As the big banks continue to write-off billions of dollars, many are blaming the universal banking model for the travails of global banking. Is the break-up of Citigroup, HSBC and other big banks imminent? By Shivshanker Verma

It is an obvious understatement that the last 12 months have been very painful for the global banking industry. If analysts had predicted a year ago that Citigroup, Merrill Lynch, UBS, HSBC, Wachovia and Bank of America would announce write-downs of over $200 billion between them, they would have been laughed at. The huge losses, which would have appeared preposterous a year back, are already a reality, and worryingly enough, nobody thinks the industry is anywhere close to an end of the pain.

Back then, banks were on a high. Though there were some early signs of trouble, like the failure of a couple of Bear Stearns hedge funds among others, they were mere pin-pricks. The big banks were all so diversified, present in most business segments across most geographies. So, even if there were weaknesses in a couple of businesses, others would more than make up.

If one market slipped, others would continue to do well. If the US housing market weakened, the banks could pump billions into emerging market real estate deals.

For every overstretched American or European borrower, there were many in China and India waiting to join the global consuming class. Then there were the new mega-size opportunities being created by the petrodollar outflows from oil exporting countries.

Those days, the banking industry boasted of very strong balance sheets and was headed by aggressive leaders who were often talked about business models with endlessly sustainable profit growth. Risk management steadily gained significance and at least appeared to be getting more and more sophisticated. New risk management models were developed, each version seemingly more robust than the earlier ones, to monitor and control the ever increasing complexities of the modern banking business.

Despite the spectacular growth in securitisation which involved the development of ever more complicated derivative securities, risk managers were thought to be on top of the game.

That was until what started as a problem in a relatively small market segment like the US sub-prime mortgages blew up into the ongoing global credit crisis. To resort to a cliché, the rest is history. Almost every bank of any significant size across the globe has lost money. Heads of top executives have rolled, thousands of jobs have been slashed and big banks are scrambling to raise additional capital.

No end in sight, as yet
Even after some of the biggest ever losses in their history, there seems to be no end to the banking industry's woes. They continue to write-down asset values by billions of dollars, sell assets to raise cash and fire employees by the thousands. The housing price meltdown is now spreading across Europe while credit card and mortgage defaults even among prime borrowers in the US are rising fast. The slowing global economy brings more bad news to the embattled banks. Corporate debt defaults, which have been extremely low so far, may rise as earnings fall and force banks to book more losses.

Merrill Lynch, which is among the biggest losers so far, recently sold more than $30 billion worth of mortgage-backed securities for close to a fifth of its book value. Merrill was so desperate to get those securities off its books that it agreed to finance the buyer nearly 75 per cent of the sale value.

UBS had also agreed to a similar transaction to take out more than $15 billion worth of securities from its books. Merrill is also trying to raise billions of dollars in additional capital.

Citigroup will incur losses of more than $16 billion in its asset portfolio if it were to dispose off the assets the way Merrill did, according to some analysts. Citi was recently forced to buyback $7.5 billion worth of auction-rate securities it had sold in previous years, to avoid litigation. On top of it, the bank also paid $100 million in penalties. (See:Citigroup becomes the latest Wall Street entity to be charged with securities fraud  and UBS follows Citigroup to settle auction securities fraud) 

Lehman Brothers, speculated by many to be the most vulnerable among Wall Street firms, is now trying to sell $40 billion worth of real estate assets and mortgage backed securities in its books to stay afloat. As buyers are hard to find, Lehman has added a sweetener in the form of an undertaking to absorb up to $5 billion of any losses suffered by potential buyers after the sale. Lehman saw its portfolio decline by as much as $12 billion since last December and may look at other ways to divest the assets, if it cannot find a buyer soon. (See: Lehman Brothers may raise additional $5 billion in capital) 

UBS, which has lost nearly $40 billion so far, is finally being broken up into multiple entities. Pressure is increasing on other global banks to follow the UBS lead and that pressure is the most on Citigroup.

Even those who had so far managed to avoid big losses are now coming under pressure. JP Morgan last month announced a $1.5 billion write-down of mortgage backed assets. The bank continues to hold more than $30 billion in such securities and may have to incur more losses if market conditions deteriorate further.

Goldman Sachs, which has been the least perturbed by the credit crisis, is now expected to see a 40 per cent fall in profits for the third quarter. Transaction volumes have been low as global markets remain weak while earnings from advisory and underwriting services have declined as there are not many big deals happening.

Some analysts now say Goldman is over-exposed to global equities and may take a big hit in coming quarters, as the world economy slows down further. (See: Goldman Sachs says worst yet to come for banks, but sees turnaround in 2009) 

Should banks become banks again?
Many blame the transformation of traditional banks to one-stop financial supermarkets, where you can get every service from a simple savings account to complex currency derivatives and advisory services for billion dollar overseas deals, for most of the ills now plaguing the industry. It is argued that large global banks became too large to be managed effectively with all risks being monitored and kept under control.

Large organisational structures demand more delegation of supervisory control and since the business is spread across multiple services and geographies, bank boards have become increasingly clueless about the business and risk profiles of different units.

The favourite whipping boy of those who argue along these lines is of course Citigroup. The firm has so far writte-off nearly $55 billion over the last year and the figure is expected to easily cross $100 billion before the business stabilises. Citi's stock is down nearly 60 per cent over this period and its ex-CEO Charles Prince, who is credited with the most defining of all quotes about the credit crisis, was unceremoniously shunted out.

The bank has already raised billions of dollars in additional capital and will need many billions more in the near term. Critics contend that Citi would have been much better off if it had fewer lines of business, focussed on select geographies.

But, those who criticise the universal banking model fail to acknowledge the superior performance of global banks like HSBC and JP Morgan. HSBC's most recent results were better than expectations though it provided more money for asset write-downs.

What saved, and will possibly continue to save, HSBC was exceptionally strong business growth elsewhere, especially in emerging markets. Despite more than $25 billion in losses because of the credit crisis, HSBC's stock has lost just over 5 per cent over the last year.

Similarly, JP Morgan has steered clear of heavy losses from the credit crisis and now stand ready to acquire weaker competitors at depressed valuations. Like the acquisition of Bear Stearns, which JP Morgan acquired for practically nothing.

Even in the case of Citi, it can be argued that without its business units in emerging markets which continue to do well, the firm would have collapsed by now. Citi would have found it difficult to raise additional capital if it did not have viable businesses in its portfolio.

In other words, Citi would have already failed if it were a smaller firm focussed on select business segments. It should not be ignored that all the banks that have so far failed have been smaller ones. The biggest of the failed banks, Bear Stearns, was the smallest investment bank on Wall Street. So much for the criticism of the universal banking model!

It is not any particular business model or structural deficiencies that brought about the ongoing banking crisis. As it happens at most business cycle peaks, some banks stretched the envelope of manageable risk and took on more than they can chew. The opportunities seemed too easy and too lucrative to let go. And now, like a speculator with large naked derivative positions caught unawares by an unexpected market move, those banks are paying the price.

The clea-nup will take a while as the damage has been quite extensive. It is likely that many business lines will be scaled down dramatically, if not completely shut down. More banks may land in trouble and get acquired by stronger ones. In any case it is a safe bet that, by the time the world gets over this credit crisis, the banking industry would be more consolidated.

The era of large global banks is not over, it has just started.