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Saturday, 18 November 2017

IFR Future of Investment Banking Roundtable: Part 1

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IFR: The subject of today’s discussion is in many ways a daunting one. We’ve been through a fascinating four or five years in the investment banking industry, which is contending with regulatory, supervisory and strategic challenge in an environment of poor economic growth.

We’ve seen banks deleveraging, re-strategising, recalibrating their client relationship models, trying to integrate their back office and technology infrastructure and attempting to figure out who and what they are, why, for whom and indeed how much money they can make from it. The return on equity model is clearly under stress and we’ve seen bank stock prices trading below book value.

At the same time, or partly as a result of the above, major corporates are able to raise money more cheaply than banks, which undermines the banking model. I’d like to articulate some of the main issues and assess how and where we’re going in the coming years. Harps, could you make a few introductory comments as to what you see as the hot -button issues of today?

Global investment banking fees by year (top) and Global investment banking product mix based on fees % (Bottom)

Source: Thomson Reuters Deals Business Intelligence

Global investment banking fees by year (top) and Global investment banking product mix based on fees % (Bottom)

Harps Sidhu, KPMG: I would be remiss if I didn’t lead with the regulatory environment because we’re in the midst of the biggest shake up this industry has seen from a regulatory perspective. Things like Glass-Steagall pale by comparison to the range of different types of regulation, how many of the banks’ business activities it touches and the fundamental impacts it’s having on the business model.

The effects are broad-ranging, including what business you do, how you organise your legal entities and where – and how much – capital is held. It will also have huge implications for cross-border flow and for underlying economies. It’s very easy to lose sight – particularly in light of the public fervour – of the fact that this industry plays a vital role in reducing the cost of capital and in allocating that capital to its best use in the economy. Some of the regulations under scrutiny may have a drastic impact on that.

Combine all of that with the commercial aspects; investment banks were very revenue-centric organisations that, in many cases, ratcheted up their cost-income ratios through insufficient strategic infrastructure investment through the cycle. One of the questions we are faced with is: is this time different to previous downturns in the industry, where costs were removed through headcount, efficiencies and slowing down investments? I think the answer is yes, in terms of the impact of the regulation, the length of the downturn in markets and the accompanying economic downturn, plus the debt overhanging the market and the accompanying monetary policy response.

So you’ve got the cost of complying with the regulations, the resultant reduction in the scope and profitability of doing business, the increased cost of capital, and margin compression. All of this is biting at the same time, with minimal net interest income or spreads to offset that, so it’s analogous to a perfect storm. Getting the cost-income ratio down to support achieving a sustainable ROE will take large strategic investments on top of the efficiencies being extracted, which are very difficult to swallow at this stage.

Julian Wakeham, PwC: Building on what Harps has said, we recently conducted our global CEO survey, which has a banking and capital markets slice. The three top issues identified by CEOs were economic uncertainty (particularly in Europe), the regulatory agenda that Harps has already highlighted and the changing nature and needs of the customer, and how they respond to those changing needs. There was a clear recognition in that report that further cost reduction and organisational change was still to come.

But at the same time, around 75% of respondents said they were going to increase tech spend which was interesting given the pressure of regulatory compliance. And 64% said they were going to increase R&D and innovation spend so perhaps we could see an indication of how they are going to respond to some of those customer need changes.

Interestingly, 45% felt they could comfortably see revenue growth and another 42% said they were slightly comfortable they could see revenue growth which is reasonably positive given the challenging environment we are in. Of course, this is banking and capital markets in its broadest sense.

Steven Lewis - Ernst & Young

Steven Lewis - Ernst & Young

Steven Lewis, Ernst & Young: These kinds of comments reflect a broad consensus around what the issues are. We’ve talked about regulation, we’ve talked about the broader economic situation and I think the other factor that is linked to that is the political situation which particularly in Europe has been driving a lot of activity and a lot of decision-making around what types of activities banks engage in, where they engage in them and how that is changing.

If we think back to pre-crisis, there was an expectation and a hope that a lot of banks could be all things to all people. Even after the global financial crisis, people still thought they could get away with not having to make significant changes to what they were doing, so one of the key themes now is around accepting and then adapting. As a result of the combination of the three factors I highlighted, they have begun to accept that actually things are not going to go back to the way they were.

So, there is now that need to adapt and recognise that unless you have scale and genuine global reach then certain activities are just going to be off the table. You’re also starting to see competition from niche players, particularly around some the advisory areas where you don’t need that massive balance sheet behind you. The overriding theme for me is that there needs to be a genuinely strong strategic review as to what is going to work and what is not going to work and then to go forward from there.

Matthieu Lemerle, McKinsey: We’ve touched on regulatory uncertainty which is linked to revenue and that is also quite uncertain. We’ve talked about cost and the return of strategy. It’s interesting to note that of the top 12 banks, the management teams of a number of them have changed over the last 18 months. That speaks to the fact that we had a generation of leaders who were groomed to expect vertical growth rates, and the only question was: are you going to grow by 15% or 22% next year? Those were the people leading the banks until very recently.

The challenge now is very different. Banking is becoming a boring industry where returns are just scratching the cost of equity; therefore the set of skills you need to run that kind of institution is very different from just being a good trader and printing tickets and doing deals. It’s about managing.

The theme of the return of strategy and the softer side of management is becoming absolutely essential because banks are faced with a Tsunami of cost issues, balance sheet issues and regulatory issues that are just too much. Banks now need the ability to step back, prioritise and pick their battles; otherwise it’s just overwhelming.

That’s one of the themes; the other is the cost issue, which is an important one. The issue here is that the industry has been growing extremely fast and we’ve seen the headcount reductions in London and New York which are quite staggering. But when you look at the time series on costs, it’s kind of flattish; plus or minus 5%. So there is this notion of running very fast just to stand still. That is one of the new challenges for the industry, which is just starting to poke its head above the parapet.

Global M&A fees by year (top) and Global M&A region mix based on fees % (bottom)

Source: Thomson Reuters Deals Business Intelligence

Global M&A fees by year (top) and Global M&A region mix based on fees % (bottom)

Andrew Goulden, Deloitte: I think we’ve gone through what consultants term a paradigm shift. I think lower margins are here to stay and the regulatory requirements that are coming in are going to make the cost of capital for banks much higher. We are definitely seeing a situation whereby we are no longer going to get the concertina effect that we have seen in the past: grow like crazy in good years, shrink and fire 30% of your people when you have a couple of bad years, and then grow again. That has gone.

Banks are recognising that they’re going to have to fundamentally change their operating model. And this is to meet the fact that you can no longer just build a silo business, and keep adding. You have to start to think about which businesses you want to be in, which you can make money at and more importantly, if you should own or not the infrastructure to deliver against that business.

Senior management are asking questions they have never asked in the past. It was unheard of to outsource a chunk of this or that you would not have in-house delivery capability and infrastructure around virtually all products in ops, in tech, in finance, in risk. Yes, we have seen off-shoring and yes we have seen bits of IT maintenance outsourced but it has never been at the core of the banking capability. You would not out-source your derivatives processing, for instance.

Today you have got to ask the questions. If we are in that business, if we are in the flow business, can we make money out of it, how can we be one of the three or four people that can provide volumes? If we can, how do we get our costs-per-trade down to a point where we can be effective in 10 years’ time? The winners are the ones who are going to be investing in next-generation platforms.

The problem is there are not many alternatives today. You don’t have any real outsourcing capability that could pick up, let’s say, the flow processing of a tier one institution. But that could come. And I think that we are seeing that the only way forward is to look very hard at a whole series of things. It was too easy to make money in the past. It was too easy to launch some structured product, add on a commodities trading team, add on a structured derivatives team etc. The margins were so fat that it didn’t matter how much it cost to process things.

Investment banks talk about customer centricity and they talk about product profitability. They have no idea about either of those, in my view. Banks think customer centricity means building custom solutions for every one of their big clients. The point is: today you can’t do it. You’ve got to be more cost-effective. Customer-centricity for me is understanding, if you’ve got a corporate finance division, global banking, global markets, a global transaction bank, how you get better fertilisation across those.

Most of the tier one banks have been very siloed and competitive; the last thing you want to do is share information with your colleagues, or give them only enough information so that they realise how much margin you’re making on their business. So customer centricity is going to change,.

I think banks are going to have to cut down the amount of bespoke solutions they’re building for customers and I think they’re also going to have to rationalise the portfolio. But I don’t think the banks today have a clue how profitable individual customers are and I don’t think they have a clue how profitable certain products are. They’re going to have to go into the Walmart-type industries of this world where they have a much better feel about products and margins.

On product profitability we all know the problems of regulation and the fact that banks are all having to pay for it, but I think the biggest risk we are seeing today is de-globalisation.  RRegulators are almost forcing global players to become much more regional.

The amount of pressure that is going to be put on European banks in terms of how much capital to have in the US, the amount of pressure put on non EU banks to allocate capital in Europe; exactly the same in Asia-Pacific is going to force banks to consider how they set up their businesses. So they now have this problem of one the one hand you want to globalise, you want to industrialise your operations etc, but on the other hand you’ve got the regulators almost forcing you to become regionalised.

Keith Mullin - IFR

Keith Mullin - IFR

IFR: On Andrew’s latter point, I wanted to pick up on the issue of regulatory collaboration as well as the notion of over-regulation. The G20 has an agenda to enhance regulatory collaboration at the same time as national regulators are pulling against each other to support national champions and domestic economies. Beyond that, I wanted to touch on the extent of regulation and whether investment banking as we know it is being regulated out of existence. Have they gone too far? The system did need re-regulating, but some of the fervour looks to be driven by what I consider to be a degree of political vindictiveness. Have we thrown the baby out with the bath water?

Matthieu Lemerle, McKinsey: A judgement on whether regulation is good or bad is difficult at this point in time. We can always say cynically that regulators are fighting the last war and we just have to wait until the next one to see if regulation is efficient. Some issues have been addressed, although I think it’s interesting that the industry itself was slow to recognise that regulators meant it.

But there are two issues which are real right now. One is the sheer volume of regulation. I think somebody counted thousands of pages in Dodd Frank, which is just a bandwidth issue for banks to execute. The sheer volume of regulation coming through is just too much to absorb for many banks – and for the regulators too, by the way.

The more serious issue which is emerging and which I think you were alluding to, Keith, is that there was good co-ordination after 2008 or good intent on co-ordination because people observed that when Lehman went under, the system totally broke down. But what has emerged more recently is an inconsistency between national regulations and double talk between what is said publicly and the fact that national regulators – in particular in Continental Europe – tend to protect the interests of their national champions.

In the US it’s different. When you talk to senior politicians and lawmakers in the US you see another trend evolving. So, on the face of it you might say the US is winning and has an advantage versus Europe. But when you discuss regulation in Washington, the politicians are shifting their mindset towards being more radical in the implementation of regulation. So it is an unlevel playing field and how that will play out is worrisome as is the fact that it is just inconsistent. This will put some banks in an impossible situation.

IFR: Doesn’t this undermine the global banking model?

Matthieu Lemerle, McKinsey: The cross border model, yes.

IFR Future of Investment Banking Roundtable: Part 2

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