Credit Suisse and the Hotel California Effect

(Bloomberg Opinion) -- For years, European banks spent heavily to bolster their investment-banking franchises. The problem is that unwinding them is a costly project too.

The latest to confront the question is Credit Suisse Group AG. Last week, the troubled institution held a board meeting in Singapore to discuss strategic options for the business under new Chief Executive Officer Ulrich Koerner. It has promised “a new model for Credit Suisse” in which its investment bank will probably take a backseat role.

Thus would close a chapter of Wall Street history. Twenty years ago, Credit Suisse fancied itself in a league with the biggest firms in the industry. It had just acquired junk-bond powerhouse Donaldson, Lufkin & Jenrette for $11.5 billion and boasted top three or four rankings across global league tables. Market-share growth was an explicit target of the business. The acquisition was the culmination of groundwork laid by Rainer Gut, now the group’s honorary chairman, whose ambition was to be “a major player in every area of financing activity around the globe.”

Even after the global financial crisis, Credit Suisse remained committed to the vision. In 2015, outgoing CEO Brady Dougan told shareholders that the firm had strengthened its position in investment banking, continuing to win market share. “Some argue for a change of tactics,” he said. “But instead, we have persevered and worked to reshape this business into a streamlined division that is focused on core clients.”

Yet by then both regulators and investors had soured on the strategy. Post-crisis rules made investment banking more capital intensive and expensive. Dougan’s successor, Tidjane Thiam, found that a fifth of the division’s assets didn’t earn their cost of capital. His solution was to shrink the business to its more profitable parts, promising that what was left would deliver a return well into the double digits.

It was the first of many attempts to bolster returns. In spite of – or perhaps because of – the continual tinkering, profitability never reached its promised heights, with return on equity averaging around 3% a year. Good assets got thrown out with the bad – an outcome that became apparent last year when Credit Suisse lost around $5.5 billion from its involvement with Archegos Capital Management. An independent inquiry commissioned by the board concluded that the loss partly stemmed from “injudicious cost-cutting”: headcount reductions led to a less experienced workforce, notably in risk management.

From a franchise on par with Morgan Stanley’s 10 years ago, Credit Suisse is now a quarter of the size by revenue. The board is faced with a question whether to continue the bloodletting or deliver a final blow. The problem is that shutting down an investment bank isn’t entirely straightforward.

First, it’s expensive. About 18,000 people are currently employed in the investment-banking division, and letting them go entails heavy redundancy charges. It cost Credit Suisse 1.3 billion Swiss francs ($1.3 billion) upfront to execute its 2015 restructuring plus up to another 1.2 billion Swiss francs over the duration of the three-year program.

Charges today could be even higher, largely due to deferred compensation. In order to stem the talent drain over the years, the firm handed out retention awards, including a 289 million Swiss franc slug in July. As of June 30, the group had 2.3 billion Swiss francs of unrecognized deferred compensation on its books — a lot of which it would have to pay out immediately in the event of a shutdown of the division.

Second, the upfront costs would weaken the group’s capital position. And it doesn’t have that much wiggle room. Its current capital ratio is 13.5%, in the middle of its target range of 13% to 14%. A large-scale restructuring would likely require a capital raise – further diluting shares that have plummeted more than 50% since the start of last year. 

Finally, while hardly profitable, it’s possible that the benefits of maintaining an investment-banking franchise show up elsewhere. Back in 2015, Dougan quantified “cross-bank collaboration revenues” at 4 billion Swiss francs. Thiam highlighted segments within the investment bank that had “wealth-management connectivity.” There’s a risk that pulling out of investment banking may lead to erosion in the businesses that remain.

Credit Suisse isn’t the first European investment bank to retrench. But more than the others, it shows that dismantling a franchise can be as expensive as building one.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is author of the weekly finance newsletter Net Interest.