By Margaret Doyle

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

The Commerzbank bonus trial is a throwback to a greedier era. Just as the furore over bankers’ pay reaches its annual climax, an English judge is set to hear 104 bankers’ claims that they are entitled to around 50 million euros of unpaid bonuses for 2008 – the same year their German employer lost over 6 billion euros. The case may smack of hubris. But even if the bankers win, new pay regulation makes future claims much harder.

The bankers’ case is stronger than it first appears. It centres on a 400 million euro “guaranteed minimum bonus retention pool” unveiled to investment bankers at Dresdner Kleinwort in August 2008 as rumours swirled that Allianz, the German insurer, was about to offload its parent.

Commerzbank, which subsequently bought Dresdner, contends the guaranteed pool was nothing of the sort. It cut most investment bank bonuses by 90 percent shortly after its takeover was finalised in Jan. 2009. Commerzbank’s decision is understandable: Dresdner had suffered hefty losses. However, the German lender’s defence is less that the awards were undeserved than that bonuses are, by definition, discretionary.

English law is not so clear cut. Case law has established that employers’ bonus discretion is not absolute. The bankers also have an unlikely ally in Britain’s Financial Services Authority, which had put Dresdner Kleinwort on its watchlist in May 2008. The watchdog was worried that uncertainty about the bank’s future could lead to key individuals leaving or becoming disaffected. In 2009, three senior ex-Dresdner Kleinwort bankers won their claim for 11 million euros in guaranteed bonuses and severance payments.

But even if the judge finds these arguments persuasive, banks are unlikely to face such cases in future. The FSA now tends to frown on bonus guarantees. Moreover, the watchdog insists that pay is more closely linked to long-term performance. That means a proportion of bonuses are deferred, and banks have the explicit power to claw back payments in the event of losses or poor risk management. The ex-Dresdner bankers may be the last of a greedy breed.

By Margaret Doyle

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Royal Bank of Scotland, the state-owned UK lender, is cutting its investment bank, again, and is merging it with its international payments unit. The new division aims to make more than the 12 percent groupwide cost of capital. It must do at least that to have any value. But it is a big ask given regulatory and political headwinds.

The cash equities business was never a strength for RBS – not even after the purchase of Hoare Govett which came with the disastrous ABN Amro acquisition of 2007. The fixed income business is stronger. Indeed Greenwich Capital Markets, acquired with NatWest, is something of a jewel in what is otherwise a pretty tarnished crown. Helped by Greenwich, America contributes the largest share of RBS’ investment bank revenues, almost one-third of the total. It also earned a healthy 24 percent return on equity in 2010.

Sadly, the strengths are shrinking. Greenwich was a big player in now-diminished U.S. mortgage trading and returns will come under further pressure because Basel regulations require RBS to assign more capital to fixed income. Moreover, new UK rules that will ring-fence retail banks from riskier wholesale arms raises the latter’s cost of funding. Analysts at Credit Suisse forecast that, without restructuring, return on equity at the investment bank would have shrunk to 6 percent.

The restructuring outlined on Jan. 12 might be enough to boost returns above the 12 percent. But for the time being, potential buyers are likely to bid only at a sharp discount to the 15 billion pound book value of the investment bank. If RBS can show it can jump the 12 percent cost of capital hurdle, it might find buyers ready to pay a more acceptable price. But there is still plenty that could go wrong. UK politicians’ propensity to want to bash bankers could throw a spanner in the works, though commercial imperatives – for the time being at least – appear to have the upper hand.

Soldiering on with the investment bank may be RBS’ best option, but that doesn’t mean it’s an attractive one.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Will there be fewer investment banks at the end of 2012? Brutal market conditions forced almost all wholesale banks to cut costs and jobs in 2011. New regulations will force further shrinkage simply to generate acceptable returns. Unless the market picks up soon, smaller players may conclude they’re better off out of the game altogether.

Banks cut thousands of jobs from their wholesale divisions in 2011, as revenues collapsed amidst the euro zone crisis. And new regulations will halve average expected return on equity (ROE) across global investment banks in 2012 to 8.3 percent, according to analysts at JPMorgan, well below the 13 percent needed to cover their cost of equity.

To reach that required return, banks have to shrink further. Even factoring in further headcount reductions of up to 20 percent and a 5 percent cut in non-compensation costs, returns would still be too low. To reach a 13 percent ROE, banks will have to slash pay too – by a hefty 23 percent per head on average, JPMorgan reckons.

Those cuts will not just remove fat, they will also undermine revenue. The most vulnerable banks are those that are already sub-scale. JPMorgan analysts estimate that 2011 revenue at Royal Bank of Scotland, UBS and Societe Generale will be barely half that of industry leaders Goldman Sachs and Deutsche Bank. Nomura too, faces a tough call – its investment bank is losing money in Europe, while the threat of a ratings downgrade could undermine its counterparty status.

No one is yet contemplating quitting – publicly, at least. Nomura reckons that its capital strength and liquidity position will allow it to gain from euro zone turmoil. UBS’s new chief executive, Sergio Ermotti, insists its smaller investment bank is essential to its private bank.

However, there are signs of retreat. The UK government, RBS’s major shareholder, made clear in December that it wants to shrink the investment bank faster. And SocGen has installed its chief financial officer at the head of its investment bank, suggesting a tighter focus on costs.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

It’s back to the future for Royal Bank of Scotland’s investment bank. The UK government has said the state-backed bank should further shrink its wholesale arm and focus on serving UK companies. The outcome could be something resembling County NatWest, the UK progenitor of RBS’s current Global Banking & Markets (GBM) unit. But that could hardly be called a proper investment bank.

RBS has been hacking away at GBM, which now accounts for just a third of core profit, and it hasn’t finished chopping. Still, the government clearly wants a more radical retreat. RBS’s current approach is to eliminate businesses that face funding challenges or can’t earn their cost of capital. It now looks like RBS must apply a “Union Jack” test: does this business support domestic economic activity?

The equities business, which is loss-making according to someone familiar with the division’s numbers, looks likely to be the next casualty of the shake-up. It may not be hugely capital consumptive, but RBS has never been a strong player – it generated a sixth of the revenue that industry-leader Goldman did in 2010, according to JPMorgan analysts. Equity capital markets and advisory, including its Hoare Govett UK corporate broking arm, would follow. That’s ironic, since Hoare’s retains a strong following in UK Plc, despite its owner’s travails. RBS’s relative strength has historically been in credit. But if the preference for UK business is to be respected, RBS might have to offload the former Greenwich Capital Markets business in the United States. That could dent returns: FICC is a scale business.

These disposals would leave RBS’s investment bank a London-centred debt house offering some limited corporate finance advice, foreign exchange, hedging, debt capital markets, and trade finance in addition to loans to a domestic client base.

Backtrack 25 years and County NatWest looked not much different – only it had a small UK-focused stockbroking arm. But County NatWest wasn’t a great success, hence its forced expansion into the global – although not much more successful – business that was NatWest Markets. The notion of a pure UK investment bank looks even less viable now than in 1987. But the government is paying this particular piper and it will call the tune, however off-key.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Radical measures for tougher times. With its share price plumbing new depths, Societe Generale is moving chief financial officer Didier Valet to be head of its investment bank. The division is at the heart of the French lender’s struggle to meet new capital and funding rules. Outgoing CIB chief Michel Peretie did a good job restructuring the division he took over after the 2008 Kerviel debacle. But his remit had clearly been to grow the business and restore it to its former glory. Someone else will now prune it back.

Peretie, a seasoned former Bear Stearns banker, diversified the bank away from its equity derivatives stronghold towards safer and less capital intensive activities like advisory. He also oversaw the disposal of some 10 billion euros of SocGen’s legacy assets between July 1 and Nov. 1 alone. And he implemented reforms designed to prevent a repeat of 2008’s 4.9 billion euro rogue trading loss.

But Peretie’s main brief – to grow the investment bank – didn’t sit well with the group’s struggle to meet new capital and funding targets. The investment bank must pare down to reassure both equity and bond investors. Valet’s skills as CFO may be more suited to these objectives.

He will have his work cut out. SocGen looks like it should just about hit the new 9 percent European Banking Authority capital target at the end of next June, having decided to pass on its dividend. But funding pressures remain intense.

The French lender is already embarked on a fire sale or shutdown of its dollar assets now that U.S. money market funds are shunning European banks. For example, it quit physical energy trading in the United States less than a year after buying core parts of the former Sempra’s trading operation. And it is turning to alternative sources, like its retail customers, to fund the 10-15 billion euros it will need in 2012.

The European Central Bank is helping, offering euro zone banks 3-year money at around 1 percent. But relying on the ECB is not a sustainable business model. Once Valet has steadied the ship, he and his colleagues will have to show that they have a longer-term strategy to make the bank safer and sounder.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Have MF Global’s clients suffered an action replay of the collapse of Lehman Brothers? That’s the intriguing question posed by the broker’s demise, which has left executives facing accusations of misusing client funds. One theory is that MF Global was able to use a legal process called rehypothecation to use customers’ money to back its own trades.

When investors enter into a trade with a broker, they typically secure the deal by posting collateral, which is deposited in a ring-fenced account. Rehypothecation is the practice whereby brokers ask clients for the right to use the collateral to back the broker’s own trades or borrowing. In return for allowing their assets to be reused in this way, clients get cheaper funding and services.

In the United States, regulators have limited the practice. Brokers are only allowed to rehypothecate assets worth up to 140 percent of the client’s liability. So if a client has borrowed $100 secured by collateral worth $300, the broker can rehypothecate assets worth up to $140. The remaining $160 of collateral remains untouched. But in the UK there is no limit to rehypothecation, so the broker can use the full $300 as collateral for another trade.

MF Global appears to have taken advantage of this transatlantic difference. According to accounts filed by MF Global in the UK, the broker’s London-based subsidiary had sold or repledged $16.1 billion in customer collateral as of March 31, 2011.

There’s no way of knowing how MF Global used these funds. Jon Corzine, the former New Jersey governor who ran the broker and masterminded its failed $6.3 billion bet on euro zone debt, has denied misusing client funds. KPMG, the administrator for MF Global’s UK arm, says it has no evidence that contractual terms were breached. But as rehypothecation was explicitly permitted in MF’s client agreements, this wouldn’t constitute a misuse.

Nevertheless, the apparent scale of MF Global’s use of rehypothecation is surprising given that many hedge funds were burned by the practice when Lehman collapsed in 2008. Many of the client assets in the Wall Street broker’s UK arm had been rehypothecated, leaving customers to fight for their cash as unsecured creditors.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

The euro zone crisis has European bankers scrambling for their Latin primers. Lex monetae – the legal principle that states can redenominate their currency without defaulting – could leave banks nursing large losses in a euro breakup. There is precious little lenders can do to limit risks on existing bonds and loans. But they are likely to favour foreign law for euro zone contracts in future.

Few current contracts provide for a breakup, and banks have little leverage to change that: why would borrowers agree to give lenders greater protection from what is a real and growing risk? Even where banks wield notional bargaining power, using it is not straightforward. Sovereigns, for example, have traditionally been considered risk-free and, therefore, excluded from posting collateral on derivatives trades. Banks would like to change that, but are loath to do so for fear of exacerbating the crisis.

Instead, banks are focusing on future defences. The simplest way is to ensure bonds and loans are issued outside the euro zone and under foreign law, probably in the established commercial jurisdictions of England or New York state – which offer greater protection for creditors in the event of a default. That is the exception for euro zone states now. Nomura estimates that just 18 percent of euro zone sovereign bonds were issued outside the national market, and many of these were issued under local law.

Private sector bonds should be easier to secure. In the euro zone, two thirds of bonds issued by financial institutions, and 42 percent of corporate bonds, are already issued outside home markets, according to Nomura. Governments may resist issuing new bonds under foreign law. However, investors could then demand a premium for the extra risk.

Lawyers are also looking at inserting clauses governing payouts in a euro zone breakup. Like the “gold clauses” common during the era of the gold standard, such provisions would fix liabilities at a conversion rate to gold, or the dollar. But the dollar and gold can be volatile too. The assets against which the loan is secured could fall further than the newly redenominated currency, leaving the bank worse off.

Banks will have to live with redenomination risk until politicians sort out the euro zone crisis. It could be a long wait.

By Margaret Doyle The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

UK investors have finally grown a backbone. Having suffered several years of collapsing share prices and dividends, the Association of British Insurers is demanding that banks cut high pay to ensure they earn the cost of equity. Though the proposals are sensible, the plea will be in vain unless investors are willing to vote against poor remuneration plans, or the directors responsible for them.

The ABI’s core demand is that no bank should pay bonuses until its return on equity exceeds its cost of equity. In the current climate, that’s a big ask. Had Barclays wanted to hit its target 13 percent return on equity in 2010, it would have had to cut total compensation by 31 percent.

Banks argue that they are taking steps to tackle pay bills by cutting staff and shrinking bonuses. And because most pay is now in the form of shares, employees are suffering alongside shareholders. No bank wants to be the first to cut pay dramatically for fear of losing disaffected staff to rivals. But, as the ABI points out, with pretty much every bank shrinking, poaching is hardly a risk right now. Another problem is that regulatory demands for deferred bonuses have made it harder for banks to quickly cut pay when income shrinks.

Shareholders can’t have it all their own way: as the Bank of England has pointed out, bigger capital buffers mean that bank returns will have to fall. But if the consequence of reform is that banks are safer, investors should be willing to accept utility-like returns.

Apart from selling bank stocks, shareholders have so far done precious little to show their displeasure. Investors can flex their muscles by voting down bank remuneration reports, and opposing the re-election of directors who fail to rein in pay. But unless they act on their demands, shareholders can hardly claim to be surprised if bankers continue to pay themselves ahead of their owners.