Lynn Strongin Dodds explains why banks can’t turn back the clock.
Hope may spring eternal but any chance of investment banks returning to their modus operandi has been dashed by the ongoing eurozone crisis, the prolonged economic downturn in the West and a cascade of regulation. As a result many believe that the industry is undergoing a once in a generation change and that the model will have to be dramatically reconfigured.
“With the demise of volumes across plain vanilla and cash products – in some cases more than 40% – and the retreat from structures and complex risky instruments due to intense regulatory scrutiny and new legislation, investment banks are under exceeding pressure to reinvent themselves,” says Maurizio Bradlaw, a Frankfurt based partner at Capco, a global business and technology consultancy. “The key challenge is that for many, investment banking was the main bread winner for the organisation. “
This position is now under severe threat and they have to come to terms with the fact that both the historical returns and growth in this sector are gone. It will be sometime – potentially even questionable – if they will ever return, at least in the traditional sense of an investment bank’s trading function.”
Job losses are typically the first line of defence and the axe has fallen widely for junior as well as senior positions. The figures make for sober reading on both sides of the Atlantic. Wall Street banks laid off over 75,000 people in 2011 and analysts estimate that overall they will have roughly 10% to 15% fewer employees in early 2013 than they did at the start of 2012. Europe has been equally impacted with the City of London taking the brunt. When the dust settles this year, the number of jobs is likely to stand at around 255,000, a level last seen in 1996.
Equities has been one of the worst affected areas with a recent study by Greenwich Associates – European Equities Investors – showing that banks are in a phased retreat or retrenchment. For example, Nomura recently announced that it was realigning its equities trading business, opting to consolidate execution services under its Instinet agency brokerage brand while Italy’s Unicredit has withdrawn from Western sales and trading, handing French broker Kepler Markets the right to service its clients. Moreover, Credit Agricole is in talks to sell Cheuvreux to Kepler while retaining a strategic stake. In the UK, state-owned Royal Bank of Scotland decided to refocus its attention on fixed income and withdraw altogether from most of its equities business.
Even the behemoths are making adjustments with firms such as Deutsche Bank, Citi and Credit Suisse integrating their equity trading services offered to institutional clients. However, they are expected to capture the lion’s share of business as the commission pool continues to shrink. The Greenwich report showed that global banks with investment and research services grew their share of the commission pot from 66% to 70% in 2011. In the UK specifically, it increased from 63% to 68% in the same period.
This is at a time when the overall institutional bucket shrank over 25% on a pan European basis during the period from the first quarter of 2009 to the same period in 2012. Predictions are that it will be flat for the year although it could be under if soft equity trading which has marked the first six months continues into the second half.
According to Jay Bennett, consultant at Greenwich, the contraction in equity commission and broker trading revenue is the result of three market developments: de-risking of institutional investment portfolios, the economic recession in Europe and the European sovereign debt crisis, the last of which has prompted institutions to keep money on the sidelines, limiting trading activity.
A sharper knife
The concern is that the downsizing, headcount reduction and consolidating trading desks that has taken place over the past year has been too modest compared to the drop in trading revenues and a more drastic approach may be required. “To this point however, they’ve been pruning around the edges,” says Greenwich consultant John Colon, “But if things continue on this track, at some point they’ll have to move from giving up fingers and toes to arms and legs.”
The two main reasons why European and global banks have resisted deep cuts is because trading and research capabilities in European equities are viewed as important sources of market knowledge and intellectual capital that is leveraged in capital markets origination, mergers and acquisitions and other high-margin businesses. The other is that few want to raise the red flag of defeat. “People will stay the course in equities much longer than you might expect based strictly on profitability,” says Bennett. “To some extent, pulling back from European equities is admitting defeat in investment banking generally.”
Miranda Mizen, principal and director of equity research at Tabb Group notes, “The commission wallet is shrinking and one of the biggest challenges facing banks is that they are looking at the same areas at the same time. They need to be able to stand out and differentiate themselves and the question is how they are going to do that economically. There is a lot of navel gazing going on but they have to start making the difficult decisions and focus on their core strengths while exiting the weaker areas.”
The main challenges according to a report by J.P. Morgan entitled ‘Global Investment Banks: IB landscape changes across the globe – the path to an acceptable ROE for Tier I and II players.’ is that there is little chance of the industry returning to the growth levels of the halcyon 2005 to 2006 period plus the scope for product innovation is limited. Moreover, banks should not rely on emerging markets as the engine because they are not expected to be a material driver for revenues over the next five years.
As a result, banks need to rethink their value propositions. “One of the key drivers behind the restructuring are the low volumes in the market and banks are going back to what they specialise in whether it be equities, fixed income or a specific area of expertise,” says Tony Nash, head of execution services at Espirito Santo. “Some are paring down their global ambitions and are focusing on a particular region while others are combining different skill sets on one trading desk such as electronic trading and programme trading. In general, banks are reining in their ambitions and are in a survival mode.”
Those that do will more than survive and in time could thrive. As Bradlaw points out, “What’s new in the battle for market supremacy is that by and large the fight has shifted from breadth of product coverage and inter-bank trading to a greater focus on corporate needs, home market supremacy, consolidation and optimisation of post-trade functions. This paradigm shift has and will have a substantial impact on market liquidity, cost of trade and corporate governance and heads of investment banks need to take a more holistic approach in securing transactional volumes and returns”.
Bradlaw adds, “In this shift there will be winners and losers. Mid-tier banks who have aspired to be recognised as global players will focus on national markets while the top six to seven global players will dominate even more as smaller firms withdraw from certain asset classes or investment banking activity completely. In addition, investment and corporate banking groups will need to work more closely together so that new cross products can emerge which are outside of regulatory oversight and capital demands – but in effect with the same underlying hedge/investment effect.©BestExecution 2012/13