Investment banks: too big to shrink

Austerity and investment banking are not words that often appear in the same sentence. So many investment banks have found the enforced restraint of the past few years something of a struggle. Everything has been cut back, from bonuses, staff and expense accounts, to risk-taking, proprietary trading and leverage.

Everything that is, except balance sheets. Investment banks are supposed to be reining themselves in under the combined pressure of the slowdown in financial markets and regulatory reform. You would therefore expect balance sheets to be shrinking.

But instead, over the three years to the end of June, the balance sheets at a sample of nine large comparable investment banks increased by 6% in dollar terms when measured by total assets, according to my analysis (see chart).

That may not seem like a huge increase. But, over the same period, revenues across the industry have fallen by around one third and pre-tax profits by closer to two thirds.

Logic would suggest that investment banks should be frantically dumping assets overboard like the crew of a sinking ship, not taking on more cargo. Do too many banks have a misguided faith in their own ability to ride out the storm better than their rivals? If so, it raises the fear that they have merely postponed a painful process of deleverage and shrinking.

Weighty issues: of the nine banks, only two cut the size of their balance sheets over the past three years

            Feeling bloated

Of the nine banks, only UBS Investment Bank and the markets division at Bank of America Merrill Lynch reduced the size of their balance sheets over the past three years. The securities and banking division at Citi has ramped up its assets by nearly one fifth over the past three years and the investment bank at JP Morgan has increased its balance sheet by around 12%, while the investment banks at Barclays, Deutsche Bank and Credit Suisse (yes, Credit Suisse) are just behind.

In the past year, the growth has been even more remarkable at some firms. Reported total assets in the investment banking arms at Barclays and Deutsche Bank have risen by more than 10% in dollar terms (but they are up by much more in local currency over the past year). With profits falling, return on assets – a simple measure of how much money you make on the stuff you throw at the wall – has collapsed at most firms.

So what is going on? First, it is important to note that balance sheets have shrunk from their pre-crisis peaks at many banks by between one quarter and one third. This has also been accompanied by an increase in equity, so overall leverage in the industry has fallen.

Second, there are lots of reasons why the balance sheets of investment banks might be growing – or, at least, not shrinking. You might expect balance sheets to grow at those banks that are more confident they can take advantage of the current dislocation in the market to grab market share. This would explain some of the growth at JP Morgan, Barclays, and perhaps Deutsche Bank.

More recently, after years of stumbling through the financial crisis, Citi has set out to expand its business in markets where other banks are on the back foot, such as European credit. A big push in corporate banking at firms like JP Morgan and Bank of America Merrill Lynch, with greater willingness to put their balance sheets on the line for clients, might also explain some of the growth.

You might also expect the overall upswing in asset values, the revaluing of derivatives holdings and changes to accounting rules to be responsible for some of the increase. For European banks in particular, access to virtually free money and the opportunity to gorge themselves on supposedly risk-free government bonds might prove irresistible.

Hung, drawn and quartered?

But these explanations don’t account for the apparent contradiction of ever-expanding balance sheets and an industry that would have you believe it is being hung, drawn and quartered by regulators and politicians. One banks analyst said he was “confused” that balance sheets had not shrunk in line with the pressure on the industry.

A clue to this resistance can be found when you look at the relationship between total assets and their somewhat more nebulous cousins, risk-weighted assets. One of the fundamental flaws of the new regulatory world is that it leaves banks with an enormous degree of leeway to calculate their own risk-weighted assets, the denominator in calculating how much equity investment banks must set aside against their business.

In allowing them to calculate the risk-weighting of many of their assets using their own models, banks have a clear conflict and incentive to understate the risk in their balance sheets. Lower RWAs equals lower equity, which equals higher leverage and higher profitability.

This disconnect becomes clear when you look at what has happened to RWAs and total assets, which have either fallen slightly or actually risen. In other words, through some strange alchemy, investment banks have been able to reduce the riskier stuff on their balance sheets that would otherwise reduce their leverage and profitability, while managing to increase the size of their total assets at the same time.

At Deutsche Bank’s corporate banking and securities business, total reported assets increased by 3% in the first half of this year while RWAs fell by 3%. At Credit Suisse, assets fell by just 1%, but RWAs dropped by 9%. It is a similar story at Barclays and Goldman Sachs.

This could be simply a case of replacing riskier assets such as securitisations with larger amounts of less risky and lower-return stuff like government bonds and cash. It’s also a question of banks focusing on the urgent priority of bringing down their RWAs, before turning to the rest of the balance sheet.

But it could hint at something murkier: instead of taking on board the message from the past few years that they need to get in shape, many investment banks – like midnight-snacking dieters – are jumping through hoops to persuade regulators and investors that they are shrinking, while their overall girth quietly expands.

Sooner rather than later, they might just burst.