Monday, February 16, 2009

Breaking up is hard to do – but it is the right thing for Citi

By Ted Chan, Pooja Goradia and Sharon Cong Geng
Written for our class with Lester Thurow

Risk management in financial services firms is a major challenge even when a company is focused and tightly integrated.  For a firm like Citigroup, broad in scope with less than stellar integration between different operational arms, the financial crisis posed a risk management challenge too great.  While in good times, a financial services supermarket strategy has major advantages, Citi’s focus must now lie in restoring confidence in its core operations.  This translates to focusing on essential businesses, wiping toxic assets off the balances sheet and using those funds to recapitalize its core business.  

Advantages and Disadvantages of a Financial Services Supermarket

In 1999, the Gramm-Leach-Bliley Financial Services Modernization Act repealed the part of the Glass-Steagall Act of 1933 that prohibited a bank from offering investment, commercial banking and insurance services.  (Wikipedia)  This act paved the way for Sandy Weill and Citibank to create a financial services supermarket.  

The benefits to being a financial services supermarket include economies of scale, cross-selling opportunities, elimination of double marginalization problems and more robust integrated reporting.  On the consumer end, customers like the idea of looking to one provider for a range of services and products.  The ability to utilize bundled pricing strategies is also an advantage. 
For instance, in the institutional fund space, many services are sold as a bundle (recordkeeping, custody, asset management, brokerage, securities lending, performance reporting).  Firms with greater economies of scale can offer lower fees (expensive to develop or buy software batch process transactions).  Furthermore, it is easier to sell many of these services as a loss leader and make the profits back on other services.  Thus, achieving these benefits can only be achieved by providing the entire spectrum of services.  

However, things do not always dovetail across lines of business.   For instance, the services that retail banking offers customer versus the services investment banks offer corporations do not overlap or benefit from integration.  For Citibank, decoupling these services will allow for more management visibility into risk profile and agility in specific business segments.  Citi expanded for reasons other than strategic (e.g. Sandy Weill’s desire to conquer the world), unlike organizations like Wells Fargo and BNY Mellon.

There are two major downsides to the supermarket strategy.  The first is that enterprise risk management is much more difficult in a large firm with many different operations.  In many cases, it is simply too much for a single management team to oversee.  Secondly, when one part of a financial services supermarket suffers, contagion to other business lines is easy.  Many of Citi’s losses were caused by non-core businesses such as consumer lending.  These losses have affected the reputation of the entire bank, and thus made it difficult for customers to do business with any operation within the Citi umbrella.  

Structure of Citi Breakup

Citi has already sold its Smith Barney brokerage group, selling a 51% stake for $2.7 billion to Morgan Stanley.   Morgan Stanley will run the brokerage group while Citi retains a minority 49% interest.  In preparation for a large breakup, the company has re-organized into two groups.  Citicorp will be the core businesses including the private bank, investment bank, credit cards and the retail banking franchises.  This group will manage approximately $1.1 trillion in assets.  (Citi Website)

The remainder of Citi’s assets will be allocated to Citi Holdings.  This company will have approximately $850 billion in assets under its management.  This includes the 49% stake in the Morgan Stanley/Smith Barney joint venture.  However, it will also hold many of the troubled assets and riskier operations that Citi considers non-core.  This includes Citigroup Asset Management, and consumer finance groups like CitiMortgage and CitiFinancial.  The so-called “toxic assets” comprises approximately $300 billion of the $850 billion number.  One of the major goals of Citi Holdings will be to sell off these assets to remove the uncertainty from the balance sheet while re-capitalizing Citicorp’s core operations.   (The Street, Citi Website)

Political Backdrop and Effect

Although the government has guaranteed $300 billion of Citi’s toxic assets in an unprecedented intervention, it did not prevent the forthcoming Citi breakup in January 2009.  Regulatory agencies including the FDIC, the SEC, the Fed, and the treasury played an instrumental in Citi’s rescue because they have a strong interest in keeping the financial supermarket in stable condition. It is unrealistic for regulators to allow other troubled “one stop shops” to simply replicate Citi’s model, ruling out any enforced separation of commercial banking from investment banking which dates back to the Glass-Steagall Act.  In today’s age, modern banking is too complicated to allow for such simplistic separations.  

In 1998, Citibank merged with Travelers Group after the Gramm-Leach-Bliley Act was passed to legalize mergers involving commercial and investment banks.  Looking back, politicians argued that the Act was passed to cater to bankers.  Today, in the midst of the global financial crisis, regulators have little choice to modify the laws once again because they are effectively saying they are changing the law back.  It is imperative to reevaluate the regulatory structure and create a system that will avoid a repeat of the current financial meltdown by increasing oversight, managing risks, and creating a system of checks and balances.  Massive reforms need to be instituted such as establishing a capital adequacy regime and changing the mark to market accounting rule. 

Analysis

Selling the brokerage helps against contagion from spreading to this profitable unit that caused none of Citi’s problems.  However, many question how wise a move this is.  For instance, Ladenburg Thalmann analyst Richard Bove said "from a pure business standpoint, this deal makes no sense for Citigroup since Smith Barney did not contribute to Citi's losses, and Citi will be contributing 60% of its profits to the new group, but getting just 49% of the earnings.”
In many ways, the structure of the breakup is designed to help regain customer confidence in Citibank’s core operations.  The first step towards this is removing the toxic assets from the balance sheet, removing riskier business lines, and recapitalizing Citicorp, thus making it look like a “safe” bank.  From this standpoint, the formation of Citi Holdings seems like a good idea.  

However, a major problem will be selling off the bad assets and risky operations at a fair value in this environment.  For instance, few firms are looking to purchase consumer lending operations at this point.  Furthermore, it is difficult to imagine that this structure can put Citi on equal competitive footing with JP Morgan and Wells Fargo any time soon, as both have demonstrated far better banking management before and during the financial meltdown.  Other competitors like Bank of America will have superior regional reach and scope of services after Citi divests. (The Street, Naked Capitalism)

Conclusion:  Supermarkets Can Work, but Not the Way Citi was Structured

Wells Fargo, BNY Mellon and JPMorgan are all large diversified financial services firms with supermarket characteristics to them.  Each firm’s focus on core businesses helped them manage operational and asset risk appropriately across their enterprises.  Citi’s history is different for reasons due partly to corporate strategy, and due partly to former CEO Sandy Weill’s desire to build the biggest mousetrap, Citi’s purview is much broader in scope than other big banks.  Meanwhile, the loose integration of various units was spotty and made risk management far more difficult.  

Sources

Bradway, Bill. “Citigroup: Will Breaking Up Be Hard to Do (Well)?” 15 January 2009, Gerson Lehram Group. 11 February 2009. .
Brewster, Mike, and Amey Stone. The King of Capital: Sandy Weill and the Making of Citigroup. New York: John Wiley & Sons, 2002. 
“Citi to Reorganize into Two Operating Units to Maximize Value of Core Franchise.”16 January 2009. Citi Corporate Website. 12 February 2009. .
"Gramm-Leach-Bliley." Wikipedia, The Free Encyclopedia. 14 Dec 2005, 19:21 UTC. 11 February 2009.
LaCapra, Lauren Tara. “Citi’s Breakup Leaves Street Skeptical.” 16 January 2009, The Street.com. 11 February 2009 http://www.thestreet.com/story/10458265/1/citigroup-reports-83-billion-loss-will-realign-business.html.
Smith, Yves. “The Case Against a Citi Breakup.”13 May 2008, Naked Capitalism. 11 February 2009. .



2 comments:

Anonymous said...

I completely agree. Many of Weill's acquisition didn't have a strategic fit unless you consider catch-all a strategy. In the last days, it didn't feel like Citi was the best at anything though they had their hands in everything.

Ted Chan said...

Yeah, of course hindsight is 20/20...and we were writing books and bowing at the altar of Sandy Weill just five or so years ago. In some ways, it's a big credit to Weill that he was able to integrate and manage such a large firm while he was there. I've never been sold on the management that was brought in after. Succession for a giant like that must have been pretty hard. Maybe that's the point the company should have been broken up (maybe not legally, but in terms of distribution of management time).