European Investment Banks Are Falling Behind

ON ONE side of the Atlantic a handful of banks still find it possible to earn a decent living by trading stocks, bonds and other financial instruments. On the other, tightening capital standards and unbalanced business models are making it almost impossible for investment banks to make a buck doing much the same.

The latest chapter in the tale of woe of European banks was written this week by Barclays, a British bank. Its £5.2 billion ($8.6 billion) pre-tax profit for 2013 was marred by an appalling fourth quarter in almost every department: the three months yielded a mere £191m profit. Antony Jenkins, its reforming chief executive, was lambasted for topping up the investment bankers' bonus pool even as earnings fell.

Weak profitability is not just a problem for Barclays. Its arch-rival, Deutsche Bank, posted a loss of €1.2 billion ($1.6 billion) for the fourth quarter. The travails of both reflect a sudden downturn in the trading of bonds, currencies and commodities (FICC in the jargon), on which they are unhealthily dependent. After a brilliant start to the year in 2013, that market faltered: Deutsche's FICC revenue dropped by 64% from the first to the last quarter and Barclays' by 47%.

Leading American banks such as JPMorgan Chase, Bank of America, Citigroup and Goldman Sachs experienced a dip too. But their profits were buoyed by better equity markets, in which they have a bigger presence than Barclays and Deutsche. That difference shows up in their return on equity, a standard measure of profitability (see chart).

Barclays and Deutsche have already jettisoned some businesses that they deemed unprofitable, such as trading American mortgages and complex derivatives. Now they see cutting costs as a route to restoring their returns. Barclays aims to trim its expenses to £16.8 billion by 2015 from £18.7 billion last year.

It will be shedding 12,000 staff, including about 400 pricey investment bankers. Deutsche has fired nearly 3,000 employees since 2011, including 1,500 investment bankers.

But these cuts may not offset an inexorable rise in the costs of complying with new regulations and meeting higher capital requirements. Both banks insist they are comfortably capitalised, but their cushions look meagre if assessed by the most rigorous measure, the leverage ratio, which is gaining supporters on both sides of the Atlantic.

Both banks have shrunk their risk-weighted assets: Barclays by £32 billion and Deutsche by €32 billion. Yet as tougher standards bite, each will need more capital or fewer assets. Neither option is a recipe for improving their return on equity. Barclays hopes returns will beat the cost of equity, estimated at around 11.5%, by 2016. That looks unlikely without big changes.

One lever banks can still pull is on compensation. Yet it has barely been touched. That may partly be due to the persistence of the go-go culture that predominated before the financial crisis. It is also because many senior bankers expect markets to rebound, leaving behind those firms that cut too deeply. Such optimism seems increasingly misplaced.

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