Warburg at a crossroads
The crisis at the City's leading merchant bank has highlighted the fundamental changes that are taking place in the financial world as global players emerge, writes William Kay
Sunday 19 February 1995
Today Warburg's newly formed executive committee, headed by the charismatic chairman, Sir David Scholey, is meeting to plan the bank's future. They do so at the end of a week that, according to an insider, has left the senior echelons of the previously most self-confident finance house on this side of the Atlantic feeling uncharacteristically chastened.
The week had begun with the shock resignation of the group's chief executive, Lord Cairns, who had been hoping to succeed Sir David in only four months.
Lord Cairns had quit in response to a rising tide of staff departures, most notably the joint heads of equity trading, Maurice Thompson and Michael Cohrs, who have become part of Deutsche Bank's plans to build its Morgan Grenfell subsidiary into a stock market force. Those defections hurt particularly, because equities are Warburg's strongest card in the merchant banking pantheon.
"If something like this can happen to Warburg, we are all in danger," said the worried head of a rival house.
It is a far, far cry from 8 December, the day that Warburg was forced by stock market speculation to announce that it was discussing a possible merger with Morgan Stanley Group of the US.
Until that moment, Warburg had seemed a near-impregnable fortress among Britain's merchant banks. But one disastrous year, involving losses on bond trading and advising on a poorly conducted and ultimately abortive bid by Enterprise Oil for Lasmo, changed all that.
The very fact that it was entering negotiations with Morgan Stanley as the probable junior partner was enough to spark a fundamental reassessment of Warburg's standing. When that apparent escape route was blocked, confidence inside Warburg and beyond just melted like butter on a bonfire. It was the end of many ambitions born a decade ago, when plans were being laid for the London Stock Exchange's Big Bang.
That was the nickname for a deregulatory bonfire that for the first time in over two centuries allowed outsiders to buy stock market firms and to merge the functions of broker and market maker. It enabled foreigners and domestic players to create integrated houses, combining stock market operations with banking and corporate finance - and eventually replicating that pattern round the world.
In those heady days, Sir David, who was knighted in 1987 in recognition of his part in Big Bang, said: "I do not think we have any sensible alternative to being a global investment dealer. As far as we are concerned, it is a question of being active in all the key markets, as well as the related markets like Zurich, Geneva and Hong Kong. Our group will certainly be in a position to do the bought deal and the other deals requiring large capital commitments."
The common wisdom was that, while lesser fry would survive as niche players in their domestic markets, the global scene would be dominated by no more than a couple of dozen of financial King Kongs, of which Warburg was tipped as the likeliest UK contender outside the clearing banks.
Events have turned out otherwise. More presciently, Lord Kingsdown, in his days as plain Robin Leigh-Pemberton, Governor of the Bank of England, prepared the City for disappointment when he said in a speech at the Mansion House at the height of Big Bang fever: "We need to keep very clearly in mind that the more entrepreneurial environment in the City brings greater risk of loss as well as greater prospect of gain. When the gains come they will be generally welcome, but when the losses come - and they will - they should be construed not as a failure of the new City but rather as evidence of market forces at work in a new competitive environment."
That reflected the fact that, as London's Big Bang approached in 1986, the British contingent rightly feared the awesome financial firepower of the American and Japanese banks.
The slight surprise is that the Japanese houses have not made their much greater muscle count more, although that is partly explained by early wrangles over reciprocal access to one another's markets, and more recently to the temporary decline of the Japanese economy.
While the Japanese took things slowly, it was equally characteristic of the Americans to wade in with both boots and all guns blazing.
Stanislas Yassukovitch, then London head of Merrill Lynch, America's biggest broker and still a force in the City, said at the time: "Clearly Big Bang and everything associated with it is designed to produce a securities market that will bear quite a close similarity to the US. The US houses are going to have a major competitive advantage which will more than compensate for the disadvantages we have - not being indigenous, not having the traditional roots of the domestic operators."
But while Merrill made only one small purchase of a London broker and Goldman Sachs and Salomon Brothers preferred to build from scratch, the likes of Citicorp and Chase Manhattan bought a pair of big London brokers each - and duly withdrew after running up huge losses as they tried to overcome the cultural hurdles to which Mr Yassukovitch alluded.
Perhaps the greatest foreign inroads have been made by the continental Europeans, who have the advantage of being virtually on the City's doorstep but were dismissed by analysts on the grounds that they had little experience of equity markets. Nevertheless, the Swiss and French banks have established firm footholds in the City and Deutsche Bank has recently demonstrated that it is serious about building a City presence by poaching some of Warburg's star names to add to its takeover of the Morgan Grenfell merchant bank.
The only British banks that could withstand the US heavy artillery were and are the high-street clearing banks. But Lloyds and National Westminster were curiously hesitant about how to enter the merchant banking arena, and although Midland took steps to buy a merchant bank and a stockbroker, it was in its turn bought by Hongkong and Shanghai Banking Corporation. Barclays alone with BZW made a clear bid for the high ground.
Mr Yassukovitch said last week: "There is no question that the City as a whole is the world global investment banking centre. It all depends on how strongly people feel that one of those global players should be indigenous. I guess what is considered to be the tragedy of Warburg is that it was thought of as the one non-American player likely to make it into that small global club, and Warburg itself seems to have signalled that it doesn't think it is going to be able to do that on its own. But I think it is far more important that London is a global centre, generating invisible earnings, tax revenues and employment, rather than who happens to own the players."
Mr Yassukovitch takes the view that the Americans were always going to have a built-in advantage in producing the lion's share of the global players, as their huge domestic market gave them both the profits from which to amass the necessary capital base, and a training ground to develop distribution systems. The natural equivalent to that should be the European Union, which with its 350 million population outranks the 240 million Americans. But those 350 million are spread through more than a dozen countries, each with their own customs, culture and barriers to foreigners. Although the barriers are being slowly dismantled, it will be a long time before financial distribution networks can be set up to rival those in the US for speed and efficiency.
One leading British merchant banker said: "To challenge the power of US investment banks such as Goldman Sachs and Salomon Brothers, there is a lot more to do. We need a stronger European base and more effective access to the US. But I think we are on track, given where we started from."
Because British merchant banks have such a relatively small home base, they gain whenever flows of money burst their own domestic boundaries. The creation of the Eurodollar market in the 1960s was one such boon, as was the Arab and Japanese search for havens for their enormous accumulations of foreign currency in the 1970s and 1980s respectively. More recently, the internationalisation of US pension funds has performed the same service.
In the days immediately after the Warburg-Morgan Stanley talks became public knowledge, there was a widespread belief that the merger would lead to Big Bang II, in which the foreign hordes would sweep in and mop up the remaining independent British merchant banks and stockbrokers. That may yet happen, but the failure of the Warburg-Morgan Stanley talks suggests that the invaders are more cautious this time round than their counterparts were in Big Bang I.
Cutbacks at Warburg are only part of a worldwide pressure on investment banks. Last week CS First Boston and Salomon Brothers, two of Wall Street's most powerful firms, sacked 1,500 as they got out of the loss-making municipal bonds business and eliminated overlaps within their operations. Virtually the entire merchant banking community is wearing sackcloth, after a terrible drubbing in bond markets last year when interest rates ratcheted up.
One of the biggest sources of problems has been the growth of derivatives markets, based on futures and options contracts. Because they offer such a vast potential for making profits and protection against losses, merchant banks have felt obliged to offer them as a service to corporate clients - without always fully understanding the pitfalls. Some are quietly withdrawing from derivatives, preferring to risk losing clients than to continue incurring losses.
The derivatives trap has highlighted an aspect of the global game that no one predicted at the time of Big Bang nine years ago. In those days, pundits expected the world to be divided into global players, offering everything to everyone everywhere, and niche players concentrating on their local markets.
Greater competition has led merchant banks into finer and finer specialisation in the effort to add value and get an edge over rivals. That has created a new animal, of which Warburg could be one of the first examples: the global niche player.
"Our speciality is equities," said the Warburg insider. "People forget that we have 550 people in New York, and we are easily the biggest distributor of non-US equities in the US."
That could be the key to Warburg's future, but it will be several months before clients and competitors can assess the long-term damage - if any - to Warburg caused by last week's events. By Christmas, Warburg could have been shrugged off as a minor hiccup - or it could be seen as a turning point in the company's history.
Much depends on the view taken by the boards of such client companies as BAT Industries, Boots, Legal & General Group, Unigate and Unilever - and, ironically, Saatchi & Saatchi, where confidence has proved an equally fragile flower.
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