while moving funds away from “capital hog” units, Gorman said at an investor conference this month. Gorman also said he hopes to improve returns from the firm’s fixed-income trading business after increasing headcount in its rates and foreign-exchange groups by more than 20 percent.
The bank posted ROE of 9 percent last year. Morgan Stanley’s return on equity averaged 19.7 percent from 2000 to 2006, before falling to 8.9 percent in 2007 and 4.9 percent in 2008. The firm posted its first per-share loss in 2009.
Banks have proven adept in the past at responding to regulatory pressures and are likely to do so again, said Jordan Posner, senior portfolio manager at New York-based Matrix Asset Advisors Inc., which oversees more than $1 billion.
“Over time, the investment banks have been very creative,” Posner said in an interview. “The expectations have come down. The performance will rise faster than the targets do as the banks figure it out more quickly.”
Posner said he doesn’t expect returns to regain the heights attained before the financial crisis, when markets were “ebullient” and capital requirements were lower.
Banks unwilling to accept lower returns on equity that result from higher capital requirements may fuel new bubbles by chasing returns in commodities or emerging markets, consulting firm Oliver Wyman warned in a report published last month titled “The Financial Crisis of 2015: An Avoidable History.” It urges executives and shareholders to accept that returns of the past are unsustainable and says banks need to do a better job monitoring risks, especially in areas that produce high profits.
“Banks need to be less leveraged,” Barrie Wilkinson, a London-based partner at the firm who wrote the report, said last month. “The true test for me of whether they’ve deleveraged is if the industrywide ROEs come down. If they don’t, I’m very suspicious that there are hidden risks in the system.”