The Great Investment Bank Shakeout Of 1998

Staff cuts are just the start for Europe's investment houses

What a difference three months makes. On July 20, several European stock markets hit all-time highs. The euphoria didn't last long. By Oct. 13, TV camera crews were gathering outside the London offices of Merrill Lynch & Co. to get employee reaction to the investment bank's huge layoffs.

Merrill had just announced the elimination of 3,400 jobs, more than 400 of them in London. Making provisions for severance payments caused Merrill to lose $164 million in the third quarter, its first quarterly loss in nine years. Merrill's move was clear confirmation that a long-awaited shakeout in the global securities business was under way.

For the past few years, investment banks have hired and acquired like crazy to chase what promised to be a bonanza of deals in Europe, emerging markets, and the U.S. But the meltdown in Asia and Russia's debt default on Aug. 17 have dimmed that promise and radically changed the outlook for investment banking. Once-profitable businesses, from junk bonds to equity issuance to leveraged buyouts, have either slowed or ground to a halt.

MEAGER DEAL FLOW. Banks are now scrambling to bring costs in line with expectations of sharply lower revenues. Given the third quarter's meager deal flow, the next few months look grim. The value of initial public offerings outside the U.S. was only $6.2 billion in the third quarter, down a stunning 58% from the year before. International mergers dropped off by 12%, to $154 billion, according to Securities Data Co.

In London, the nerve center of global investment banking, executives are honing their paring knives at just about every institution. After issuing a profit warning because of trading losses in emerging markets, on Oct. 1, ING Groep announced layoffs of 1,200 people at its ING Barings Ltd. investment banking unit and the resignation of Chairman Marinus Minderhoud. Back in 1997, ING also paid a top-of-the-market price of $600 million for Furman Selz Inc., a modestly sized New York-based investment bank, but there's no word yet about big cutbacks there. Meanwhile, Barclays Capital, the bond-trading unit of giant British bank Barclays PLC, is trimming jobs after taking a $425 million charge to cover losses in Russia and emerging markets.

Even Switzerland's UBS, the lender once regarded as the next global powerhouse, now looks a lot less mighty after an embarrassing $1.6 billion loss from emerging markets and the Long-Term Capital Management debacle. UBS Chairman Mathis Cabiallavetta paid the price for the bank's dealings with LTCM, resigning on Oct. 2. The current UBS is the product of a string of ambitious and costly commercial and investment banking mergers. A strategy review of UBS's investment banking business is now under way.

UBS isn't the only bank that used a fat checkbook to propel itself into the big leagues. Merrill, for instance, acquired the international bug late, doubling its staff in Europe in the past three years. It spent big trying to catch up to the competition in mergers and securities origination and now has a staff of 8,000 in Europe, compared with 2,500 at Goldman Sachs International. Merrill's biggest move was paying $5 billion for London-based Mercury Asset Management Group PLC last year. Although probably a smart strategic acquisition, Mercury came at a very high price--25 times earnings. In fact, the sale now looks like a brilliant piece of market timing by Mercury's principals.

Along with UBS, Continental European banks have also been big spenders. Deutsche Bank was instrumental in salary escalation. It raided, among others, technology specialist Frank Quattrone and a team from Morgan Stanley for a king's ransom. Quattrone recently defected to Credit Suisse First Boston, which itself paid a stiff $675 million for Brazilian securities house Garantia last June. Estimates are that since Brazil and other emerging markets have cooled, Garantia would today fetch no more than $400 million.

The wave of retrenchment, which is probably just starting, is disquieting for those whose jobs are in jeopardy. But some senior executives at major banks hope the downturn will lessen some of the intense competition from second-tier players that has made investment banking in Europe and emerging markets less profitable than it is in the U.S.

ING is the first major player to rein in its investment banking activities. But if the downturn continues, other middleweight players, including Deutsche, Dresdner Kleinwort Benson, Commerzbank, Paribas, and ABN Amro, may also face moments of truth. Matthew Czepliewicz, an analyst at Salomon Smith Barney in London, says that no European players will earn the average 15% aftertax return on equity that is needed to justify the high risks of investment banking. Investment banking firms tied to more conservative commercial banks will find themselves under increasing pressure to improve returns and lower their risks--a likely recipe for mediocrity.

But further retrenchments would only strengthen the position of big American players, such as Goldman, Sachs & Co. and Morgan Stanley Dean Witter, that already dominate European investment banking. With a few exceptions, British investment houses are either gone or in foreign hands. The Continent, which has only recently opened to American-style mergers and other financial engineering, has proved to be a gold mine for American firms. National stalwarts, such as Deutsche Bank and even the legendary Lazard Freres in Paris, have had a hard time keeping up with them.

THE BIG LEAGUES. Even if the midsize players reduce their scope, competition for survival will be intense among the top banks. Along with Morgan Stanley Dean Witter and Goldman Sachs, J.P. Morgan, Merrill Lynch, UBS, Credit Suisse, and Salomon Smith Barney all aspire to be top global players. But according to Salomon's co-CEO for Europe, Ronald M. Freeman, playing in this league is so expensive that only three or four companies are likely to stay the course. Others, he adds, won't be able to generate the revenues to support the many high-priced personnel required to staff offices in key cities and make available a full range of product offerings to clients. "The big story is who will be left standing," says a senior London banker.

Certainly, Merrill has had its credibility dented, but with $1.2 billion in client assets generating a steady stream of fees, it's hard to believe that it won't remain a force. Morgan Stanley and Goldman also are likely to remain big hitters. Others may have to seek mergers to survive. But those often rumored, such as a J.P. Morgan-Deutsche combination, would face serious cultural problems. In the next two years, or perhaps sooner, the global ranks of investment banking will be dramatically transformed. Today's troubles are only a warning of further turmoil to come.

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