NEW YORK (The Deal) -- The collapse of Lehman Brothers sent a seismic shock throughWall Street, but the wrath it incurred among Main Street and theregulators entrusted to protect its denizens continues to change thebusiness of banking five years later, especially when it comes toinstitutions whose size and interdependence with the global economy makethem systemically important.Amid the crisis of 2008, the superficial structure of banks changedquickly. Lehman filed for bankruptcy, Bear, Stearns & Co. failed and wasbought by JPMorgan Chase ( JPM), Bank of America ( BAC) bought MerrillLynch ( ML), Wells Fargo ( WFC) scooped up Wachovia and Citigroup ( C) suffered losses that would trigger the sale of its Smith Barney businessto Morgan Stanley. Now the "systemically important" designation under the Basel III accordshas almost become a curse for the survivors. Following the flurry ofcrisis mergers, a fear of becoming a "too big to fail" financialinstitution has politically handcuffed large banks from undertakingweighty acquisitions. Instead, they continue to look inward, overhauling their businesses andmoving away from high-risk sectors such as proprietary trading,fixed-income and commodities, which have become operations that either nolonger return their cost of capital because of stricter regulatory demandsor pose too high a litigation risk. Wealth management and otherfee-generating businesses are favored now for their stable revenues andlack of additional capital requirements. Even the ever-charging, go-go culture of Wall Street, once a badge ofhonor, has changed as banks bow to public perceptions about how theyoperate. One senior banker pointed to the regulatory and media scrutiny ofworking hours after a BofA intern was found dead in the shower afterreportedly working 72 straight hours and of hiring practices in the wakeof JPMorgan allegedly hiring the children of powerful Chinese officials.Such practices ¿ grueling work hours and nepotism in hiring ¿ were viewedas standard until the credit crisis, the banker notes. This newfound sensitivity has affected large banks' willingness toparticipate in certain businesses. Witness JPMorgan's exit of the studentloans sector. While declining profitability and stiff competition havebeen cited as reasons for the bank's departure, industry pundits point tothe bad impression that would be created by chasing down students who areunable to meet payments. Some observers said they believe this perception issue will lead banks tomove so cautiously with new businesses and products that they could cometo resemble utility-type operations, with greater financial innovationoccurring at less-scrutinized private equity and hedge funds.
Alas, the so-called shadow banking system these funds and other alternatecredit-providers comprise is expected to grow in the aftermath of Lehman,as tighter credit criteria from banks leaves a larger pool of consumersunable to access credit. Royal Bank of Canada ( RBC) co-heads of the financial institutions group, JerryWiant and Henry Michaels, believe a back-to-the-future scenario has seenbanks reassess their priorities. "Banks have been pushed into more client-facing fee-generating businessesas opposed to high-risk activities where they are putting the bank'scapital at risk, such as energy trading," Wiant said. Michaels pointed to greater investment in commercial rather than retailbanking given tighter regulation around the latter. Little wonder then why Morgan Stanley has embraced retail brokerage withits completed acquisition of Citigroup's former Smith Barney business ¿ afar cry from its ballooning trading businesses that once laid bets onrisky mortgage securities. Commodities operations that were once lucrativeare 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 theyprovide, Wiant said, but these institutions are being more selective. "It doesn't pay to focus on the marginal consumer or credit, so banks aremoving up to the high net worth customer base," he explained, adding thatthere is less risk of provoking consumer protection issues when dealingwith sophisticated investors. Both Citigroup and BofA have exited various retail portfolios worldwide,namely credit card businesses. BofA has instead chosen to focus on retailbanking within the U.S. while moving to become a global corporate andcommercial bank after its acquisition of Merrill Lynch. It has alsochanged it emphasis in retail banking, having put dozens of branches upfor sale as it reduces its network to around 5,000 from 5,300 by the endof 2014. BofA management is now listening to customers' financial adviceneeds rather than pushing products ¿ perhaps a response to lingeringmemories of being dogged by foreclosure scandals. Banks even extend the duration and quality of their funding after thefreeze in markets caught many short. "Without a doubt, the financial industry has become better capitalized andmore liquid," Standard & Poor's analyst Rodrigo Quintanilla told clientsin a Tuesday, Sept. 17, report. "Asset quality has improved and balancesheet repair is nearly completed."
More immediately, however, Quintanilla warned that the industry'sprofitability 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 therewas an agency
responsibility problem where a bank may originate an uglymortgage asset," said Wells Fargo managing director of financialinstitutions, Brian Moon. "But if others were willing to buy it, buyerbeware." But Moon said markets need liquidity and capital leverage for optimalfunctioning, and with that circumstance comes inherent risk. Thatmentality is missing now. "If banks are forced to keep so much capital that they can't effectivelylend money, then we have moved too far," he continued. Indeed, in a Sept. 17 memo leaked on the Internet, JPMorgan CEO JamieDimon outlined for the bank's staff the company's approach to ongoingregulatory disputes: simplify its business and bulk up on risk andcompliance staff. The aversion to risk and flight from high-return businesses has led banks'return on equity to nosedive. Before Lehman collapsed, ROEs for investmentbanks were 15% to 20%. Post-crisis, large bank ROEs are only in the highsingle 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 toreduce or exit capital intensive businesses, the fixed costs ofre-entering a trading business will be "very high." Hintz conceded the near-term outlook for ROEs is difficult but remainsoptimistic on the long-term prospects for investment banks, noting theiradaptive nature to client demands, market dynamics and regulatorydevelopments. -- Written by Jane Searle in New York