IFR Future of Investment Banking Roundtable: Part 3
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IFR: So what does all of this mean for not just bank strategy but for market stratification? Back in 2006, there were probably a dozen and a half banks that had aspirations to be global and multi product and they didn’t see any kind of impediment to that being achieved. Today, we could probably agree that there may be half a dozen firms that can attain or want to attain global bulge bracket status. Where does the rest of the industry stand?
Matthieu Lemerle, McKinsey: I remember a global head of equities of a big firm in 2005/6 telling me he wanted to be top three in cash equities, but there were about eight or nine banks all wanting to be top three. My limited knowledge of mathematics tells me that’s just not sustainable. I really believe that banks are engaged in a cultural revolution, , of changing their objective functions i.e. it’s not revenue, it’s not top three any more. The notion of being bulge-bracket doesn’t really matter any more, or should not matter.
IFR: But have the banks really got that?
Matthieu Lemerle, McKinsey: Well the term bulge bracket is fading away. It’s less and less about that, I’m not sure we are quite there yet but I think that is clearly the direction of travel. To your question, there will be a limited number of banks that will be capable of being global, of deploying vast amounts of balance sheet on different products in different geographies and make good returns.
They tend to be universal banks, by the way, because you need balance sheet, you need funding etc. But there’s a low- to- mid single digit number of players in that category. For everyone else, it’s a bit like rugby: you lead with what you’re good at, and the rest has to follow and quite frankly what’s not good will just stay in the scrum behind.
So you’ll have very few flow monsters, three or four banks. Beyond that, it’s where your client franchise is and what capabilities you have to support it. The trick for many banks will have to be around linkages. What’s blocking that right now is that people say: ‘well I can’t exit this business because it’s linked to that business and this other business is linked’. And before you know it, you have this enormous web where everything is linked to everything and then you can’t move. And to your question on cultural revolution, that’s where bank management struggle. There are genuine linkages but they are limited; selectivity is going to be the key word here.
Julian Wakeham, PwC: I think that’s absolutely right. I mean it is a lazy banker’s observation to say: ‘I have to have the full bundle of products and services’. That’s untested. It’s about precision around really understanding the franchise and the needs of the clients and which of those needs can you service efficiently because the banks still have to make a return. How do you find scale in your model to be efficient to that part of your chosen franchise?
I absolutely agree that being top three around the world is irrelevant. Today, it’s about being number one to your chosen customer. That’s the important message. And to your question: do the bankers get that?. Actually I think they I do, because I hear it more and more. I do definitely get the notion the banks are beginning to understand the way they serve customers.
Steven Lewis, Ernst & Young: Expanding on the client point, we did a survey recently of CFOs and corporate treasurers at a range of global multinational clients asking them what they were looking for from their banks and what they expected to see going forward. What becomes clear is that the idea that your client expects you to be everything and everywhere isn’t true any more.
All of these major organisations – and we’re talking Fortune 100 companies – are multi-banked. Some have in excess of 20 core banks that they use and they will split that up depending on where the banks are based geographically and the types of products and services they are buying. To Julian’s point, they want to buy the best.
If you are not going to be able to be the best at something, then the client probably isn’t going to go to you anyway, particularly if it’s a “change the organisation” activity like M&A. So I think the key thing is to understand who your core customer base is and what they are looking for, and then build the business around that. And clearly there are always going to be elements where you go: ‘OK I don’t make any money on this but the customers expect it’ so a loss leader or a nice to have. But beyond that, in terms of your core product and service lead it has to be driven by where the clients are and what they are looking for.
Andrew Goulden, Deloitte: One of the advantages of the current crisis is capital is scarce so you can’t, as in the past, just add everything on. Each player is going to have to make some choices. These are not simple organisations. They have multiple divisions, apart from their securities or investment banking division, most of them will typically have a global transaction bank, a wealth management arm, an asset management arm and a retail franchise. You can’t expand all of those.
Then you have to overlay the regional aspects; how does growth in North America or Europe compare with growth in the emerging markets? All of this requires focus. So banks are going to have to focus on certain customer segments and on certain businesses.
And they are going to have to make some hard choices. The ones that succeed will make those hard choices and therefore use their capital more efficiently rather than adopting a ‘peanut butter’ strategy of trying to spread the bank budget across all activities for all segments and all products in all regions of the world. The winners that come out of this are the ones that take some very hard choices and focus.
Harps Sidhu, KPMG: To turn it on its head a little, we’ve talked about declining margins, more commoditised businesses, but some of what regulation is doing is focusing more volumes in the hands of fewer institutions. For instance I think there will likely be approximately five key players in OTC clearing due to the costs of running a global platform with a full product suite, combined with the buy side push for fewer counterparties to achieve better cross-margining and netting. I think in any market where you reduce competition, there is likely to be a pricing impact, potentially just from the banks being able to pass on increased costs to clients.
Andrew Goulden, Deloitte: To me that’s just going the way that global custody went. It’s going to come down to actually fairly low margin businesses but with a massive cost of entry, and at some point you’ll end up with three or four players and it will look like that type of model. I think it will end up being a very boring, low margin, relatively risk-free business.
But it will require some massive investment and if you are going to be one of those players you’re going to have to make some choices. The ones that make those choices earlier will be in a better place.
IFR: I wanted to spend a minute or two on FICC. UBS is exiting large parts of the FICC business and there was an expectation that others would follow in short order. Is there an expectation that other banks will decide that being a flow vanilla FICC trader is a mug’s game and will get out?
Matthieu Lemerle, McKinsey: There are two different things here. There is the flow part of FICC and there is what has become uneconomic under Basel 3. What is very clear is most banks have exited or are actively working out the risk-weighted assets which are hit most aggressively by Basel 3.
On the flow part, the question is slightly different. The big question mark right now is one of market structure related to electronification. Starting with the corporate bond market for instance, where the inventory held by the top banks has been reduced by a factor of four, and the number of Cusips and the number of bonds is orders of magnitude greater than what you have in equities because of the individualisation of bonds but it is very, very shallow.
So there are some fundamental market-structure questions about how you actually continue to provide liquidity to a market that tends to be one-way, with very little liquidity in terms of volume but also in time (most bonds trade a few days a year). How do you do that if dealers don’t want to provide inventory?
The immediate question those guys are asking themselves on the flow products is: ‘OK so it’s going to go electronic and because of that we will be able to reduce headcount in the front office’. The problem with the electronic debate is that it’s all about revenues or volume; it’s not about making money and when you start looking at the full P&L of an electronic business in fixed-income. Iit’s not a good story.
And therefore there are some really substantial questions on the flow business which lead to scale; we also talked about central counterparty clearing and collateral management and all those things. It’s a tough business. I think what you are going to have is basically a few players playing all-in in terms of being real flow monsters. We’re talking about maximum four or five players.
Beyond those, it’s going to be more about working backwards from clients and sticking to what you can do because of client intimacy. If, for instance, you do FX hedging with your corporate client base and you have a quasi-captive franchise and can recognise the full net revenue then you will stay there. So people have to be clear about what they can do and why they can do it.
IFR: So do you see a time when investment banks will actually start to route business through to the flow monsters because they can’t compete on pricing?
Matthieu Lemerle, McKinsey: It’s already happening.
Andrew Goulden, Deloitte: Because being a flow monster effectively means you’re looking for automation all the way through so it becomes a cost play around how to build an infrastructure that is massively automated and either 90% off-shored or outsourced. I think your problem today is that yes, several of the big players have it but at the moment no-one has taken the step to create a third party that is not a bank or which is not owned by one of the big players.
If you’re number six, seven or eight, would you want to give all of your trading volumes to one of the three, four or five above you? Everyone tried it in 2000 with that Field of Dreams notion of if you build it they will come. We saw all of the major players try to build these utilities but no-one wanted to go into a utility that was owned by a competitor. So all you got was one or two tiny tier three banks sign up.
So I think it almost requires, whether it’s an Indian outsourcer or whoever, I don’t know but it would need a third party and it would need one or two of the big players [using it] in order then for everyone to have the choice of either staying in the game or using the third party.
Matthieu Lemerle, McKinsey: There are two big questions which come up every three years. One is utility and the other one is: will Europe become a corporate bond-friendly market? And it never happens. But on utility, if it’s going to happen, now is the time because of economic pressure and because you can no longer use the excuse of not letting go because your control has gone when you are not making money. Those barriers have to fall. The economic case is compelling. I mean you can get savings of up to 50% not if you out-source but if you actually give your flow to a genuine utility that concentrates a big chunk of industry volume and can therefore capture the economies of scale.
Julian Wakeham, PwC: Looking at it as a single business is also difficult. It’s understanding the difference between institutional and corporate business and understanding where value is genuinely created and the economics of those businesses because they are very different. Again it’s coming back to the same question: do you understand why you are doing it and the context of your customers and all of the economics of providing that service?
Steven Lewis, Ernst & Young: I think there’s an interesting analogy if you look at the asset management industry and where that’s going in terms of the relationship between the asset manager and the securities services providers, where more and more you are getting to the point where the asset manager makes the decision on what to invest and where but execution right the way through the rest of the life-cycle is done by somebody else, It doesn’t need to be done by the asset manager because their core value, their core skill is not in middle and back-office activity.
A lot of the securities services providers are also asset managers. So I think it’s about a shift in attitude and I think Matthieu is right, if it’s going to happen then now is probably the time it will, otherwise we might lurch back to the point where people will try and protect those elements of the flow business because they either think their customers need them or they think they can make money out of it.
I think from the discussion that we have been having today, we are not sure that’s the case. So I think it just needs that attitude shift.
IFR: Another area I wanted to touch is the half-way house solution that banks like UniCredit and Credit Agricole have come up with i.e. outsourcing EMEA equity sales, trading and research. Is this a viable model?
Harps Sidhu, KPMG: It’s difficult to see the very largest global institutions following suit at this point. I think, however, that this is the sign of a trend that will continue to grow. Those banks that aren’t already in a dominant position in certain asset classes and/or geographies will look to ways to reduce their cost base. Equities is one of the toughest businesses to make money in at the moment and the costs of sales and research in particular used to be a big part of the investment in getting further up the league table. That can’t be the focus any longer, particularly for institutions that don’t already have large market share.
IFR: There has been a lot of talk about the need to change the banking model. But what do you think is actually going to accelerate that?
Andrew Goulden, Deloitte: There are a number of banks today who are looking at operating model-driven change where there are certain leaps of faith needed. I don’t know if it will happen because again, you get into discussions around whether a top five or six player would be willing to outsource a huge chunk of what was considered to be core business to a third party.
The problem is at the moment I think there is no third party. But then again, on the issue of whether banks want to industrialise their operations, historically they’ve have been too siloed anyway so they industrialise within divisions. But basically every tech ops, finance, or risk function you can you can do it as well but much cheaper, right?.
So I think a lot are thinking about going across divisions, figuring out synergy between, say, wealth and the investment bank; between asset management and wealth. At the end of the day, you can just merge asset management and wealth. But in reality, asset management is where you’ve got the most options externally not even to do a lot of the back-office work. There’s a lot of change going on at the moment and I think decisions will be taken on products.
Matthieu Lemerle, McKinsey: It’s happening now but it will take three to five years. It’s started to happen in the middle and back office; the problem is that phase 1 of that has probably reached a bit of a plateau because when you have done wave 1, wave 2, wave 3 and wave 4 of your favourite cost-cutting programmes, you’ve taken out the flowers in the lobby and you go from first to business class to economy class, I mean you’re starting to run out of options, right?
On the cost side, people haven’t really done the thinking to understand it and we’re still in this situation of: ‘on Monday I have a meeting with my IT infrastructure guys and we’re thinking about how to bring things together and take costs out but then on Tuesday I have my guys from compliance and regulation saying here are seven new systems you have three days to implement for US$200m’.
When you move from a growing revenue pool to a shrinking revenue pool, transition economics are very hard. Derivative accounting is a big one which is, you know, you recognise revenues up front but then you have the costs for 30 years. When revenues are going up it’s fine; when they’re going down it’s a disaster. You have the same problem on the transition of payment from cash to multi-year awards. So there will be a transition but it will take three to four years for things to re-stabilise.
But then I think the next big thing, the next frontier, is going to be the front-office which hasn’t really been touched. OK, it’s been touched indirectly in fixed-income through the cleansing of complex products and that leads to thinking about simplification. But there was no notion of product management in banking. So you had a guy who would say: ‘I’m going to do this seven-leg trade in India; fantastic but to do that I need seven books, I need a product controller for five books, so I need two product controllers, oh it’s two people so it’s a team right, so a manager now three and I need a risk guy somewhere to manage us’ so before you know it you’ve created a monster, simply because there is no process in the front-office to gate-keep product management.
The next frontier is in equities where even the very largest players just don’t make money when you start to look at the underlying economics. So they are starting to take a very hard look at the core engine room. IBD is the other one, where particularly in Europe you have this layered cake of country bankers, product bankers, coverage bankers etc all covering the same shrinking pool of fees. That is where now people are starting to look, because again they have no choice.
Julian Wakeham, PwC: I am sure we’ve all read papers about operating models having to change, but it didn’t happen. There was a small uptick in the market and I think basically a lot of organisations dumped a lot of assets into a bad bank, they took 10% out of the remaining core business and thought well we’ll just weather it out because everything is going to go back to normal.
And it hasn’t and I think there is a genuine understanding in the last 12 to 18 months at an executive level that this is a fundamental shift and actually it is not just taking out 10% of costs and placing poor performing assets into a bad bank; structural change is required. I think we are going to see substantial further structural change in the organisations, simplification of models, simplification of reporting lines, de-layering operating models.
IFR: I want to have one final round the table. Given all we’ve said, I’d like to ask each of you to articulate your level of optimism about investment banks’ prospects for success on a 1 to 10 level where 1 is no hope and 10 is slam dunk. And if you’d like, please give a short closing comment.
Andrew Goulden, Deloitte: You would look at quite different numbers for each of the major banks, wouldn’t you? Just looking at the cost-income ratios by division of the IBs and where they have got to get to, there are some banks you would probably put at three and you might put some at seven. Does that mean the average is 5 or 6? I think I’ve got to go north of 5.
IFR: That’s sitting on the fence.
Andrew Goulden, Deloitte: OK in that case, I’ll go with 6.6 but with some banks below five.
Matthieu Lemerle, McKinsey: I would go with eight but with a wide standard deviation. It’s just a boring industry financing the economy so I am boringly optimistic.
Harps Sidhu, KPMG: Acknowledging the wide standard deviation, I would say seven, maybe eight, but I think it’s very much dependent on the swift recognition of the challenges that lie ahead and being bold in making the required decisions quickly and decisively. That means deciding which businesses to be in, where, closing the other ones decisively, and making the needed strategic investments to build a lower-cost, sustainable platform. Only then can an institution start being more on the front foot and start focusing on the right revenue opportunities to achieve an acceptable ROE.
Julian Wakeham, PwC: I think I’d say seven as well at much lower levels of scale and lower levels of return. I support a wide deviation and there will be losers.
Steven Lewis, Ernst & Young: For me, 7.6.
Andrew Goulden, Deloitte: I think it will be a matter of how quickly people get the joke and stop shuffling the deckchairs. There’s a lot out there that’s masking underlying earnings around transition economics and the positive carry people generate via cheap funding. So it’s how quickly people get the joke and address the real issues.
IFR: I make that a fairly bullish consensus of 7.34, although the wide standard deviation is duly noted. Gentlemen: thank you for your very insightful comments.