The big question mark over the new Macquarie model is whether its failure to gain traction and generate respectable performance is due only to the peculiar market circumstances or whether the model itself is incapable of generating the kinds of returns Macquarie investors and staff have become accustomed to.

In the wake of today’s warning that first-half earnings will be about 25% lower than the September half last year, and the market’s savage response to it, the skeptics will be emboldened.

The question is critical, not just in terms of Macquarie’s near term share price, but because the real value in an investment bank lies in its ability to attract and retain people, which in turn is reliant on its ability to generate the returns on capital that drive the performance remuneration investment bankers expect.

The 10% return on equity Macquarie has been generating has produced meagre bonuses and the group, which has been on an expansion and hiring spree through the crisis, is experiencing an uncharacteristic leakage of senior executives. That’s partly because there has been a peculiar, counter-cyclical hiring binge by its global competitors in this market, seen as one of the more stable and attractive markets for investment banks wanting an indirect exposure to Asia.

Within Macquarie there is a contrary view that this tough period isn’t necessarily a bad thing, that some losses of senior talent within a group that has increased its staff numbers dramatically in recent years isn’t necessarily a negative because it does free up positions and opportunity and creates energy and urgency. There has been considerable movement within the upper echelons of Macquarie’s hitherto very stable management.

Ultimately, however, Macquarie has to produce if its core capabilities are to remain intact and competitive with its larger global investment banking competitors, particularly now that its strategies aren’t as distinctive as they once were.

A key element of the old Macquarie model was its ability to generate multiple streams of income from transactions supported by its balance sheet, bringing its financing, capital market, funds management and advisory capabilities to bear.

The demise of the listed satellite funds strategy has forced Macquarie to pursue a more conventional investment banking and funds management strategy and removed much of the revenue leverage it once had.

The jury is out on the new model, largely because the conditions for investment banking are poor but partly because the group is carrying abnormally large levels of capital as insurance against another financial shock.

Macquarie isn’t alone in blaming lower confidence and client activity levels for a fall-off in profitability. Goldman Sachs last month reported second-quarter earnings that, even if one excluded its $US550 million settlement with the Securities and Exchange Commission and the $US600 million impact of the UK’s bank payroll tax, were about half the levels generated in the same period of 2009.

Investment banks need transactions. Macquarie said today that the global investment fee pool was down 32% in the June quarter to its lowest levels since 2004 and appeared likely to fall a further 8% in the September quarter. There is little merger and acquisition activity occurring and, after the extraordinary levels of 2008 and 2009, equity issues and debt raising have fallen to negligible levels. Macquarie also said that the value of retail broking in Australia has almost halved since its 2007 peak.

These aren’t the kind of conditions that enable any meaningful judgment to be made about the effectiveness of the new model in more normal circumstances, assuming that at some point in the not-too-distant future capital market activity and M&A volumes do improve.

Macquarie itself is predicting that full-year earnings will be similar to last year’s if there is some recovery in market conditions.

The second half will be helped by the Canada Pension Plan Investment Board’s $3.4 billion bid for Intoll, the ‘good’ part of the former Macquarie Infrastructure Group. Macquarie has an 18.3% stake in Intoll, which is in its books at $472 million but which is valued at more than $610 million by the bid. The offer will enable the group to not only book a tidy $150 million profit but release low-returning capital.

With $5.6 billion of equity investments in its balance sheet, Macquarie could release a lot more capital and improve its returns — and its bonuses — by rationalising that portfolio.

Ultimately, however, like its peers, Macquarie needs its clients and markets to become more active. That’s not something it has much influence over. Unless and until conditions improve, doubts about the ability of the new model to produce the returns Macquarie has generated in the past will remain and its ability to retain its key people will be undermined.

This item was originally published at Business Spectator.