The incredible shrinking investment bank

CIBC World Markets is becoming the incredible shrinking investment bank as it moves this week to shut down its European leveraged finance operations.
Fifty staff learned on Monday that they are likely out of work as the division is closed. The logic is that while lending on European buyouts can be lucrative, it was a business that saw the investment bank taking on large credit exposure without much prospect of getting other fee-generating work from the clients.

In simple terms, European leveraged finance was relatively high risk, and risk is a four-letter word at parent CIBC these days.

The pull-back in London - where there are still 320 investment banking, foreign exchange and equity trading employees -comes on the heels of CIBC World Market’s decision last month to sell its 700-employee U.S. investment banking group. That sale, which played out for pocket change, reversed a decade-old U.S. expansion strategy.

CIBC World Markets is also exiting the structured credit business, most of which is U.S.-based, after taking a pounding on these derivatives. The bank said last week that it still faces the potential for “significant losses” on what was supposed to be a $9.9-billion (U.S.) hedged credit portfolio. A number of counterparties on these positions are bond insurers, and they are in deep financial trouble. Analysts expect the bank faces $2-billion in writedowns on these positions.
In addition to the steady downsizing of foreign operations, CIBC World Market is seeing some of its domestic operations moved to new homes in the parent bank. CEO Gerry McCaughey pulled the commercial banking sector out of the investment dealer on Monday, and placed the unit in the retail banking division that’s run by Sonia Baxendale. Like Mr. McCaughey, her roots are in wealth management.

Moving to this structure was billed as being consistent with other banks, and part of a two-year push to bring related client activities under one roof. But it also marks a further loss of horsepower at the dealer, the engine that drove the bank until Mr. McCaughey’s arrival in the corner office.

The sense at CIBC World Markets is that more cuts are coming - a marked contrast to a domestic rival such as RBC Dominion Securities, which is building global capabilities. Mr. McCaughey got the top job on a promise to eliminate the unpleasant surprises in CIBC quarterly reports, and produce a dependable stream of profits. The CEO, who ran CIBC World Markets for 18 months before moving to the parent bank in August, 2005, is still on a search-and-destroy mission for any business that puts that strategy at risk.

Under intensive care

UBS and Citigroup take steps to reassure investors. But big questions remain

SURGERY, as any doctor knows, is just one step on the road to recovery. Two of the biggest banking casualties of the carnage in America's mortgage market are out of the operating theatre—though not by any means in the clear. On December 11th, after five leaderless weeks, America's Citigroup announced that Vikram Pandit, the head of its investment-banking division, would be its new chief executive. The previous day Switzerland's UBS had unveiled write-downs and capital injections designed to reassure investors that the worst of the subprime crisis was over. But the long-term prognosis on these two huge banks remains decidedly uncertain.

UBS looks the healthier. Its announcement of a $10 billion write-down on its exposure to subprime-infected debt, to go with a third-quarter hit of $3.6 billion, hardly sounds like good news. UBS now expects a loss for the fourth quarter, which ends this month. It may end up in the red for the entire year. But in today's topsy-turvy market, the bank's decision to take a much more conservative view of the value of its assets was welcomed as a sign that further big mark-downs are less likely.

What is more, UBS strengthened its tier-one capital, an important measure of bank solidity, by SFr19.4 billion ($17.1 billion). Most of that money will come from sovereign-wealth funds, the white knights of choice for today's bank in distress. Singapore's GIC, which manages the city-state's foreign reserves, has pledged to buy SFr11 billion of bonds convertible into shares in UBS; an unnamed Middle Eastern investor will put in a further SFr2 billion. UBS will also raise money by selling treasury shares, and will save cash by issuing its 2007 dividend in the form of shares. Its capital ratio is expected to exceed 12% in the fourth quarter, a strong position.

Citi is following a similar course to UBS but it has more to do. It too has admitted that it might make huge losses, but further bad news is likely. Its estimate of an $8 billion-11 billion fourth-quarter hit on its collateralised-debt obligations was made in early November, since when the market value of subprime-related debt has declined further. It too has attracted money from a sovereign-wealth fund (last month's $7.5 billion investment by the Abu Dhabi Investment Authority) but its capital ratio remains under scrutiny given its exposure, not just to subprime-related investments but also to off-balance-sheet vehicles and to a wider deterioration in consumer credit.

Citi has mimicked UBS in cleaning out the management suite, but the search to find a successor to Chuck Prince, who was ousted as chairman and chief executive last month, revealed both a dearth of suitable candidates inside the bank and a lack of interested ones outside it. Doubts circulate about Mr Pandit's credentials for the role, despite his distinguished career in investment banking at Morgan Stanley, a spell running his own hedge fund and a reputation for cerebral calm. He joined Citi only in April, snipe the critics; this is his first time in the boss's chair at a listed company; and he has scant experience of consumer banking, which accounts for half of Citi's earnings.

For Mr Pandit and Marcel Rohner, his counterpart at UBS, the priority is to stabilise their banks. But each of them must then answer two, more fundamental questions. The first is what went wrong with their approach to risk management. Both banks wound up with larger exposures to toxic instruments than their rivals did; shareholders want to know why. (The line from UBS's top brass that, like hooliganism, the problems were down to a small number of people in one part of the company, does not wash: according to Simon Adamson of CreditSights, a research firm, the Swiss bank has long had a greater appetite for risk than its peers.)

The second question is whether the banks' business models need to change in light of the credit crunch. Mr Rohner stands by UBS's approach of combining an investment-banking arm with its booming wealth-management franchise, but there are clearly tensions between the needs of risk-averse private-banking clients and the volatile profitability of an investment bank. Mr Rohner promises to shrink the bank's balance sheet and to reduce the amount of proprietary trading it undertakes, as well as to tighten risk controls.

Mr Pandit has even thornier problems to resolve. Doubts about Citi's sprawling business model and disparate internal cultures predated the credit crunch: the bank's shares performed anaemically throughout Mr Prince's tenure. But diversification seems to have multiplied Citi's woes. Given the continuing questions about its capital base, the case for a break-up looks stronger than it did—although size has its own benefits, not least making institutions too big to fail. Mr Pandit, true to his reputation, is not going to rush any decisions. But sooner or later, more surgery looks inevitable.