nally eschewed while earning more and more non-interest income (unrelated to lending) from sources such as asset management and fee-based services. They appear to be building durable non-lending businesses that should layer valuable profit streams over their already wide-moat* business models.
European Banks: A History of Failed Expansions
A potential investor might rightly ask what took them so long. To be fair, British banks have watched their European counterpoints meet with either failure or only moderate success in an attempt to break lower Manhattan's near monopoly on the lucrative world of investment banking. Dutch bank ABN Amro is the poster child for bad capital allocation, vaporizing over a billion euros of shareholder money in a failed capital-markets push. Firms such as Deutsche Bank, UBS, and Credit Suisse spent lavishly on acquiring US firms or hiring away star bankers. One peek at the latest investment banking league tables, however, shows the most lucrative banking fields remain dominated by the usual American suspects. A fine example is the latest global market share in the much coveted merger and acquisition advisory business. The top five firms (in order) were Goldman Sachs, Citigroup, Morgan Stanley, JP Morgan, and Merrill Lynch.
The UK banks appear to be pushing into arenas in which they have a fighting chance, though, so we expect them to win a better return on their investments. In its recently announced fiscal 2006 results, Barclays posted an impressive 55% revenue growth performance at its BarCap investment banking unit. BarCap's £2.2 billion in profits represented 31% of the firm's pretax profit, up from 20% in fiscal 2002. The biggest contributors to this performance were businesses such private equity, trading, and foreign exchange--areas where traditional banks have held there own against pure investment banks. Our international bank analysts have noted similar non interest income growth at other UK banks. HSBC may have taken it on the chin from too much exposure to the US subprime mortgage market, but its non-lending income jumped 19% versus fiscal 2005 primarily due to big gains in fund management, credit cards, investment banking, and brokerage fees. Finally, Lloyds TSB posted banner results in large part due to its continued success in convincing its retail banking clients to sign up for investment products while winning more commercial clients for services such as securitization and structured credit.
Why Their Success Should Continue
An evolving global regulatory environment, in our opinion, points to continued success in these new markets. Once the undisputed champions of global capital, New York City's biggest investment houses are looking on in alarm as more and more business drifts across the pond to London's Canary Wharf and Square Mile financial districts. The shackles of the Sarbanes Oxley legislation have made it more complicated and expensive for foreign firms to list their shares on New York exchanges. London's softer regulatory touch, along with its proximity to fast-growing emerging markets, have made it a much more convenient destination for growth companies in search of capital. New York mayor Michael Bloomberg recently released a study claiming that his city is in danger of quickly losing it number one spot in global markets if regulations are not eased (see the report here).
A less publicized but nevertheless interesting regulatory opportunity is the recent loosening of British pension guidelines. The A-Day reforms the came into force on 6 April 2006 give UK savers more latitude in choosing their investments vehicles; subsequent legislation has shown signs of liberalising the regime on ISAs and making them more accessible and easier to understand. British banks have the chance to win their retail clients' brokerage work, which has up until now been the province of the local insurers and their affiliated financial advisor networks. As these banks own many of the UK's leading fund managers, they should also benefit from an increase in investment funds under management.
It is not a sure thing that UK banks will continue to evolve in such a profitable fashion. America's financial services groups are already bulking up staff in London and Hong Kong to pitch clients that are no longer showing up at the front door. A similar foreign invasion is occurring in areas such as investment management. Also, European governments have been less and less resistant to potential acquisitions of their national champion banks. Bigger global fish could swoop in to swallow the UK's lending institutions. The recently rumoured marriage of ABN Amro and Barclays is a notable example.
UK banks will have to remain on top of their game to keep winning non-lending business. The favourable regulatory landscape and continued growth in the emerging markets means there is still plenty of new business for these firms to capture, however. These are not your father's British banks, and we expect them to continue to evolve beyond their traditional roots.
* To read between the lines of comments from Warren Buffett--who spoke of moats long before Morningstar ever started rating equities--there are two basic components of an economic “moat”: 1) one or more competitive advantages, and 2) an attractive business at the middle of that moat that earns above-average returns on capital.
