Seven years on from the start of the financial crisis, many investment banks are still lost in the fog, casting around for a viable business model. With regulatory pressures continuing to mount, and operating costs getting ever higher, can the industry find a workable way through the gloom?

On October 8, Deutsche Bank gave warning that it expected a €6bn loss for the third quarter of 2015. It attributed the vast majority of this shock figure to an unexpected rise in capital requirements for its investment bank, the biggest such business in Europe.

Having expected to report profits of about $1bn, the announcement is a stunning reverse for the bank, and further sign that, seven years after the onset of the financial crisis, there are still serious problems within the investment banking sector. Many participants are still searching for a viable business model, and significant challenges remain.

New standards

In the wake of the financial crisis, regulators at international and local levels have established a vast array of new standards for the banking industry, many aimed at the activities undertaken by the investment banks. Capital ratios have been significantly increased across the board, and specific new capital charges have been set up to better reflect the risk of trading in derivatives and other complex financial instruments. Derivatives trading has, in general, become much more consumptive of risk-weighted assets (RWAs), which capital ratio calculations are based upon. Two new liquidity ratios have been introduced to make bank funding models more resilient, alongside a 3% leverage ratio that will act as a risk-blind safety net across all banking activities.

Extensive structural change has also been made to the trading markets that form the backbone of most investment banks’ activities. Central clearing has been introduced for all standardised, over-the-counter (OTC) derivatives, ostensibly making that market safer, but also increasing the monetary and logistical costs of participating in it and continuing to offer solid OTC liquidity for buy-side clients.

Reduce or restructure? 

  • UBS Axed fixed-income trading, cut 10,000 investment bank jobs and concentrated efforts on wealth management.
  • Société Générale Separated its foreign exchange trading into an agency desk model with acquisition of brokerage firm Newedge.
  • BNP Paribas Created an investment banking-focused ‘global markets team’ within its corporate and institutional banking business. Moving towards a completely cross-asset platform for clients.
  • RBS Currently reducing its investment banking activities to a negligible part of overall banking group due to unsustainable costs.
  • Deutsche Bank In the process of exiting from credit default swap markets. Has merged fixed-income and equities trading into a cross-asset framework. Recently announced large quarterly losses due to higher capital requirements for its investment bank.
  • Nomura Has attempted a series of cross-asset projects for its fixed-income and equities businesses. Now cutting back on fixed-income staff levels in its London trading rooms.

In addition, the increasing role of non-bank trading platforms in the derivatives markets, fostered by regulators through the advent of swap execution facilities in the US and similar processes in Europe and Asia, further threatens banks’ dominant market-making position in derivatives by ‘democratising’ the bid-ask process and opening the door to non-bank liquidity providers. The non-trading, advisory-led investment banking services, such as bond issuance, initial purchase offerings and mergers and acquisitions, are still profitable, but smaller, boutique investment banks are eyeing up these areas in an attempt to steal a march on larger rivals distracted by other concerns.

Many of these regulatory changes have been necessary, a welcome leash on the wilder side of the banking world. However, their cumulative effect has plunged the investment banking sector into a state of flux.

“Some banks are pulling back from certain markets, other banks have pulled out from certain business lines entirely. At some point, we need to think about where this will leave the industry when it comes to serving the real economy,” says Scott O’Malia, chief executive officer of the International Swaps and Derivatives Association, a representative body for dealer banks and their clients. “Banks are still evaluating where they put their resources in light of the capital charges, many of which are still to be phased in over the coming years,” he adds.

Participants are scrabbling to find a new model of business that still serves clients effectively, but that can also cope with massive new cost pressures and capital requirements. The key question for the architects of these plans is whether changes and challenges will keep coming thick and fast for investment banks, or whether the current period of instability is likely to give way to calmer waters soon. Is designing a new, secure path for investment banking even possible at the moment?

Giving up?

Some banks seem to have given up the ghost already. At the Royal Bank of Scotland, the past three or four years have been punctuated by the closure or sale of portions of its trading business. The bank announced the sale of its retail structured products and equity derivatives businesses to BNP Paribas in June 2013, exited the swaps clearing business in May 2014, and announced plans to wind down its core fixed-income trading activities in Asia in December 2014. At the end of July this year, it announced that its entire investment banking presence would be wound down over the next two to three years to become an insignificant part of the overall group profile.

Saddled as it was by a rash of bad assets in the aftermath of the financial crisis, and under strong political pressure to rein in costs and get back to full health, the RBS investment bank was an obvious target for cost-cutters at the firm.

UBS, on the other hand, made some big decisions for its investment bank much earlier. In an effort to return to its private banking roots and control its mounting RWA pile, in October 2012 it shut up shop on its fixed-income market-making business, axing 10,000 jobs in the process. It has stepped back from market-making on a number of fronts, and poured resources into non-investment bank business lines, such as its wealth management operations.

Stepping back

While other banks may not have subjected their investment arms to such intensive surgery, many have had to limit their horizons and step back from a ‘full-service’ offering. Far in advance of the latest dire earnings announcement, Deutsche Bank scaled down its credit default swap (CDS) portfolio at the end of 2014, selling $250bn-worth of single-name CDS notional to Citi.

In fact, the slow decline of the CDS market, which has lost more than two-thirds of its notional value since the financial crisis, encapsulates the problems affecting the trading side of investment banking. CDS margins have been squeezed by capital hikes, and then squeezed further by the prospect of mandatory clearing and other logistical changes to the trading process. Add in the low volatility of the past few years, which makes it less necessary for buy-side clients to hedge credit risk, and the CDS market has withered on the vine.

“Large investment houses will always have to examine the worth of businesses that they participate in. That process is now a permanent feature of our sector. It may be that the CDS market is not the only casualty going forward,” says one senior banker at a major US investment bank.

Fixed income generally forms the largest asset class on an investment bank’s trading book, and while most of the larger players still run a market-making service for these instruments, the product range has shrunk somewhat. Thanks to the Basel III credit valuation adjustment (CVA), a capital requirement that reflects the credit risk taken on by the bank, interest rate swaps with tenors running into the decades have become much less common, as CVA costs are compounded by longer maturities. Clients needing to hedge long-dated exposures, such as pension funds or life insurers, are instead required to roll shorter term hedges, which can be more time consuming and costly.    

Cross-asset approach

Deutsche Bank, along with some of its competitors, has in fact merged its credit and fixed-income trading desks in a bid to lower costs. This cross-asset approach is becoming increasingly common – it allows for a more ‘product neutral’ strategy, which bankers say helps clients find the right solution without first having to talk to a set of entirely siloed trading desks. Happily for bankers, it also reduces expenditure by cutting down on defunct trading systems and excess personnel. Furthermore, it allows banks to cut away some of the complex, resource-intensive products that require support from large numbers of specialists in the front and back office.

“Front-office costs may grab the headlines, but a key focus for banks at the moment is cutting down on back-office costs. In the past few years, many banks have discovered that back-office functions contain a vast web of different payments systems and compliance systems that create big operational and maintenance costs. Many of these systems do exactly the same jobs, so distilling these down to the essentials can offer big savings,” says Kevin McPartland, head of market structure and technology at US advisory firm Greenwich Associates.

The cross-asset process is much more heavily tilted towards advisory services, with teams of salespeople filtering clients down to the right product or area of the business. At BNP Paribas, the end goal is a single platform where clients can view the entire product range on offer and choose what they wish, with input from the bank’s salesforce. A lighter, more automated service is what the firm has in mind. In BNP Paribas’ view, banks must ‘industrialise’ their processes and focus on the mass production of simple products that can be traded electronically, rather than over the phone.

This picture of investment bankers as production line managers, rather than risk takers, or the suppliers of complex products, is far removed from the industry’s traditional approach to trading and client interaction. But, as dealers’ ability to warehouse is further and further reduced, other methods must be explored to keep clients happy.

The cross-asset approach has not worked smoothly for everyone, though. Nomura pushed ahead in this direction in March 2011 with regard to its equities and fixed-income businesses. It then scrapped this cross-asset venture in January 2012 and revived it in December 2012. In August this year, after posting a second-quarter loss of Y9.7bn ($82m) in Europe, it cut about 60 jobs on its fixed-income desk.  

Trouble ahead

If the industry had its way, these new-model investment banks would now be given time to bed in and test themselves in a stable environment. Any further tinkering could be done in a more relaxed setting, without the desperate need to keep cutting costs and rejigging internal structures in the face of more challenges.

“The big question is how much of the change we’ve seen is permanent, and how much is cyclical. We’re seeing unprecedented regulatory and economic change at the same time. It’s hard to weed out the different effects that each is having on investment banks,” says Mr McPartland at Greenwich Associates.

As far as the economic conditions are concerned, investment banks find themselves in an odd position at the moment. The low-interest-rate environment has eased concerns over funding, as it has been relatively easy to secure cheap, long-term financing through bonds or equity releases. This has been a huge boon for many firms, particularly those in Europe that needed to boost capital levels quickly after the crisis.

On the other hand, low rates have meant a virtually unprecedented period of low volatility, particularly in fixed income and foreign exchange. This trend has been jolted by the occasional crisis in Greece or elsewhere, but overall the markets have been becalmed. Low volatility has produced low trading volumes – according to the Bank for International Settlements, the gross market value of outstanding OTC derivatives has fallen from $25,000bn at the end of 2012 to $17,000bn by the middle of 2014. This has depressed trading revenues, making it ever harder to justify the capital costs of running a large, market-making investment bank.

Revenue performance this year has been particularly poor. Up until October, only one of the top 10 best-performing investment banks had seen an improvement on the figures for the same period in 2014 (see table). Globally, investment bank revenues are down 11% to $58.5bn. On a regional level, total revenue has fallen by just 1% in the US, but by 27% in Europe.

The effect of a rise in interest rates, which is likely to come soon from the US Federal Reserve and the Bank of England, is hard to quantify. Funding may be more expensive, but trading activity should get a boost from even a modest rate increase, as clients look to hedge against additional volatility.

Permanent change

On the regulatory side, most of the demands placed on the industry are now permanent. Indeed, many of them are going to get more stringent. Banks have known for a long time that under the Basel III standards they will have to build a core Tier 1 capital buffer (mostly met with common equity) of 4.5% of RWAs by 2019. Large, systemically important banks will also have to build an extra capital buffer, though the size of this is likely to change from jurisdiction to jurisdiction. All told, Basel III’s minimum total capital requirement by 2019 will be 8%, not including a 2.5% ‘capital conservation buffer’. Most of the major investment banks are there or thereabouts already, and many have gone to great lengths to cut RWAs.

The battle is not won yet, though. The total loss absorbency capacity proposals recently released by the Financial Stability Board recommend a minimum capital ratio of between 16% to 20% for globally systemically important banks, a definition that would almost certainly include all the major investment banks. This is far above the 8% minimum required by Basel III. Dealers fear that such a precipitous increase would force them to pull back from even more markets.

There are further hurdles to jump when it comes to Basel’s two new liquidity standards, the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR), which are designed to make banks’ short- and long-term funding profiles more secure. The LCR is currently at the implementation stage, though the NSFR will not be in force until 2018 at the earliest. A recent Basel Committee study found that of the top 50 banks in the world, the so-called ‘Group 1’ banks, only 60% were in full compliance with the current NSFR standards as of December 2014. The committee calculated that, in total, the 300 or so banks included in the assessment would have to find €523bn of extra stable funding by 2019 to meet the requirement.

Though the public ire generated by the financial crisis has abated somewhat, the industry is still vulnerable to political decisions. In September, Swiss legislators approved proposals that would see the leverage ratio requirement for its two biggest banks, UBS and Credit Suisse, jump to 6%, double the minimum standard agreed by the Basel Committee.

In or out of house?

There will be beneficiaries of the changing investment banking world. Just as banks can no longer offer every product in every market, they can no longer build every IT system and compliance procedure in house.

“Banks can buy so much good stuff off the shelf from third-party providers, which is easier to manage and cheaper than constructing everything themselves,” says Mr McPartland. “This route is especially attractive for non-differentiating functions. Everybody needs to clear and settle trades, for instance. You’re not going to win business by being above a certain standard in this area, so why do that in house? It makes more sense to seek out an external provider who can keep track of regulatory changes and make the necessary adjustments to the systems. It’s too time consuming for a bank to do all that itself.”

However, Christian Meissner, head of global corporate and investment banking at Bank of America Merrill Lynch (BAML), believes that most investment bank functions are too important to contract out to an external party, whatever the cost implications. “With our clients at the centre of all we do, our approach is to provide integrated, end-to-end services for clients under one roof,” he says.

If cost pressures become even stronger, banks may end up moving toward an ‘agency desk’ trading model, which essentially involves banks recusing themselves from trading with their own principal at stake and becoming more like brokerage firms, connecting clients who wish to trade but without taking any actual risk themselves. Société Générale has already gone down this road in foreign exchange with its acquisition of global broking firm Newedge in May 2014.  

There are concerns that an escalation of this trend would damage liquidity in the markets, as banks would be less able to act as market-makers during times of stress. However, it is a door that is being kept open at many banks. “We have to constantly evaluate our way of doing business and keep all options on the table, even ones such as agency desk trading that seem far removed from traditional investment banking methods,” says Pascal Fischer, head of global markets at BNP Paribas. “The industry can’t sit back and expect that the way things work now will still work in the future.”

The American moment?

The outlook for investment banking might not be particularly cheery, but there is optimism out there. Mr Meissner at BAML believes that the conditions are favourable for investment banking on his side of the Atlantic. “I think we might be about to see an ‘American moment’ for investment banking. The major American players have constructed healthy balance sheets and put together durable business models. I think we’ll see that work rewarded over the next few years.”

Looking at the figures, it is hard to argue with this view. The recent decline in investment banking revenues has been far less severe in the US than in Europe. All of the top five investment banks by revenue and market share are from the US, as are six of the top 10. As Mr Meissner says, US legislators and regulators got started early on changes to bank safety and market structure, mainly through the Dodd-Frank Act.

Consequently, US banks have a much clearer view of their regulatory responsibilities than their European peers, who are still waiting for legislation such as the European Markets Infrastructure Regulation and the Markets in Financial Instruments Directive to be implemented. European banks have also been slower to deal with the bad asset hangover from the financial crisis and, as can be seen from their various different internal restructuring efforts, many are still stuck in a kind of existential crisis.

However, European regulators may be about to give their banks a shot in the arm. At the end of September, Lord Hill, in charge of financial regulation at the European Commission, stated that in support of the planned capital markets union, banks within the EU could provide evidence of ‘unnecessary regulatory burdens’ and other ‘unintended consequences’ of the current prudential rules. The overall aim is to free up capital markets activity and make the EU more like the US, where more economic activity is funded through debt and equity issuance rather than bank lending.

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