Investment banks will be forced to make stark choices in the coming years – exiting unprofitable business areas or shutting down entirely, according to a new report from the Boston Consulting Group (BGC).
Although the industry will continue to evolve, and some people will inevitably suffer, the prognosis from BGC is not entirely bleak. We have distilled the key points from the 28-page report.
BCG is expecting modest revenue growth across the investment banking industry this year. However, the performance of banks’ FICC divisions will be subdued, it suggests, as quantitative easing potentially finishes, credit trading becomes squeezed and banks lose market share in commodities to independent trading houses. Meanwhile equities, equity capital markets and M&A will benefit from improved stock market performance, it suggests.
However, overall (as the chart below demonstrates) tier one investment banks are vastly outperforming their tier two rivals across all asset classes, and appear the safer option.
As investment banks make strategic choices about which business areas remain viable and which to exit, six successful business models will emerge, suggests the report. From a volume employment point of view, the ‘powerhouses’ model – namely large investment banks with the scale to remain profitable in a low-margin, high fixed-cost business areas and the spending power to invest in IT – remain the most appealing option for most traders and investment bankers.
However, there’s also the option of working for ‘advisory specialists’, namely those who can offer 'premium' M&A and capital structuring advice, which could operate as independent businesses “within an investment or universal bank”; the ‘relationship experts’, who develop deep ties with clients, acting as “one-stop-shops” for all client product needs; hedge funds, which can escape more stringent regulations and target higher returns; ‘haute couture’ institutions, which house specialist traders, structurers and quants developing high-end products for hedge funds, private banks and sovereign wealth funds, or ‘utility providers’ offering IT, operational and accounting solutions to banks looking to reduce costs.
Like Morgan Stanley and Oliver Wyman analysts before them, the authors of the BCG report believe that increased regulation will provide new revenue opportunities through collateral management – namely, turning risky assets into what appear to be safer ones in order to appease regulators. “As capital optimization and risk management become key differentiators, the importance of players involved in after-trade and repo activities will increase,” said the report
Morgan Stanley analysts believe the revenue potential is $5-8bn, but BCG puts it at $4-7bn by 2016.
One of the obvious short-term consequences of the European Commission’s bonus cap, which will limit variable pay to 100% of base pay (or 200% if shareholders agree) is that European banks will feel compelled to raise base salaries in order to compete with their international counterparts. However, because of the dangers of raising fixed costs when revenues remain volatile, this is not a long-term viable solution, believes BCG and also “may not be enough for banks to match top-level compensation in the industry”. Non-European banks will therefore have an advantage, it says.
Investment banks have yet to fully exploit the opportunities in rapidly developing economies (RDEs), where companies continue to raise equity capital and governments are still issuing debt to fund their social goals, suggests the report. Local and regional players still serve prominent companies well, and global firms struggle to get a foothold.
Part of the reason for this is a scarcity of talent, it says, suggesting that there’s an opportunity for those who can develop expertise and connections in these markets.
As the electronification of more asset classes becomes more prominent in the investment banking industry, firms will have to decide whether they’re willing to invest in the technology required to compete, says the report. Equities and FX are well along the road to electronification and there’s likely to be limited change here, says BCG, but the credit market is still immature.
Less than 20% of credit trades were performed electronically last year and it will take many years – possibly decades – before it becomes a largely technology-driven market, suggests BCG. However, “price transparency and tougher competition will constrain the total value that players can capture”, says the report. IT investment is required in order to maintain or develop credit platforms, it says, and only a few have a “long-term business case” to justify this investment.
“Tier 1 banks should consider whether they are willing to make the investment required to remain in the business in the long-term”, it says. Tier two firms, meanwhile, will need to decide whether to “continue with a limited niche position, partner with larger banks, or offer a white label version of these products”.
From an employment point of view, BCG says that “people capabilities will need to be rebalanced” for the new era of trade automation. However, it will also shake up banks’ sales teams: “We will see greater emphasis on selling the IT platform (and internal support of the IT platform) and less on the direct voice-based sales relationship…players will have to revamp their ‘voice’ sales forces to focus on more value-added activities.”
The deluge of regulation hitting the banking sector, from Basell III, to the Markets in Financial Instruments Directive (MiFID) to the Dodd-Frank Act in the United States has left institutions with compliance bills that are hitting return on equity (RoE). Banks need to make efforts to restore this, says BCG.
Even with recent cost-cutting initiatives in place, banks either need to reduce expenses by a further 10%, suggests the report and raise revenues by 10% (assuming a post-regulation RoE of 7%). The alternative, assuming a post-regulation RoE of 10%, would be to cut costs by 5% and increase earnings by 3%.