Which Banks Will Rule?

I recently had a fascinating conversation with Ann Lee, a former Wall Street investment banker and derivatives trader now teaching economics at New York University who believes that the major American banks will rise from the ashes of the credit crisis stronger and more globally dominant than ever.

Lee's take isn't so much that U.S. banks will repent and rebuild their balance sheets more sensibly and sustainably, having learned important lessons about overleveraging. It's more that they are cleverly gaming the government's newPublic-Private Investment Programto their own advantage. Citibank, for example, has been one of the most active buyers of toxic assets such as retail mortgage-backed securities. According to Lee, these products might be marked at 80 cents on the dollar on Citibank balance sheets, even though the bank can buy them at about 40 cents on the dollar in the secondary market. Eventually, the bank will be able to sell such assets back to the government under the program for about 60 cents on the dollar, making a tidy profit at the expense of taxpayers. It's what economist Joseph E. Stiglitz calls "American socialism"—socialize the losses, privatize the gains.

The bottom line: because the crisis has already claimed many of America's most beleaguered banks (Bear, Lehman, Merrill, etc.), those that are left will actually increase their global footprint. That's very much counter to the conventional wisdom, which is that the U.S. banks are done for. Certainly, if you look at the league tables, there's a new financial world order already. The Financial Times recently ran a very comprehensive chart showing that in 1999, six out of the top 10 financial institutions in the world by market capitalization were American (the No. 1 and 2 spots were held by Citigroup and Bank of America). Today, American banks hold only three of the top 10 spots—and the No. 1, 2 and 3 places are held by China's state-owned banking behemoths. Over that same period, the total market capitalization of the U.S. banks fell from $1 trillion to $378 billion. The Chinese banking sector, on the other hand, grew from literally nothing to $509 billion (as in many areas of the global economy these days, the U.S. and the Chinese remain far out in front of everyone else).

Still, the truth is that these numbers are deceiving. Despite their huge market cap, the major Chinese banks are still mainly local retail and commercial players—they don't yet do the sort of major cross-border investment banking that American institutions pioneered, and certainly none of them are one-stop-shopping financial giants along the lines of a Citigroup. Because of this, their market capitalization doesn't really reflect their place in the international financial universe. That can, and probably will, change—when I was in China last year, Jiang Jianqing, the head of ICBC, China's largest bank (who once said he had aspirations for ICBC to become the "Citibank" of the Middle Kingdom), told me that he had plans to expand the group's investment business.

Of course, it's going to take a very long time before Chinese financial institutions, which are still extremely immature compared with Western counterparts, have the talent and skill sets of a Goldman Sachs or a Morgan Stanley. The lending practices of these institutions are completely opaque, and thanks to the massive Chinese state stimulus program that's now underway, lending is more than ever dictated by the whims of the government. When Beijing asks, "Who wants to give some more loans?" there's no doubt that every Chinese banker will raise his hand, regardless of the risk of default (and given that Chinese bank lending was up 1,000 percent year on year last December, it's pretty clear that there's going to be more of that in the future).

This is not to say that China won't eventually punch its weight in the financial industry. A March report by Deutsche Bank predicts that China will control 13 percent of the world's banking markets, 16 percent of equity markets and 5 percent of global bond markets within the next 10 years. But even in this scenario, the U.S. would remain the largest global player. American financial institutions still hold 31 percent of the world's $196 trillion in financial assets—the largest share by far.

Even if the increased regulation coming down the pike means that U.S. investment banks won't be able to leverage 32 times their capital into deals anymore, it's likely that the existing American giants will only become more globally dominant in the short term. After all, as Lee pointed out to me, postcrisis consolidation means that instead of having about 10 major U.S. banks holding the bulk of the world's capital, we'll have about five. So much for creative destruction.

© 2009