Banking - Why European wheeler-dealers are laughing all the way to the bank.

They gave it their best shot, but British banks have finally had to admit defeat in investment banking. But, as Jules Stewart points out, it was never really a proud British tradition. throw in the towel in their struggle to take on the US and Europe in global investment banking.

Only a few months after it hosted its 10th anniversary party in a posh St James’s restaurant, Barclays’ BZW sombrely announced in October that it was seeking a buyer for its investment banking group. A string of euphamisms – “reorganisation”, “rapidly changing market environment”, and so on – did not disguise the fact that shareholders were fed up with BZW’s pathetic returns of about 8%, compared with almost four times that for the group’s retail banking operation.

Last month, the deed was done, sort of. Barclays agreed the sale of its UK and European equity and corporate advisory businesses to Credit Suisse First Boston (CSFB) for a bargain #100m, #50m short of its net asset value.

“Barclays continues to seek purchasers for BZW’s businesses in Australasia and Asia-Pacific,” the bank announced.

At NatWest’s investment banking arm NatWest Markets (NWM) there has been little reason to celebrate following its #90m interest rate options book debacle. Although the bank has not officially put NWM on the block, the back-to-basics philosophy that drove the sale of its failed US retail banking venture NatWest Bancorp will be very much behind talks with potential European suitors.

BZW was always looked upon as the more successful of the two big UK merchant banks, but it never stood a chance against the US bulge bracket, an appropriate metaphor for the boys with the big bellies and the cigars brought in to replace the Ivy Leaguers, sent packing after Wall Street’s Big Bang of the 1970s.

“One of the issues at Barclays was that as consolidation was proceeding in the US (eg, Oppenheimer, Dillon Read) there was the question of buying a large firm such as Lehman Brothers to acquire a strong presence in North America to go with its European business,” says analyst John Leonard at Salomon Brothers in London. “The ownership of BZW is more shareholder orientated than the owners of some of the other European merchant banks.” Hence Barclays never took the plunge and was doomed to wage a losing battle against the Wall Street giants. Quite apart from the question of shareholder returns, neither Barclays nor NatWest, given their debacles in US retail banking, had the stomach to face the issue of culture clash: who is going to run the bank, will the operating headquarters be in London or New York, should it be run it geographically or functionally?

If the two big British banks were loathe to confront shareholders with a low-yielding acquisition, why have European banks been piling into the UK market to snap up the premier merchant banking houses? This, after all, is a process that began more than a decade ago when Phillips & Drew went to UBS, followed by Morgan Grenfell’s sale to Deutsche Bank and a string of sell offs that reached a peak in 1995 with SBC, Dresdner and Merrill Lynch taking over SG Warburg, Kleinwort Benson and Smith New Court, respectively, not to mention Barings’ collapse into the arms of ING.

The answer is that European banks are used to poor returns, they have been in this business all their lives and can afford to buy into the London market without raising their shareholders’ hackles with appeals for capital.

Deutsche Bank was able to pull nearly #1bn out of its pocket to buy Morgan Grenfell without having recourse to a rights issue, CSFB would no doubt have done likewise with BZW and presumably whoever takes over NWM will not be short of the necessary readies.

This leaves Hambros, the blue-blooded merchant bank that has commissioned Schroders to do a strategic review of its business. There is little doubt that in reality this means putting the business in shape for a suitable sale.

“Hambros has no area that it can call its own,” says analyst Martin Cross at UBS. “They’re not even dominant in the domestic UK market and they earn a pretax return of 3% to 4% on pure banking. The lesson is that you’ve got to be very focused to survive. It is fatal to be spread over too many businesses when you don’t have critical mass.”

One needs to be very cautious about indulging in nostalgia for the demise of a proud British banking tradition, for one can arguably say that merchant banking never really was a British tradition. All the great houses were founded by foreigners.

Culturally the European banks were universal houses from the start. Dresdner or UBS have always been investment banking powers within their home markets, and most of them also developed fairly strong positions in the Eurobond market in the 1960s and 1970s, especially in their home currencies.

Some UK players who tried to compete came unstuck in the process. It happened to Warburg in 1994 when expenses raced ahead of revenue. After its ill-fated merger talks with Morgan Stanely, Warburg’s name was in question. Lacking enough resilience to live through a year of losing people and some deals, it was pushed into a sale. A few niche players will undoubtedly survive. Lazards will probably not, as its parent company Pearson has all but confirmed that their stake is up for sale. Deutsche Bank, UBS and the other usual suspects will want to talk to them, as the Europeans are generally stronger on execution than on corporate finance and origination.

Schroders, while not covering its cost of capital, makes up for this on the back of its highly successful fund management business and the bank’s 10% to 11% return on equity is probably the sector’s best. Schroders, which made its fortune in bird droppings in South America, is likely to survive on sheer self-confidence. The bank is still imbued with the spirit of 100 years ago when its frock-coated directors, on an annual inspection tour of their fetid guano processing plant in what is today London’s Docklands, would remove their white gloves and toss them to the workforce, who scrambled for them.

Jules Stewart is a freelance journalist.