Letter number 70 of November 2012


News : Should retail banks be separated from investment banks?

Yet again, we are hearing talk about the separation of investment and deposit banks.  This is a very topical issue, even though the Liikanen report, ordered by the European Commission and published in early October contains a recommendation that can only be described as "limp" (1).

What are the motivations behind such a separation? 

• Reducing the probability of banks going bankrupt, thus reducing the systemic risk. In our view, this proposal is rather unconvincing.  As many commentators have remarked, no banking model has been specifically less impacted by the risk of bankruptcy.  The financial crisis has caused problems for investment banks (Lehman Brothers, Merrill Lynch), deposit banks (Northern Rock, the Spanish savings banks), and specialised banks (Dexia).  In the end, it is the universal banks (JP Morgan, BNP Paribas, Barclays) that have withstood the crisis and that have come to the rescue of struggling banks, when governments could not or would not do so. The fact that Santander and BBVA are holding out much better than other Spanish banks, is thanks to their geographic and business diversification, which both of them began 20 years ago.

• Shifting towards smaller entities at which control and corporate governance is easier to implement.  Additionally, reducing their size will help to avoid the systemic problem of being too big to fail.  Probably in theory.  Certainly not in practice.  When we see the French government coming to the rescue of Crédit Immobilier de France, which has a 3.5% share of the real estate loans market with 50,000 loans granted per year, we wonder which bank wouldn't be too big to fail? If size is the problem, then a split-up is the wrong answer. Better in this case to limit the size of the balance sheet or the market share.

• Political reasons: inflict a symbolic punishment, that is visible in the media, on a sector which is seen to be the root cause of the problems.
Although a lot has been written on this subject, it is striking to note that the point of view of firms and even of banks’ clients, is often not included in the views expressed.  We’d like to take their point of view here. 

What would the consequences of a separation of banks be for firms?

• Larger equity requirements (increased risk for smaller banks that are not able to rely as much on diversification) and higher financing costs through debt, leading in the end to more expensive financing terms for firms.  In this regard, it is striking to note that in the financing of banks, financial synergy is a reality – size combined with diversification generally brings the cost of financing down substantially, which in the end, is beneficial to clients.  So, the BNP Paribas 5-year CDS is 40 to 50 bp lower than that of Crédit Agricole or Natixis, which both have a Corporate and Investment Banking activity that is small or being scaled down dramatically.  The difference between Deutsche Bank and Commerzbank which are in a similar situation is today 70 bp.  The same goes for Barclays and RBS (30 bp). 

• Nevertheless, we might hope that separating investment banks from retail banks would reduce the volatility observed on the volumes of credit offered to firms.  The reasoning behind this is as follows: the volume of credit depends directly on banks equity levels.  If one year, universal banks incur major losses on the financial market (as a result of a financial crisis for example), they will have to introduce restrained credit policies for firms since their equity will have been reduced in due proportion.  They thus act as agents of contagion, turning a financial crisis into an economic crisis.  On the other hand, when the markets are euphoric, universal banks can make large profits on the markets, , and then cash rich, they can be very generous with firms.  This was the situation in the mid 2000s (2).

To summarise, we conclude that universal banks have two advantages for firms – lower loan rates and efficient one-stop shopping. They do, however, have the drawback of reflecting on the bank loans market, the volatility that they experience on the financial markets.

 We note that the corporate clients of banks have not expressed a desire to separate the investment and retail activities of banks, demonstrating that the status quo suits them.

Don’t get the wrong idea, we’re not saying that all is well in the fairy kingdom of banks.  Recent events have shown how difficult it is to effectively control market operators, a lack of business morals on the part of some parties and some banks (the Libor scandal), and the absence of a serious fundamental financial analysis prior to the granting of certain loans or the investment in certain products that are complicated to a greater or lesser degree.

We cannot have a healthy economy unless we have healthy banks.  It is thus very important to avoid banks going bankrupt.  But let’s not deceive ourselves. Eradicating them completely is impossible.   In any event, separating investment banks from retail banks is certainly not the way to achieve this goal.  It will, however, raise the cost of bank financing for firms, without bringing them any advantages.
The real problem isn’t the nature of the activities exercised by banks, but the quality of their management and of their managers.  That is what is crucial.  We can practically say with certainty that the banks that have collapsed since 2008 are those that were the least well managed, i.e., in the banking world, those that consciously or unconsciously took on the most credit, solvency and liquidity risk.

It was right to raise the solvency ratios which sometimes reached ridiculously low levels in order to reduce the risk of bankruptcy.  Claiming that, as a result of this, the cost of credit would be increased appears to us to be wrong in a stabilised world.  Yes, banks would have more equity capital to pay out but at a much lower average rate, since their capital structure would be less risky as a result of this excess equity.  For their part, lenders who would run less of a risk with this less risky capital structure should also require lower interest rates.  All in all, the total overall cost of banks’ financing shouldn’t be impacted by their capital structure.  We find here the reasoning of Modigliani and Miller, which is well known in the world of business (3).

It was right to regulate payments and their structures in order to avoid “heads I win, tails you lose” type of behaviour, and thus to act on incentives.  And we must not ease the pressure on this crucial issue. 

It was right to limit, even to forbid, proprietary trading activities, even though the limit that separates them from trading on behalf of clients is not simple. 

It was right to let CEOs who were not guilty, but who were responsible, go (most recently the CEO of Barclays). 

We think that going further than that (separation of activities) would be counter productive for clients. 

If you’d like to give your opinion on this subject, there is a survey on the home page of www.vernimmen.com that you can take part in.
(1) The report recommends the carving out of market activities (proprietary trading and market making), but not an effective separation of universal banks.
(2) For more details see the Vernimmen.com Newsletter n° 10 October 2005
(3) For more information, see chapters 33 and 34 of the Vernimmen.

Statistics : Corporate income tax rate around the world

The average corporation tax rate in OECD countries in 2012 was 25.31%, continuing the downward trend it has been on since 1993 (38%)! But the average has been brought down by countries from the former Soviet Block as the scope of the KPMG study has been extended to a number of small countries with rather low corporation tax rates, intended to attract investors.


This year, the rate is going up in France and falls in the UK and in Japan.

These rates are useful to compute corporate income taxes to be paid on pre-tax profits to compute free cash flows or cost of capital. produce business plans. But they cannot be compared from one country to the other one to appreciate the tax burden borne by companies. Indeed in some countries some local tax are not levied on the pre tax result but on added value, turnover or the renting value of buildings.

Research : Competition and the cost of debt

This paper (1) investigates the effect of product market competition on the firm’s cost of debt.

Using a large sample of loan contracts from publicly traded U.S. firms over the years 1992 to 2007, Philip Valta presents empirical evidence that banks charge significantly higher loan spreads for loans to firms in competitive environments.

Using the Herfindahl-Hirschman Index as a proxy for competition in three-digit Standard Industry Classification (SIC) code industries, loans in competitive industries have, on average, a spread which is 9.6% (17 basis points) higher than comparable loans in less competitive industries, controlling for other factors that affect spreads. In the sample, this difference translates into an average additional cost of debt of USD 527,000 per year.

This result is robust to alternative industry classifications and empirical specifications and suggests that competition captures risk arising from the firm’s competitive environment that goes above and beyond the risk captured by traditional proxies of default risk.

In order to mitigate endogeneity concerns that financing choices impact industry structure, the paper uses changes in the intensity of competition measured by exogenous reductions of industry-level import tariff rates. The idea is that unexpected reductions of trade barriers facilitate the penetration of foreign rivals into local markets and trigger an intensification of firms' competitive environment. Using tariff data for the U.S. manufacturing sector, the paper identifies 54 industries that experience a large import tariff rate reduction between 1992 and 2005. Using these tariff rate reductions as a proxy for a sudden increase in the competitive pressure that firms face, the estimations reveal that these reductions in import tariff rates cause an increase in spreads by 15% to 22%. Moreover, the effect of a competitive shock is significantly larger for firms operating in concentrated industries and for firms not protected by other barriers to entry.

Further analysis explores how the difference between a firm and its rivals’ financial status and the intensity of interactions within industries change the effect of competition on spreads. Consistent with the idea that the exposure to “competitive risk” depends on the difference between a firm and rivals’ financial strength, the relation between competition and spreads is magnified when small  firms face financially strong rivals. Moreover, the effect of competition on spreads is higher when the amount of strategic interactions within industries is high. Finally, the effect of competition on spreads is significantly larger in illiquid industries.

As such, this result supports and complements recent findings that asset liquidity is an important determinant of firms’ cost of capital. Overall, consistent with the idea that banks price “competitive risk”, the impact of competition on spreads is significant and multifaceted.
(1) "Competition and the Cost of Debt", Journal of Financial Economics, septembre 2012, vol. 105, n° 3, pp. 661-682.

Q&A : The failure of the EADS-BAE merger, or the problems you face when you go up against your shareholders

If there’s one lesson to be learnt from this merger that was halted before it got off the ground, it’s that it is very difficult to carry out a link-up between two groups when the shareholders are not convinced of the strategic and financial relevance thereof, and you have managers who give the impression of wanting to push it through in order to free themselves of their shareholders.

The failure of the merger was presented as being the result of the inability of the British, French and German governments to reach an agreement.  But if this agreement had been reached, would the majority of shareholders have voted in favour of the merger in a general meeting?  There are reasons to doubt it.

On the EADS side, Lagardère and Daimler have made it known that they are keen to sell their historically held stakes in the short term, as these assets are no longer in line with their core strategies.  So it’s obvious that any project, the announcement of which leads to a fall in the share price is not likely to find favour with them, as this would lead to the evaporation of a part of their capital gains.  All the more so if the project is complex and will probably take a long time to complete and to have the desired effects.

Why did the EADS share price fall by up to 17% following the announcement of the merger project?

For two reasons.  Firstly because EADS' long-term shareholders had not understood the strategic interest of dilution in civil aviation (EADS’ main activity) which is doing well with good prospects for the years ahead, to be followed by accretion in the defence activity (BAE’s main activity) which, as a result of tight government budgets, is unlikely to flourish in the near or distant future.  Next, the premium of around 30% which would have been paid in the form of a 60/40 exchange ratio, when that of the share prices before the announcement was 34/66, appeared to be high in comparison with synergies that could be made.  In a certain way, the British shareholders, for whom all is potentially for sale on condition that the price is right, pushed their luck too far in the financial negotiations with EADS management for it not to have been a priority.  By being too greedy, they lost out in the end.

EADS shareholders wanting to diversify their risk and gain exposure to the defence sector, didn’t need a merger with BAE on the basis of a rather unfavourable exchange ratio in order to do so.  All they needed to do was buy shares in Thales, BAE or Northrop Grumman.  They wouldn’t be taking the risk of a complex integration between two groups which do not have much experience in successful external growth operations, especially BAE.  Of course, they wouldn’t benefit from any synergies generated, but such synergies still have to be generated and there are not so many of them in a merger presented as being a merger of two complementary groups. 

From the British shareholders, one might have expected a better reception, given the exchange ratio negotiated, but since the operation was to take place entirely through the exchange of shares, the premium proved to be a illusion for the BAE shareholder who received this premium in EADS shares, the value of which was falling.  With the EADS share price down by 17%, the premium falls to 7%. From the dividend point of view, the BAE shareholder might have feared a drop, since BAE's dividend payout rate (42%) is much higher than that of EADS (28%).  A crime for any UK institutional shareholder which has liabilities to manage (pensions to pay).

When you add to all of that, the very clear feeling that the managers of EADS were pushing this merger in order to reduce the influence over their company of the French and German government shareholders, both through a 40% dilution of their stakes, and also through the entry as stakeholders of the British and US governments, customers and hosts of BAE’s activity, you can understand that it was going to be very difficult to have this merger approved by the owners of these two groups, i.e., their shareholders.

Following the substantial revision of the terms of the Glencore-Xstrata merger, to the detriment of the Xstrata managers, this failed merger is a new illustration of shareholder power, and of how, if it is overlooked, disappointment may result. 

Financial data
On the vernimmen.com website, 31 basic financial figures are available for 16 000 listed companies from Europe and North America. Here are. As an example. the figures for BAE:

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