Breaking Up the Banks — Can Investors and Occupiers Agree?

By Daniel Ferry - July 2, 2012 | Tickers: BAC, C, GS, JPM, NES.DL | 0 Comments

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“Break up the banks” might sound like a rallying cry for Occupy Wall Street. But increasingly, restructuring the largest banks and spinning off their different business lines looks like an attractive strategy for investors.

There have been a lot of reasons advanced for dismantling the nation's largest banks: their concentration of market share resembles an anti-competitive oligopoly, their centrality to the financial system makes the entire economy more vulnerable to catastrophic shock, and, relatedly, their “too big to fail” status and the assurance of taxpayer bailouts represents a moral hazard. However, perhaps the most convincing case to investors is simply that, for the largest banks, the pieces may be more valuable than the whole. Currently, five of the largest multi-service financial institutions are trading at or significantly below the value of the assets on their books, and have been for years:

Obviously, a shareholder would hope that a management team and business model would add value to the company's assets, but in these banks' cases, shareholders clearly believe that asset value is being destroyed or not realized by management. Banks that separate more client-focused retail services from high-risk, high-reward investment banking seem to be creating a lot more value with their assets. For example, retail bank U.S. Bancorp sports a P/B of 1.9, while community bank Tompkins Financial (a favorite of mine) is valued at 1.5 times book value. Wells Fargo, which does engage in investment banking, but at a much smaller scale than its big peers, is still seen as a better value creator at 1.3 times book.

Nor is it just that investment banking and proprietary trading necessarily earn lower valuations: pure-play asset managers BlackRock and Fortress Investment Group, valued at 1.2 and 3.6 times book, respectively, demonstrate that investors aren't averse to these businesses. It seems to be the combination of retail banking and investment banking that depresses valuations.

Why should this be? First, large banks with vast balance sheets and multiple revenue streams are simply more difficult for investors to understand — indeed, as we have seen from the sub-prime crisis to JPMorgan's recent London trading desk losses, these banks' businesses can be too complex for management to fully understand. Uncertainty over what's really in a bank's balance sheet and what sorts of risks the company is really exposed to will naturally lead prudent investors to discount the company's shares. 

Second, there is “a mismatch between the cultural values that infuse investment banking and those of asset management, retail banking, and private wealth management,” according to Phil Purcell, former chairman & CEO of Morgan Stanley. There is a natural conflict of interest between investment bankers, which seek to beat the market by exploiting superior knowledge over less sophisticated market participants, and retail bankers, which serve and seek to create value for many of these same less sophisticated players. We've seen this dynamic play out multiple times at Goldman Sachs, which in 2010 was fined for misleading its customers, and has been vocally accused of betting against its own clients; profiting enormously from selling products it knew to be low-quality and investing in instruments that produced returns when those products lost value. Goldman stock saw huge selloffs following each of these revelations, and investors have been slow to forgive or trust management.

In any other industry, companies selling far below their book value for years at a time would attract the attention of corporate raiders or turnaround artists, who might buy the company and divest assets in order to create value. In banking, however, regulations require that only banks may buy banks, discourage the use of debt to buy out a bank, and limit the market share of deposits that may be acquired in a buyout. These factors thwart outside agents. Instead, any move to separate universal banks into standalone businesses must come from shareholders putting pressure on boards of directors. They have every incentive do exactly that: if Bank of America, trading for 40% of book value, were forced to spin off its disparate operating segments, and these new businesses were valued in line with their non-universal peers—let's conservatively say 1.0 to 1.2 times book value—then shareholders would stand to realize a 150–200% profit virtually overnight.

The rise of the universal banking conglomerate has posed systemic risks to the economy, and it isn't clear that these behemoths have added any value by becoming so large. What once seemed like profitable expansion and acquisitions now looks a lot more like corporate empire-building. The chief officers of these firms control vast resources and can rightfully call themselves some of the most powerful men on the planet. Meanwhile, however, share prices languish and public antipathy toward big banks grows. Who are these banks serving by remaining so large and complex? Certainly not shareholders.

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