Credit Suisse and the Hotel California effect

Comment

For years, European banks have spent heavily to strengthen their investment banking franchises. The problem is that running them is also an expensive project.

The latest to confront the issue is Credit Suisse Group AG. Last week, the struggling institution held a board meeting in Singapore to discuss strategic options for the business under new chief executive Ulrich Koerner. He promised “a new model for Credit Suisse” in which his investment bank will likely play a secondary role.

Thus would close a chapter in the history of Wall Street. Twenty years ago, Credit Suisse imagined itself in a league with the biggest companies in the sector. It had just acquired junk bond powerhouse Donaldson, Lufkin & Jenrette for $11.5 billion and was in the top three or four in global rankings. Market share growth was an explicit corporate goal. This acquisition is the culmination of substantive work by Rainer Gut, now honorary chairman of the group, whose ambition was to be “a major player in all areas of financing activity through the world “.

Even after the global financial crisis, Credit Suisse remained true to its vision. In 2015, outgoing CEO Brady Dougan told shareholders the company had strengthened its position in investment banking, continuing to gain market share. “Some are arguing for a change in tactics,” he said. “But instead, we persevered and worked to reshape this business into a streamlined division focused on core customers.”

Yet by then regulators and investors had soured on the strategy. Post-crisis rules have made investment banking more capital-intensive and more expensive. Dougan’s successor, Tidjane Thiam, found that a fifth of the division’s assets were not earning their cost of capital. His solution was to cut the business down to its most profitable parts, promising that what was left would deliver a double-digit return.

It was the first of many attempts to bolster yields. Despite – or perhaps because of – continual tinkering, profitability never reached the heights promised, with a return on equity of about 3% per year on average. The good assets were tossed with the bad – a result that became evident last year when Credit Suisse lost around $5.5 billion due to its involvement with Archegos Capital Management. An independent investigation commissioned by the board concluded that the loss was partly the result of “misguided cost-cutting”: staff reductions led to a less experienced workforce, particularly in management risks.

From a franchise comparable to that of Morgan Stanley 10 years ago, Credit Suisse is now a quarter of the size in terms of revenue. The council is faced with the question of whether to continue the bloodshed or deliver a final blow. The problem is that closing an investment bank is not entirely straightforward.

First, it’s expensive. About 18,000 people are currently employed in the investment banking division, and letting them go carries heavy layoff costs. It cost Credit Suisse 1.3 billion Swiss francs ($1.3 billion) to execute its 2015 restructuring, plus up to an additional 1.2 billion Swiss francs over the duration of the three-year program.

Today, fees could be even higher, largely due to deferred compensation. In an effort to stem the drain of talent over the years, the company has handed out retention awards, including a slug of 289 million Swiss francs in July. As of June 30, the group had 2.3 billion Swiss francs of unrecognized deferred compensation on its books, much of which is expected to be paid out immediately if the division closes.

Second, the initial costs would weaken the capital position of the group. And he doesn’t have much wiggle room. Its current capital ratio is 13.5%, in the middle of its target range of 13% to 14%. A full-scale restructuring would likely require a capital raise, which would further dilute shares that have fallen more than 50% since the start of last year.

Finally, while unprofitable, the benefits of maintaining an investment banking franchise may manifest elsewhere. In 2015, Dougan quantified “revenue from interbank collaboration” at 4 billion Swiss francs. Thiam highlighted segments of investment banking that had “wealth management connectivity.” There is a risk that the withdrawal of the investment bank will lead to an erosion of the activities that remain.

Credit Suisse is not the first European investment bank to withdraw. But more than any other, it shows that breaking up a franchise can be as expensive as building one.

More from Bloomberg Opinion:

• Change at Credit Suisse? Don’t Hold Your Breath: Paul J. Davies

• UBS doesn’t want to be a Goldman – and it shows: Chris Hughes

• HSBC, Citigroup and the end of the World Bank: Marc Rubinstein

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly financial newsletter Net Interest.

More stories like this are available at bloomberg.com/opinion

Nicholas E. Crittendon