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Monday, 20 November 2017

IFR Future of Investment Banking Roundtable: Part 2

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IFR: Some of the punitive capital charges on certain products seem fairly arbitrary to me, whether it’s project lending or long-dated swaptions trading or whatever. If the intent is to create a utility banking model, does investment banking fit a utility banking model?

Harps Sidhu, KPMG: We talk about paradigm shift, I think that’s there. There’s no way the regulator is going to back down on issues like remuneration, like high capital charges on esoteric products. There are going to be fewer bespoke derivatives products, for example. That’s not going to change or go away. The bit that’s interesting with the regulation is where the impact on bank balance sheets, broader economic impacts and infrastructure costs to comply are not well understood.

For example, the economic ramifications on cross border trade are not well understood. It’s a very delicate balancing act for the banks to engage in the right way on the impact of regulation. At the moment the industry is on the back foot in terms of being trusted to assess the true impact of these changes whilst not being wholly self-serving.

Whilst I hope and believe that common sense will prevail in the longer term on topics which will directly impact bank capital, ability to lend and resultant economic impacts, I am more concerned in the shorter term about the volume of competing regulations in terms of their enormous infrastructure impact for banks, such that in many cases it is almost impossible to comply with the myriad of regulation on the currently-proposed timelines.

I’m also concerned about the cross-border impacts of the localisation of regulation and the more parochial tone being taken by regulators.

Global ECM fees by year (top) and Global ECM region mix based on fees % (bottom)

Source: Thomson Reuters Deals Business Intelligence

Global ECM fees by year (top) and Global ECM region mix based on fees % (bottom)

Steven Lewis, Ernst & Young: You can understand the regulation that has been driven by the G20, under Basel 3. You may argue about the benefits or constraints on particular products but you can understand the rationale behind it. I guess where I have a concern is that on top of that, first of all you have national and regional gold-plating, and we don’t yet necessarily know whether that’s going to really benefit anybody and the chances are it may not.

Secondly, you have this move beyond gold-plating towards a focus on subsidiarisation, so the branch model in many jurisdictions is going to be dead. The impact of subsidiarisation will be in things like trapped capital and much less efficiency. And then the third thing on top of that is that you have – and Keith alluded to this – an almost punitive element.

You can understand the concerns that people have about not wanting to repeat the mistakes of the past. I guess the challenge I have is that we haven’t yet given Basel 3 in its full impact the opportunity to work or not work and we are now embarking on things like FTT, and we are also doing things which are frankly contradictory to Basel 3.

When you think about the bonus constraints that the European Parliament has passed where actually, if you want banks to be efficient and flexible so they can move as the economy shrinks or grow, forcing them effectively to increase their fixed cost base, or move the business out of Europe altogether, doesn’t actually help the principles of Basel 3.

Andrew Goulden, Deloitte: What we’re seeing is a pendulum effect. Whether we like it or not, the banks were under-regulated so we’re seeing a ricochet effect of some very extreme regulations, such as caps on compensation. Clearly we had to have more regulation and I think you’re probably right: we are not yet seeing if Basel 3 works and gets us to a better place. But it’s all tick-box regulation; a principles-based approach is always way, way better because the tick-box mentality allows people to work around the rules in a triumph of form over substance.

Banks have got to change culture. Things like the bonus cap are a reaction by populist politicians who are elected by a public that thinks the banks have taken the economy down. But this will hurt not just the industry but the economy as a whole. We’ve got to try and get to a stage where the pendulum comes back a little to the middle to allow the banking industry to work. Yes with better safeguards than we had in the past, so not: “I’ve had a good year so I’ll take a bonus home; or I’ve have a bad year so the taxpayer can pick up the bill”, which is what it’s been for the last few years.

Julian Wakeham - PWC

Julian Wakeham - PWC

Julian Wakeham, PwC: I think that’s right. Whether it’s a genuine belief or just political awareness, the political antennae of all of the senior executives in these banks has risen substantially. There’s very little disagreement about the intent of regulation; the disagreement is around the implementation and execution of it. You’re also seeing regulators perhaps feeling their way on how they are going to achieve the intent.

So things like recovery and resolution planning still need to be walked through in terms of how it will actually work. And you see emerging regulation around conduct and culture and rather blunt instruments are being used to drive that, which creates a very challenging environment for banks because it’s a very difficult thing to do.

IFR: But at the end of the day the new regulatory approach risks making the banking model uneconomic. I presume that’s not the intent.

Matthieu Lemerle, McKinsey: It depends on how you distribute wealth creation. We talked about bonuses; it’s fair to say that in the past the pecking order of any wealth creation was employees first then the tax man and what’s left to shareholders. There is real value being created. It is just a matter of how you distribute it. We recently looked at the top  13 investment banks’ capital market and investment banking divisions and ROE last year was – on average – actually not that bad.

Now it depends where you put cost of equity but to get to an ROE of 10% to 12% (plus or minus 20%), factoring in COE of, say, 11%, 11.5%, you’re not very far off. Now there’s a massive dispersion within that and not everybody is there but on a spreadsheet you can find a way to make the economics work – on average. Within that, some models are really challenged, on the funding side in particular, if you make some harsh assumptions on regulation. But on average it works, albeit the cross-border issues and localisation of balance sheet are real issues for some institutions.

But what it does – and Andrew talked about this – is it forces the bank to make choices. The era of “I’m going to be top three everywhere for everything to everyone” has just gone. And that’s the real shift. If you realise that and you pick your battles then you can be fine but you have to be extremely clear about what it is you are not going to do. The era of having option value on everything and saying ‘I’m going to keep that business open because maybe it’ll be the next big trade in five years and I don’t really care because I’m printing money in other businesses so I can cross-subsidise’ has just gone. So getting back to an industry that is just boring, banks will be fine if people do the right thing.

Julian Wakeham, PwC: It’s not just about return on equity; it’s about cost of equity and making sure that investors understand the banks business model, can see strategy certainty and why it relates to your core franchise. Obviously there are all sorts of external factors driving uncertainty as well but the sooner the banks can describe a very clear and compelling strategy and model to investors the sooner they will reduce the cost of equity, that will help the return on equity. You’ve got to look at both sides.

Andrew Goulden, Deloitte: Yes. But I think that whether we like it or not, I think the investment banks have to start to move to a logic where 10-12% is the return. And that is good but if they are coming in at 9% and they’re a boring business and they are going to pay out dividends every year, then they’re a utility in the system. We had seen bank CEOs announcing return on equity targets of north of 20% …

Julian Wakeham, PwC: Indeed, but investors have to get used to utility models and the cost of equity of supporting those utility models should be lower. Investors are much better at understanding the risk of these businesses and therefore the overall return on equity, if it is a very different banking model, but they can work.

Global DCM fees by year (top) and Global DCM region mix based on fees % (bottom)

Source: Thomson Reuters Deals Business Intelligence

Global DCM fees by year (top) and Global DCM region mix based on fees % (bottom)

IFR: Might investors drift away from the banking sector if average ROEs are much lower? Won’t it be difficult to convince them to accept lower returns just because the model has changed?

Matthieu Lemerle, McKinsey: The implication is the volatility of returns is lower; a big implication …

Julian Wakeham, PwC: With the old model, the investor was requiring the bank to have leverage. It may be the investor who should now be taking the leverage and getting a return. It’s where the leverage is, that’s the question.

Matthieu Lemerle, McKinsey: One thing we haven’t discussed yet is the revenue outlook, which is linked to this. At the end of the day, a bank is just a leveraged play on the underlying economy. If you look at 40 or so years of data in the US, the growth of capital market revenues was roughly growing 1.7 times GDP. It’s a very good correlation – until the first half of the 2000s when we started drifting completely off the long-term trend and revenue growth started to outpace the trend, largely because of leverage.

One way to look at the recent decrease in revenues is a basic return to the mean, which you would expect if banking is a boring leverage on the underlying GDP. So what’s going to happen to revenue? Well if you assume that the froth, i.e. the kind of self-generated revenues coming from areas like prop trading or complex products whose purpose was debatable, is gone – and that’s the big cleansing process that has been happening over the past few years – you get something that you can see growing modestly with variations by regions, product and type of player.

You’ll get relatively normal growth up to high single digits or low teens in some emerging markets, but returns that are much more stable, less volatile and a cost of equity that can facilitate a good return.

Andrew Goulden, Deloitte: I guess you don’t get the write offs that you have had in the past either. The point is, when you were getting 20% returns on equity, it was great, but look at how much value was destroyed during the credit crunch. It was starting to look like the airline industry. The whole point is that it’s got to get back to being less; it’s too important for the economy as a whole that we have these highly volatile institutions that can be returning great returns and then bang! I think we have to get used to the fact that the business is going to become more boring and that returns are going to be lower, but less impacted by shocks.

Steven Lewis, Ernst & Young: To build on your point, it’s also an issue of transparency. Investors want to understand exactly what the bank is going to do and how it’s going to do it. If you can articulate that message and the investor believes you, but it looks like it’s going to be a more risky play, then as an investor you can choose that but if you want the utility model you can choose that too.

And to come back to your earlier point, Keith, which is does the wave of new regulation make the model uneconomic? No it doesn’t, as long as you are clear about what it is that you want to do and you build your business around that. The challenge that we see at the moment is that those stark choices haven’t really been made and I think it is only now that you’re starting to see that come through.

Harps Sidhu, KPMG: As we move to less bespoke and more standardised product offerings, I think new entrants in local markets – particularly the emerging markets – will find it easier to challenge the established international players, because they haven’t got the overhang of legacy assets and portfolios they need to fund and bear the operational and compliance costs for. For example, in South America we’re starting to see banks growing at very fast rates, funding inflows and outflows from the continent.

We’re also seeing a strong desire by the industry to consider common utilities for activities such as client on-boarding. This is the tip of the iceberg and we believe we will continue to see this direction of travel to look again at reducing costs in areas that the banks don’t see as driving competitive advantage. Those that are more advanced in their thinking see that as being centred on their intellectual property (such as trading technology), client relationships, better client relationship management, profitability analysis, product management etc. It’s an interesting shift that in many ways mirrors what industries such as telecoms underwent when margins receded.

Americas investment banking fees by year (top) and Americas investment banking product mix based on fees % (bottom)

Source: Thomson Reuters Deals Business Intelligence

Americas investment banking fees by year (top) and Americas investment banking product mix based on fees % (bottom)

Steven Lewis, Ernst & Young: I think the competitive advantage point is interesting when you look at emerging markets. I mean Harps mentioned Latin America, but if you look at South-East Asia you have a number of Singaporean and Malaysian banks that are developing quite sophisticated investment banking/capital markets businesses. If you are a US or a European bank, clearly you still have a number of strengths that you can put into the mix when you’re talking to clients.

But if you think about where the capital is right now and you start to see increasing flows of capital within emerging markets rather than into the US or Europe or to Hong Kong, you then start to say, OK what is the value these regional investment banks bring to the table versus a global investment bank? You then start to ask: ‘what is my competitive advantage?’ and just understand exactly where you play and where you don’t play in those markets because they are not yet as profitable as people think they are.

Andrew Goulden, Deloitte: We keep focusing on the top 10, 12, 14 investment banks and those that aspire to be in that group. But if you look, there are lots of Asian banks and Canadian banks, for example, which did not get really hit at all by the credit crunch with very healthy balance sheets. Guess what they are not doing? They are not really making inroads [into the investment banking wallet]. It’s the opposite. Why is that? Probably because it is not seen as an attractive business.

So where would you get growth today? It’s going to be stuff like: ‘well, first of all, let’s see how my retail arm is doing. Can I get more out of retail? Secondly, probably global transaction banking and capturing corporate services’. It is not: ‘I need to capture more derivatives flow’, for example. That’s part of protecting what you’ve got, it’s not your growth in terms of revenue potential.

Julian Wakeham, PwC: Actually Matthieu raised a good point earlier around the amount of management change we’ve seen. I think there’s now an awareness that assets are finite which historically they weren’t whether it was people or capital. You just got more; that’s just not the model any more. They are finite and they need to be deployed with real precision and that’s a different, or an increasingly important management skill-set that perhaps wasn’t as abundant historically.

Decisions around where those assets are deployed are going to make for some very interesting impacts on which businesses get funded and supported and have some focus. I think you’re right: inroads into pure-play investment banking aren’t being pursued because it’s not seen as an attractive way to deploy your assets in the current environment.

IFR: We’ve touched on leadership and culture; the latter in particular is a big industry talking point. As management has changed, do we think the new leaders of the bulge bracket firms and the group outside them are going to do a better job, and are we going to have to put up with this discussion about culture for much longer?

Andrew Goulden, Deloitte: The problem with culture is it’s always led by people who sound incredibly soft and fluffy and tree-hugging, but the hard reality is that many organisations persuaded their sales force to bend the rules to make sales and they basically invented products for their own bonuses not for the benefit of customers or the organisation as a whole. So you’ve got to break that culture. And that is actually quite hard because it’s investment banking and people are attracted to investment banking because they want to make money.

What you’re saying now is you need them to start to think advisory, you’ve got to start to set scorecard objectives, which are much softer and fluffier than the pure “how many sales did you make this month”? Client satisfaction surveys are going to be part of the scorecard that we judge you for your bonus. The banks are going to have to start doing that, at least with some of their personnel

Harps Sidhu, KPMG: It’s about conduct risk. The key consideration is no longer whether clients have lost money or not. The banks now need to demonstrate that they did everything they were meant to pre-trade. I think the tone around the way conduct risk will be enforced has completely changed. And there are corporate and individual ramifications which I don’t think there were before.

Steven Lewis, Ernst & Young: I think the culture question is part of a broader debate around governance and risk, If you think about the increasing number of governance issues that banks are facing and making sure that the board understands what’s going on and is bought into it so they can set the tone the whole question then becomes: what level of risk appetite does the organisation want to have? And how do you make sure that everybody understands that, buys into it, and adheres to it?

If you don’t then move into discussion around – and I don’t know whether it’s cultural or whether it’s actually understanding and accepting a common set of behaviours within the organisation – if you don’t move into that then there’s no point in the board saying, “This is what we’re going to do, this is how we’re going to do it” because the rest of the organisation isn’t going to buy into it. So I think culture is a fluffy topic but it’s part of that broader understanding of how the organisation is going to be run from the top down.

Matthieu Lemerle, McKinsey: I think culture is an outcome; you don’t say: from tomorrow at 9 o’clock this is going to be the culture.

IFR: But that’s how it’s being articulated.

Matthieu Lemerle, McKinsey: Exactly, the way it’s done is a bit clumsy maybe but maybe a couple of observations. In order to get to that right culture it is really about clarifying the priorities of the bank, moving away from self-centredness and the notion of ‘I’m here to make money for myself’ and saying: actually we are here to serve society and real economic purpose, and by the way we have clients who pay the bill at the end of the month, and let’s be clear about that.

Then you can work backwards and articulate how you get there and what doing the right thing looks like i.e. not selling your clients things they don’t understand or frankly don’t need. And then if you do that with gentle or not-so-gentle pressure from the regulators and from the top, it will take time but you have to have those kinds of influences.

And then there’s going to be an interesting transition challenge which is the people who are in the banks now have not been groomed into that environment, so there will be a kind of natural cleansing, and some people who just cannot adapt will have to go and that will take three to five years.

Julian Wakeham, PwC: Taking a slightly different angle, compensation levels in banks and particularly bonus levels are going to be substantially smaller than they were. But if you want to drive out-performance and productivity with your staff and your employees you have to give them a sense of why they are doing it. And that culture of being important to society and actually contributing and wanting to be part of something is very, very important.

Lots of firms outside the banking industry have managed to deliver a high productivity culture, a real desire to perform for the organisation. So I think at that level it is very, very important because compensation as a primary driver has probably gone.

Andrew Goulden, Deloitte: It takes a generation to get that degree of change. I think the problem the banks have is how do you move what has been a very singular, driven group of individuals? The bonus is a very blunt weapon to try to solve the problem and it’s a very bad weapon because it assumes that it’s better to have fixed costs than variable costs; it’s unbelievable.

The cost-income ratios of banks fundamentally are too high. They are not going to be able to improve revenues so much so you’ve got to reduce costs and in most cases they’ve got to take a lot of cost out: a lot meaning 25%-30% out of bases that have already been through two or three years of cost reductions. You can’t just do that by salami-slicing another 5%-10% here and there. Salaries and remuneration are going to have to come down.

And the way that bonuses are determined will also have to change. I think that this is where there’s going to have to be some sort of scorecard method. I’m not an expert in remuneration scales etc but people are going to have to be treated more as advisers and this is going to have to be an input into how they get paid at the end of the year. It’s not going to be: “oh we’re gradually going to try to make you more socially responsible, which will take forever, it’s going to be: ‘you have three sets of objectives and you failed on two of them so you only get a third of your bonus’. That would start to have an impact because fundamentally they are just driven on profits.

Harps Sidhu, KPMG: And we’ll also see a need for – Julian touched on this earlier – real talent management. Previously there was over-reliance on a very clear signalling mechanism once a year to people you wanted to leave and people who you wanted to keep. It was crude but it was key. There was insufficient real buy-in to a culture of individual career development and planning in the context of what kind of long term culture an organisation wanted to create. For the revenue-earners, it was more like a group of entrepreneurs trying to make money under the banner of a brand.

Andrew Goulden - Deloitte

Andrew Goulden - Deloitte

Andrew Goulden, Deloitte: I think the banks are going to have to lose a lot of people. They are going to have to replace them because, as Matthieu said right at the beginning, the skills going forward are going to be very different from what they have been in the past. So in the past you just wanted entrepreneurial types, and the game was: ‘create new products and as long as there is a big margin we don’t give a damn and we’ll work out how we process whatever you’ve sold’.

It’s going to become much more of a Walmart-style of piling them high and selling them cheap. And that is a different skill set. It’s delivering something at a cheap price with good quality control, risk, control etc as opposed to selling something new at a high margin. And I think that’s a lot of change.

Matthieu Lemerle, McKinsey: It’s interesting because you might be able to count on self-selection to help with that, so the pure risk takers who are only motivated by money will naturally self-select out and go to a hedge fund or elsewhere. The problem with that is you still want to keep innovation in the banks because when all’s said and done, there have been very good innovations at the sharp end of capital markets in particular, and in many cases people are very bright and innovative but are also motivated by money.

So there is a kind of balancing act which will have to be found and I am not quite sure how you do that. But you will need on the one hand to self-select people so if you’re just here to take risks and make money maybe the buy side or the shadow banking sector is better for you. But how do we make sure we still have real dynamism in the banks? You don’t want it to be just routine; you want a bit more than that.

IFR Future of Investment Banking Roundtable: Part 3

 

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