In some ways, this should be a great time for the biggest U.S. banks.
Debt-trading volumes are picking up. Corporate clients are paying bigger fees to borrow and acquire one another. Markets are becoming more volatile, which traditionally means more lucrative arbitrage opportunities.
And yet bank stocks and bonds are plummeting, with investors showing growing concern that financial firms will suffer so badly that they'll be unable to repay their debt. What gives? It doesn't seem as if the industry is heading toward a repeat of the banking crisis of 2008, which led to Lehman Brothers' demise. Aren't these banks safer than they used to be in the face of new, risk-curbing regulations?
One theory for the sell-off in the bonds and derivatives of banks, particularly European ones including Deutsche Bank AG, HSBC Holdings PLC and Standard Chartered PLC, has been that they have substantial exposure to China and oil and gas companies, leaving them with an unknown and potentially huge pile of souring loans. But there's more to the story.
There has been a profound shift in how banks do business since the financial crisis, largely born out of new regulations and a drastic reduction in staff, particularly in the risk-taking operations. Most of these changes have left the firms somewhat less vulnerable but also much less capable of capitalizing on opportunities as they arise. So there's less potential to offset the downside risks, such as more lawsuits and loan and trading losses.
For example, consider debt trading, which used to be one of the most lucrative businesses at investment banks. Corporate and government-bond trading volumes have generally risen in the face of more volatility. Yields on the riskiest company debt have also been increasing, giving brokers a wider spread to profit from.
But the biggest banks are in a weaker position to take advantage of this.
Goldman Sachs Group Inc., which has cut against the grain by affirming its commitment to debt trading, reported a paltry 1.2-per-cent increase in fixed-income, currencies and commodities revenue in the fourth quarter, a smaller increase than some of its peers. The bank is considering cutting 5 per cent of its bond traders and sales staff in coming months.
Meanwhile, several of its top traders and bankers have left, such as distressed-debt trader Andrew Silverman, who left this month for GoldenTree Asset Management, and Craig Packer, who recently departed as co-head of leveraged finance in the Americas.
BNP Paribas SA, which actually reported higher trading revenue in the fourth quarter, still plans to cut more because "all banks are under pressure to shrink capital intensive trading businesses, especially in fixed income,'' Michael Seufert, an analyst at Norddeutsche Landesbank Girozentrale, said last week.
More trading has moved to electronic trading systems, reducing the banks' position as nodes of price discovery and information. Some activity has also moved to smaller firms, such as Seaport Global, which have built up teams of more experienced traders and sales people with long-standing relationships with big investment firms.
Traders at banks have generally become much younger and less experienced after firms cut more senior, higher paid staff and thinned the ranks of highly paid managing directors. Those left in their trading seats tend to be more accustomed to distributing newly issued bonds rather than manoeuvring turbulent times, when traders need to tread lightly and rely on relationships that have been built up over years.
It's also not helping that the field of negative-yielding bonds is rapidly expanding, with some analysts even preparing for them in the United States. Such rates can essentially act as a tax on banks and materially eat into their profits.
So now, as credit risk rises at banks from Deutsche Bank to HSBC, there doesn't seem to be some golden age of banking and trading waiting out in the future to offset the bad news. Big banks' stocks and bonds are melting down because there's not as much potential profit to prop them up.