Business gurus and fashion stylists advise playing to your strengths. So why do many banks seem to follow the more motherly advice of giving it a go and doing one’s best? They do this in spite of heaps of evidence that banks often destroy shareholder value in businesses where scale or expertise is lacking. In a recent Oliver Wyman analysis of top global banks, about a fifth of revenues from up to 15 business lines made no economic profit at all. Twice as many businesses were “quite accretive”. But by far the best returns (and 40 per cent of revenues) came from just eight to 10 areas.
So most banks make most of their money from a minority of activities in which they excel. In the brutal world of investment banking in particular, excelling tends to mean being big; there is a strong link between scale and returns on equity. Morgan Stanley analysis also suggests that the larger the market share in fixed income, currency and commodity trading, the less volatile the revenues.
This relationship between scale or specialisation and returns has been around for a long time. Why did banks ignore it? The answer may be because before the crisis the biggest contributor to ROE by far was leverage, rather than operating margin or revenue growth. If you want to gear a company to the hilt, a stable, steady top line is crucial – hence the emergence of big, globally diversified universal banks operating in many businesses that could never be justified alone.