Global Capital Markets 2015: Adapting to Digital Advances

As predicted in two previous reports by The Boston Consulting Group, return on equity (ROE) in the capital markets and investment banking (CMIB) industry continued to fall in 2014 from already-low levels. Revenues declined, although costs did not—and leverage constraints increased. Regulation and regionalization made markets even bumpier and more brittle, with quantitative easing exacerbating market dislocations, as observed in the U.S. Treasury market in October 2014.

Long periods of low volatility have been interrupted by extreme spikes, with issuers flooding the primary market and dealers pulling out of capital-intensive businesses such as fixed income, currencies, and commodities (FICC) when the cost of warehousing assets became prohibitive. Negative interest rates in some European countries means that banks will struggle to maintain a positive overall net interest margin. This development, combined with other punitive capital requirements, has made it very difficult for banks to be in the risk capital business. Indeed, many are turning away.

As the capacity for risk absorption is reduced, liquidity dislocations will occur more frequently and to greater degrees. We expect significant asset repricing in the future. Moreover, such fundamental imbalances raise the specter of market risk losses, which would further hinder investment banking performance. Calls to shrink banks or to break up the standard integrated model have become louder as more CMIB business is either carved out, ring-fenced, systematized, or shut down.

For the institutions that remain, of course, reduced capacity should provide an opportunity to boost market share—but the challenging environment in 2014 prevented most from making any significant gains. Indeed, a bigger buy side (although itself under increased pressure from regulators) demands margin reduction in a world increasingly characterized by electronic trading, while higher capital costs and the need for more technology investment are impairing profitability. Banks have seemingly reached an impasse of sorts, with the industry’s cost-to-income ratio (CIR) stubbornly remaining above 70 percent, albeit with wide variation depending on the specific business model. The industry gloom that we have been forecasting for some time is now well and truly upon us.

This year’s report, our fourth annual study of the global CMIB business, emphasizes the digital domain. Our aim is to provide food for thought for senior management teams as they look to transform their organizations into lean, digitally fit, client-centric institutions.

Key Market Developments

Lower revenues, reduced balance-sheet risk, and slow progress on cost-reduction initiatives were themes of the CMIB industry in 2014. But a closer look at each area reveals nuances that may have a significant impact in the future.

Revenues

Global CMIB industry revenues declined once again in 2014 to $239 billion, down 3 percent from $246 billion in 2013 and down 12 percent from $271 billion in 2010, as cyclical and structural headwinds continued to pressure the top line. (See Exhibit 1.) Quantitative easing has depressed interest rates for an extremely long period—dampening volatility, suppressing trade activity, compressing spreads, and narrowing net interest margins.

Some specifics are as follows:

• FICC, which made up 55 percent of all revenues in 2010, has seen its share of the total fall to 49 percent ($117 billion in 2014). Unusual volatility patterns and low client flows have been the primary reasons for poor performance, although structural issues have also plagued the market. High capital costs have affected banks’ ability to warehouse assets as well as to make markets in ultralong derivatives and illiquid corporate credit, for example.

• New regulations that limit proprietary trading, such as the Volcker Rule in the U.S. and ring-fencing in the U.K., will undermine the ability of investment banks to act as market makers in the years ahead. Two extraordinary periods of extreme volatility—the first in October 2014 in U.S. Treasuries, and the second in January 2015 when the Swiss National Bank removed the Swiss franc’s three-year-old cap against the euro—caught some off guard, leading to sizable losses. The introduction of the Dodd-Frank Act in the U.S. is also hurting investment banks, driving volume toward new types of intermediaries such as swap execution facilities (SEFs), introducing less profitable modes of agency execution, allowing alternative market-making entities to gain a toehold, and fragmenting liquidity into regional pools.

• Derivatives regulation is set to come online in Europe over the next two years, further intensifying pressure on the traditional operating model. Several institutions exited the commodities trading business in 2014, continuing an exodus that began two or three years ago, and the few remaining players have gained revenues and market share as a result. But FICC businesses remain prohibitively expensive to run, with high front-office, technology, and operating costs. In foreign exchange (FX), more firms will continue to consider exiting the business or sourcing from other parties such as larger banks, as liquidity in the G-4 currencies becomes further concentrated among the leading firms.

• Stock market highs, solid volume growth, and a resurgence in corporate listings did not provide investment banks with correspondingly strong equity revenues, which declined slightly to $60 billion in 2014 after improving in 2013. Scrutiny of dealer-operated dark pools (private markets) did not help investment banks, as clients directed flow away from these channels. Meanwhile, thanks in part to critics of the U.S. equity market structure, two new alternative trading systems were launched—one designed to thwart the influence of high-frequency trading and the other a buy-side-only dark pool. The CMIB industry will face further headwinds in 2015 as the U.S. Securities and Exchange Commission implements one of the most substantial rules in recent memory—Regulation Systems Compliance and Integrity (Reg SCI), which will attempt to minimize the technology outages that have beset trading markets over the past five years. Depressed volatility hurt the shift toward equity derivatives in 2014, with revenues falling 4 percent to $22.8 billion.

• On a more positive note, primary revenues grew 4 percent to $62 billion in 2014, driven primarily by very strong M&A revenues, which grew 14 percent to $16.5 billion, the strongest growth in five years. We can expect 2015 to be another good year given the cyclical nature of M&A, which tends to follow five-to-seven-year cycles. Equity capital markets (ECM), which included the biggest IPO in history—a $22 billion listing by China’s e-commerce company Alibaba on the New York Stock Exchange—also performed well. Debt capital market (DCM) revenues expanded on previous gains as corporate clients and financial institutions continued to take advantage of the low-interest-rate environment to issue debt, easing fears that cash-rich corporations would stop tapping the debt market.

First-quarter results in 2015 were above historical averages in primary markets and equity and showed strength in FICC. We expect a modest improvement in full-year earnings in these areas compared with 2014. However, overall revenues will continue their post-2010 trend, remaining below the highs of the 2009 government-induced credit and FICC boom. In a best-case scenario, we see the favorable first-quarter conditions persisting, with increases in market volatility translating into higher volumes and revenues across rates, FX, and credit, as well as in emerging markets. If primary-market confidence continues, with a cyclical spike driving origination as well as sales and trading income, industry revenues could reach $256 billion in 2016.

Alternatively, sustained low interest rates and low volatility may continue to impair trading revenues. The fundamental review of the trading book (FRTB) and the ongoing move toward Basel IV may force banks to scale back from derivatives market-making, further damaging FICC revenues. Equity revenues could continue their long-term deterioration, while primary markets may see the issuance boom draw to a natural conclusion. In this more bearish scenario, industry revenues in 2016 could be as low as $210 billion.

Balance Sheets

Banks have primarily responded to the revenue and regulatory challenge by lowering risk. Reducing the size of derivatives portfolios has been a particular focus, given that Basel III imposes a credit valuation adjustment (CVA) charge to address counterparty credit risk. The more punitive treatment of risk-weighted assets (RWA) under Basel III has obscured CMIB balance sheet reduction programs. In 2013, for example, banks reduced RWA significantly—but new standards meant that reported RWA remained more or less the same as in the previous year. Indeed, this was the intent. Banks want neither to reduce RWA excessively for fear of shrinking the bank nor to lag behind new standards, which hurts ROE.

In 2014, RWA showed the most significant increase since 2011. (See Exhibit 2.) This rise, combined with the negative revenue climate and the challenges in cost reduction, caused industry ROE to fall to just 7 percent. The low ROE may have been due in part to the continued “raising of the bar” by the Basel Committee. Alternatively, investment banks may have started to reinvest in less risky RWA in an effort to resize and rescale.

One way or the other, however, investment banks must still reduce RWA to meet new standards. Stress tests, leverage and net-stable-funding ratios, FRTB, and global systemically important financial institution (G-SIFI) capital charges, as well as ring-fencing in the U.K. and intermediate holding company reform in the U.S., will all continue to pressure the balance sheet and, in turn, ROE.

FRTB hits CMIB institutions hardest, imposing stricter internal risk models on derivatives and securitized assets, and further increasing the regulatory capital required. We estimate that FRTB will value today’s current inventory of RWA at an 11 percent premium in 2016, placing additional downward pressure on ROE. We expect investment banks to respond, as in previous years, with balance sheet mitigation programs designed to keep pace with the regulatory agenda. In the absence of any such programs, FRTB would depress ROE to 6 percent in 2016, based on 2014 revenues. In short, with the ongoing regulatory schedule and the move to Basel IV, investment banks will be constrained in their ability to reduce equity as an effective lever for lifting ROE.

Costs

CMIB players continued to make some progress on a number of cost-reduction programs in 2014, with total costs nonetheless remaining fairly flat. (See Exhibit 3.) Compensation costs fell by 4 percent with ongoing staff redundancies and a decrease in average compensation. Non-compensation costs (excluding litigation) have been relatively stable since 2010. But banks are experiencing cost-reduction fatigue, with efforts to reduce head count and compensation stymied by rising litigation expenses, which increased by 11 percent.

The need for major investments in technology in several important markets means that investment banks are faced with stubbornly high CIRs. In cash equities and commodities, for example, CIRs are running dangerously close to 100 percent. Under the additional weight of not only research costs but also high brokerage, clearing, and exchange fees (relative to other asset classes), cash equity profits have been severely eroded, bordering on breakeven in most years.

Indeed, industry operating profits are at historical lows across the board, down 28 percent since 2010 to just $68 billion in 2014. (See Exhibit 4.) ECM, DCM, and M&A are the only bright spots, buoyed by strong issuance thanks to low interest rates. On the other hand, rates trading has suffered the largest decline, falling 64 percent to just $8 billion in 2014, down from $22 billion in 2012.

Ultimately, we do not see this downward ROE trend reversing, and we see ROE remaining below 10 percent unless major restructuring occurs. We also believe that it is no longer possible to be all things to all people. Banks can hold key relationships with some clients and source products as necessary, and they can also maintain a competitive or pole position in other products. But the days of being both a relationship leader and a product leader in multiple products are over.

Indeed, it is better for investment banks to commit to a few product lines in which they can gain the pole position and succeed in today’s scale-driven, electronic, winner-takes-all environment, rather than competing in too many areas and achieving only low, loss-leading market shares.

A Time To Act

ROE in the CMIB industry continues to decrease—and the prospects for improvement are dim, given capital and regulatory pressures. The market is in turmoil and new niche entrants are entering at multiple points along the value chain, attacking the integrated model even as power shifts significantly to the buy side. Revenue growth is elusive, yet it remains a key profitability lever.

As we have said in previous reports, each institution must choose its own path on the basis of its legacy, its particular strengths and weaknesses, and its aspirations—be it to become a powerhouse, advisory specialist, relationship expert, haute couture institution, hedge fund, or utility provider. (See our 2013 report, Global Capital Markets 2013: Survival of the Fittest, and our 2014 report, Global Capital Markets 2014: The Quest for Revenue Growth, for descriptions of these models and their strategic implications.) Each choice presents tall challenges but also great opportunities for the most adept players. But no matter the business model, achieving meaningful revenue growth will require improving client centricity, building stronger client-related analytics, tapping opportunities from adjacent businesses, and attracting and retaining the right kind of talent.

Of course, costs have barely moved, and this problem requires a transformative approach. All firms will need to take drastic action on the cost side, exploring which activities are not differentiated and considering utilities, shared services, and agreements to mutualize costs. Most investment banks have been structured in silos for too long, separated from the rest of the wholesale banking business. We believe that CMIB players must actively seek synergies with other businesses, including lending, transaction banking, asset servicing, and even treasury, in order to unlock new revenue opportunities and optimize operating models, cost bases, and investments. Many banks have already taken meaningful steps down this path and have started to see benefits.

In order for meaningful improvement to occur, however, digital technology must be higher on the senior management agenda. There is a strong need to redesign business and operating models in order to better integrate digital advantages. Moreover, it is critical that investment banks pay attention to and engage with the start-up community, particularly value enhancers and paradigm changers. Banks should designate a separate set of resources to independently define how digital technology can reinforce the best components of the current model, or even reinvent it. Banks must also be proactive in targeting acquisitions and exploring new partnerships that can enhance their digital capabilities.

Ultimately, digital technology must be put in perspective. It can bring both great opportunities and daunting challenges. It can spur new business models as well as help to reduce costs, improve control, and enhance the client experience. It has the power to transform end-to-end processes across IT, operations, finance, risk, compliance, and HR. Yet new digital entrants can take away parts of the value chain and potentially disintermediate the sell side completely.

The main point is that investment banks can no longer avoid embracing the power of the information technology era in which we live. The technology that has forced other industries to completely overhaul their business models is now being brought to bear on the world of investment banking. The time for digital adoption is now.

Acknowledgments

Within The Boston Consulting Group, for their valuable contributions to the conception and development of this report, our special thanks go to the core team of Valeria Bertali and William L’Heveder, as well as Andreas Bohn. In addition, Joe Cassidy, a senior advisor to BCG, and Usman Khan, chief technology officer and cofounder of Algomi, provided valuable insights and assistance.

We would also like to thank the following members of Expand Research: Raza Hussain, Tobias Lee, Damian McCarthy, Marios Tziannaros, and Franck Vialaron.