How Wall Street banks can keep their new investors happy

Activist investing has turned its eye to Wall Street, and at places like Comerica and Morgan Stanley it could lead to firms making changes to banks' business model.

Market watchers say activists — ever wary of near-term returns — may nudge big banks away from low-margin, low-risk, dependable businesses, and into mergers and acquisitions activity to further consolidate Wall Street.

In 2016, investors have bought into Comerica and Morgan Stanley; Citigroup lacks an activist but has Seth Klarman's Baupost Group among its newest shareholders. Morgan Stanley's investor, ValueAct Capital, says it is "supportive" of CEO James Gorman's work. Still, said one source, who asked to not be quoted, banks could be pushed by investors to work less on traditional banking businesses, like mortgage origination, and more on high-margin work like credit default swaps.

"You have an industry that is clearly in flux," said Richard Farley, partner at Kramer Levin and chair of the firm's leveraged finance group. "Different institutions will have to pick out different lanes" in which to operate.

It means activist investors could preside over a reordering of U.S. financial institutions, if satisfying hedge funds' demands makes big banks change (or eliminate) certain lines of business.

Activists could also force some banks to get out of lending businesses that aren't driving enough margin, like lower-middle market debt. This, in turn, could fan out more lending business to multistrategy private equity asset managers, like KKR, which has for years also run a lending business, one source said. KKR declined to comment.

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There are plenty of other levers for banks to pull with new investors at their doorstep, said CLSA banking analyst Mike Mayo. It includes strategy and capital allocation, but could also mean more layoffs at some institutions.

Some banks that have new investors already have made cuts at a greater pace than their competitors.

Morgan Stanley has reduced its workforce by 2 percent since the second quarter of 2015, according to its most recent earnings report, compared with Goldman Sachs' reduction of less than three-tenths of a percent, or around 100 workers. Citigroup has reduced its head count by 8 percent since one year ago, while Bank of America cut less than 3 percent over that same time frame. Comerica, however, has only cut staff by a little more than 1 percent over the last year.

"Any bank with single-digit [return on equity] is a potential activist candidate," Mayo said. "It comes down to efficient capital allocation."

For its part, Comerica is eliminating 9 percent of its total workforce over the next year through the consolidation of certain roles, as well as shutting 8 percent of its branch network, a representative said. It is also notable that Hudson Executive Group, one of the investors pushing for change at the bank, has already scaled back its position in Comerica.

Morgan Stanley, Citigroup and Bank of America declined to comment; Goldman Sachs did not respond to a request for comment.

Banks' strategy switch may not end there.

Another opportunity could be to dive into infrastructure overhauls like blockchain implementation, several bank industry experts said. Proponents of the budding technology say banks can replace back-office roles with automation, further slimming costs. However, according to one expert, the timeline to bring the new technology online is going to extend well beyond most activists' patience.

"Banks generally struggle with change projects like this," said Kevin Kroen, partner in PricewaterhouseCoopers' financial services advisory practice.