Are Commercial Banks the New Kings of Finance?

As the WSJ reported yesterday, the collapse of Lehman Brothers (LEH) and the sale of Merrill Lynch (MER) to Bank of America (BAC) is just the latest chapter in a stunning redesign of the financial world.  Stand-alone investment banks are dying rapid deaths, with three down in 2008 already (who can forget the spectacular demise of Bear Stearns (BSC)?).  In their place, a new king is rising - commercial banks.

The key difference between an investment bank and a commercial bank is the source of their cash flow.  A commercial bank like Bank of America or Wachovia (WB) takes consumer deposits, which are insured by the federal government to prevent depositors from pulling out all at once (a major catalyst of the Great Depression in the 1930s that is now prevented by tighter regulation and insurance).  Investment banks take no such deposits, and as a result benefit from lighter government oversight that allows them to take big risks to earn huge profits.  To finance their short term operations, rather than taking consumer’s deposited cash, the i-banks borrow in the commercial-paper market and the repo market, putting up securities as collateral for short-term loans.

This works well - as long as the securities being used as collateral retain their value.  But with the onset of the subprime lending crisis, and subsequent crash of home prices, suddenly billions of dollars in mortgage-backed securities were worth much less.  As the value of the assets they used as collateral declinded, i-banks began to struggle to raise money.  Bear Stearns and Lehman simply couldn’t borrow enough cash to cover their losses - and Merrill, afraid of the same fate, sold out before it could meet the same indecent fate.

And out of the wreckage emerges a new, more powerful type of investing institution - a hybrid commercial/i-bank.  These titans weren’t even legal in the United States until 1999, when a law dating to the Great Depression called the Glass-Steagall Act was repealed.  This law had prohibited commercial banks from engaging in the investment banking business; on its repeal, companies like Citigroup (C) and UBS (UBS) were able to combine the two business models.  This strategy has proven risky with the onset of the 2007 credit crunch; but those two companies, despite widespread speculation about their imminent failure, have thus far weathered the storm, while the prominent stand alone i-banks (without the benefit of consumer deposits to prop up their crumbling balance sheets) have capsized and sunk.

And now, Bank of America seems poised to hit the pinnacle of finance, acquiring the “thundering herd” of Merrill Lynch’s 17,000 broker-dealers to complement its ever expanding branches of retail banks.  But BAC is not the first commercial bank to have this idea - in fact, all over the world many of the industry’s titans have already hopped on the train.  JP Morgan Chase & Co (JPM) is integrating Bear Stearns; Deutsche Bank (DB) has agreed to pay $4.3 billion to acquire 850 branches of the German retail bank Postbank AG; and Spain’s Banco Santander (STD) paid $2.26 billion in July for struggling British mortgage lender Alliance & Leicester.

It makes sense that in a credit crunch, consumer deposits are one area of the financial services industry that’s been pretty stable, since a savings account seems like a pretty safe bet while real estate bleeds its value and the stock market takes investors on a rollercoaster ride.   At the end of August, according to the Federal Reserve, U.S. consumer savings and deposits were up 7.6% from a year earlier, to $6.9 trillion.  Meanwhile, the comparable asset-backed commercial paper market that i-banks rely on for funding has shrunk to $780 billion as of Sept. 10, down by more than a third since the onset of the subprime crisis.

There are challenges to the super-bank model, to be sure - both Citigroup and UBS have struggled to retain investor’s confidence in 2008 as their under-performing securitized assets cannot be separated from the more stable retail banking business.  And Goldman Sachs (GS) and Morgan Stanley (MS), the two remaining stand-alone investment banks, have strong balance sheets and analysts don’t seem to doubt their future viability.  But the world will be changing rapidly for these firms, and it seems that savings and deposits, the staple of the banking business since its conception, will once again provide the backbone of the industry.

Comments

[keithpiccir...:]

STD has been what its name implies-S&P was clueless.

2008 Sep 17 11:48 PM