The Deal: Post-Lehman Wall Street Remains Gun-Shy

NEW YORK ( The Deal) -- The collapse of Lehman Brothers sent a seismic shock through Wall Street, but the wrath it incurred among Main Street and the regulators entrusted to protect its denizens continues to change the business of banking five years later, especially when it comes to institutions whose size and interdependence with the global economy make them systemically important.

Amid the crisis of 2008, the superficial structure of banks changed quickly. Lehman filed for bankruptcy, Bear, Stearns & Co. failed and was bought by JPMorgan Chase ( JPM), Bank of America ( BAC) bought Merrill Lynch ( ML), Wells Fargo ( WFC) scooped up Wachovia and Citigroup ( C) suffered losses that would trigger the sale of its Smith Barney business to Morgan Stanley.

Now the "systemically important" designation under the Basel III accords has almost become a curse for the survivors. Following the flurry of crisis mergers, a fear of becoming a "too big to fail" financial institution has politically handcuffed large banks from undertaking weighty acquisitions.

Instead, they continue to look inward, overhauling their businesses and moving away from high-risk sectors such as proprietary trading, fixed-income and commodities, which have become operations that either no longer return their cost of capital because of stricter regulatory demands or pose too high a litigation risk. Wealth management and other fee-generating businesses are favored now for their stable revenues and lack of additional capital requirements.

Even the ever-charging, go-go culture of Wall Street, once a badge of honor, has changed as banks bow to public perceptions about how they operate. One senior banker pointed to the regulatory and media scrutiny of working hours after a BofA intern was found dead in the shower after reportedly working 72 straight hours and of hiring practices in the wake of JPMorgan allegedly hiring the children of powerful Chinese officials. Such practices ¿ grueling work hours and nepotism in hiring ¿ were viewed as standard until the credit crisis, the banker notes.

This newfound sensitivity has affected large banks' willingness to participate in certain businesses. Witness JPMorgan's exit of the student loans sector. While declining profitability and stiff competition have been cited as reasons for the bank's departure, industry pundits point to the bad impression that would be created by chasing down students who are unable to meet payments.

Some observers said they believe this perception issue will lead banks to move so cautiously with new businesses and products that they could come to resemble utility-type operations, with greater financial innovation occurring at less-scrutinized private equity and hedge funds.

Alas, the so-called shadow banking system these funds and other alternate credit-providers comprise is expected to grow in the aftermath of Lehman, as tighter credit criteria from banks leaves a larger pool of consumers unable to access credit.

Royal Bank of Canada ( RBC) co-heads of the financial institutions group, Jerry Wiant and Henry Michaels, believe a back-to-the-future scenario has seen banks reassess their priorities.

"Banks have been pushed into more client-facing fee-generating businesses as opposed to high-risk activities where they are putting the bank's capital at risk, such as energy trading," Wiant said.

Michaels pointed to greater investment in commercial rather than retail banking given tighter regulation around the latter.

Little wonder then why Morgan Stanley has embraced retail brokerage with its completed acquisition of Citigroup's former Smith Barney business ¿ a far cry from its ballooning trading businesses that once laid bets on risky mortgage securities. Commodities operations that were once lucrative are also being scaled back or put on the selling block by Morgan Stanley, Goldman Sachs & Co. and JPMorgan amid greater regulatory oversight.

Large banks still value retail customers for the valuable deposits they provide, Wiant said, but these institutions are being more selective.

"It doesn't pay to focus on the marginal consumer or credit, so banks are moving up to the high net worth customer base," he explained, adding that there is less risk of provoking consumer protection issues when dealing with sophisticated investors.

Both Citigroup and BofA have exited various retail portfolios worldwide, namely credit card businesses. BofA has instead chosen to focus on retail banking within the U.S. while moving to become a global corporate and commercial bank after its acquisition of Merrill Lynch. It has also changed it emphasis in retail banking, having put dozens of branches up for sale as it reduces its network to around 5,000 from 5,300 by the end of 2014. BofA management is now listening to customers' financial advice needs rather than pushing products ¿ perhaps a response to lingering memories of being dogged by foreclosure scandals.

Banks even extend the duration and quality of their funding after the freeze in markets caught many short.

"Without a doubt, the financial industry has become better capitalized and more liquid," Standard & Poor's analyst Rodrigo Quintanilla told clients in a Tuesday, Sept. 17, report. "Asset quality has improved and balance sheet repair is nearly completed."

More immediately, however, Quintanilla warned that the industry's profitability had peaked and was vulnerable to rising interest rates.

Some bankers said they believe that the pendulum has swung too much.

"Before the crisis, we had gone too far in terms of risk taking and there was an agency responsibility problem where a bank may originate an ugly mortgage asset," said Wells Fargo managing director of financial institutions, Brian Moon. "But if others were willing to buy it, buyer beware."

But Moon said markets need liquidity and capital leverage for optimal functioning, and with that circumstance comes inherent risk. That mentality is missing now.

"If banks are forced to keep so much capital that they can't effectively lend money, then we have moved too far," he continued.

Indeed, in a Sept. 17 memo leaked on the Internet, JPMorgan CEO Jamie Dimon outlined for the bank's staff the company's approach to ongoing regulatory disputes: simplify its business and bulk up on risk and compliance staff.

The aversion to risk and flight from high-return businesses has led banks' return on equity to nosedive. Before Lehman collapsed, ROEs for investment banks were 15% to 20%. Post-crisis, large bank ROEs are only in the high single digits.

Former CFO at Lehman and now a senior analyst at Sanford Bernstein & Co., Brad Hintz, noted that while the "easy answer" to new regulation may be to reduce or exit capital intensive businesses, the fixed costs of re-entering a trading business will be "very high."

Hintz conceded the near-term outlook for ROEs is difficult but remains optimistic on the long-term prospects for investment banks, noting their adaptive nature to client demands, market dynamics and regulatory developments.

-- Written by Jane Searle in New York

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