Dark days for investment banks

It is a sign of the times. Just hours after Macquarie Group announced it had slashed 1000 staff and said it was shrinking to mere greatness, the country's beaten-down investment bankers from a swathe of companies turned up to their annual awards bash.

It is a sign of the times. Just hours after Macquarie Group announced it had slashed 1000 staff and said it was shrinking to mere greatness, the country's beaten-down investment bankers from a swathe of companies turned up to their annual awards bash.

But for an elite once dubbed the masters of the universe, this year was different.

The venue had changed from the previous salubrious Park Hyatt Sydney. Most of the 'A' team sent their underlings in their place and the usual bragging session was replaced by speculation about which bank and which staff would be the next to pull the pin.

For attendees of Britain's investment bank RBS, the reality was even starker after its local head, Steve Williams, told several people he planned to leave following a looming sale of the business, and that staff would be slashed far deeper than the 200 expected.

As the award winners for the year rolled out, the RBS table tried to forget their impending fate, and instead focused on trying to win a table trivia quiz for a case of red wine.

It worked. Williams jumped from his seat, bolted on to the stage, and in an umprompted speech told his peers: "This is likely to be the last award RBS wins in Australia."

The troubles at RBS and the shrinking of the once dominant Macquarie into a Mini Mac are symptomatic of a global trend in investment banking. But the real bloodletting will begin after banks draw a line under their accounts for the March quarter, which will show the true state of affairs.

However, there is little sympathy for an industry that gorged on fat bonuses and played such a big role in the abomination of financial markets that ultimately caused the global financial crisis and forced governments around the world to spend trillions of dollars in bailouts to stop the system from collapsing.

Three years on, they are desperately trying to stop the wheels from falling off.

But it is a battle they will struggle to win. The Nobel prize-winning economist Paul Krugman has estimated financial services doubled its share of the US gross domestic product, and along with it, jobs.

In Britain, financial services trebled its share of GDP, and in Australia it was somewhere in between but had an even greater relative focus on structured finance through Macquarie Group, Babcock & Brown and Allco.

The growth in high-end property prices in Sydney and Melbourne was driven by the growth in jobs and income. These jobs are disappearing and many believe they will halve from their peak. This means thousands more will go in a sector that was once renowned for the millionaires it created.

If RBS and Macquarie are not evidence enough, take a look at the fees earned in Australian equity capital markets (ECM), an important indicator of investment banking activity. Last year, ECM activity was the lowest since 2002.

If mining equity issues are stripped out, the result is shocking. As an indicator, RBS made $92 million from ECM in 2009, a boom year for equity issues, but is believed to have made just $14 million last year .

As one former investment banker said: "It really proves the old adage that you cannot tell who is swimming naked until the tide goes out. It turns out most of us were swimming naked in the ocean of global liquidity."

A recent study into the state of investment banks by the management consulting firm McKinsey warned of structural changes emerging in the sector.

McKinsey reasoned that as the massive government support programs put in place around the world at the peak of the financial crisis were slowly withdrawn, markets would accelerate efforts to pay down debt. This would hurt top-line revenue growth for banks.

"Combine that with regulatory change, and we can expect returns from corporate and investment banking activities to compress dramatically if banks simply resume business as usual," McKinsey said in its study titled Investment Banking in Transition.

The demise of investment banks was predicted in 2008 when Bear Stearns collapsed, Lehman Brothers failed and Merrill Lynch was saved by Bank of America. Even two of the biggest names in the business, Goldman Sachs and Morgan Stanley, were looking shaky as they converted to traditional bank-holding companies.

But those predicting the sector's death got it wrong. It bounced back in 2009, making billions of dollars in underwriting fees after an unprecedented rush by companies to raise equity to strengthen their balance sheets and repay debt.

In Australia, companies raised $90 billion in fresh equity, which lined the pockets of investment banks to the tune of $1 billion. The banks collected an extra $200 million in fees from arranging and managing the sale of more than $53 billion in bonds on global markets.

But many believe the bell is tolling for the industry this time. Not surprisingly, the main investment banks argue their death has been greatly exaggerated.

Even the Australian arm of RBS is determined to retain a stake in the market despite its taxpayer-backed parent making a retreat from investment banking.

In January, under intense pressure to cut costs, RBS said it would make an exit from cash equities, capital markets and the mergers and acquisitions business. A spokeswoman declined to comment on the likely long-term look of the investment bank in Australia.

"A sale process is under way for those exiting businesses and RBS is in discussions with a number of prospective bidders. No other decisions have been taken, therefore it would be premature to speculate on the size of the business going forward," the spokeswoman said.

Craig Drummond, an industry veteran and the Australian head of Bank of America Merrill Lynch, said the industry would survive the downturn, although it was likely to emerge looking a lot different.

"If you think the industry will die, you'd be wrong. It has been speculated before but there will always be a demand for great people with great IP [intellectual property]," he said.

Before joining Merrill Lynch, Drummond ran the local arm of Goldman Sachs.

The head of corporate finance at Deutsche Bank, Scott Perkins, remained hopeful the market would recover, but acknowledged that investments banks were changing the way they did business. Those without a compelling proposition and critical mass would struggle.

"Yes, there are some fundamental changes under way - more capital and potential lower activity levels arising from global economic uncertainties. You have seen these pressures lead to competitors exiting some sizeable elements of their platform," Perkins said.

"The industry is resilient. Meanwhile we try and make our businesses more productive and ensure they are appropriately capitalised."

The Swiss-backed UBS said the previous year was a good one for its Australian operations. So did Deutsche Bank and Merrill Lynch. But the league tables show everyone is feeling the squeeze of fees and revenue, and that means expenses have to come down.

The Macquarie Group chief executive, Nicholas Moore, warned this week of tough times ahead for his investment bank's traditional powerhouse businesses - corporate advisory and securities trading.

The securities business is expected to make a loss this year and investment banking profits will be significantly lower than last year.

"We don't know if 2011 is the bottom, 2012 could be the bottom, 2013 could be the bottom," Moore said.

Macquarie is not alone. This week, the investment banking arm of UBS reported a pretax loss of 256 million Swiss francs ($260 million) in the fourth quarter and foreshadowed a 40 per cent cut in its global bonus pool.

Credit Suisse, which has substantial operations in Australia, said it was pushing back the equivalent of $545 million in global bonus payments to prevent a pretax loss.

The message is the same across the industry, with few bankers in line for the huge bonus payments of the past, if any at all.

Investment banks typically reserve about 50 per cent of revenue for compensation and bonuses, although total payments vary dramatically depending on a person's ranking within the company.

Between a first-year analyst and a director, the bonus paid can range from tens of thousands of dollars to several million.

But few outside the industry are likely to have much sympathy over the bonus squeeze.

"Frankly, this is some of their own making because there are some bankers out there squealing because their bonus is down 70 per cent. Why are they even getting the bonus?" a former director at a large Wall Street investment bank said.

"Shareholders of investment banks have been kicked up the arse for the last three years with just horrendous returns." They were now pushing back, prompting banks to cut costs and consider capital returns.

Investment banking will not die, but it is undergoing a deep structural change. The patient, in need of liposuction and other nips and tucks, will come out looking radically different. Those that do not have a global footprint or strong balance sheet will be euthanised or put out to pasture. And the days of huge salary packages and bonuses are gone.

"They won't come back," Drummond said. "There is a lot of dislocation, a lot of internal navel-gazing going on and that is often the best time to build new relationships in the business. A clean-out of any industry is never a bad thing."

In the meantime, there will be plenty of cutting and not much growth. One Wall Street bank is thought to be considering casting its Australian offshoot adrift, and there is also speculation that two of the biggest investment banks in Australia are planning to shed 200 to 300 jobs each, while offering their services for virtually nothing.

It is not hard to find the reasons for this. The main sources of investment banking fees - corporate activity and cash equity markets - have either dried up or flatlined.

Drummond, who recently hired the economist Saul Eslake and completed a $550 million capital market debt raising for Computershare in the US, said last year was one of the toughest years in his banking career.

"We finished No.5 in terms of fees," he said.

"There is significant structural change going on and if you aren't global, I'm not sure how you can compete in the securities business."

The brutal reality is equities are moving further into the realms of technology with the electronification of the equities market, or so-called high-frequency traders and algorithmic trading, the computer programs that punt the market.

Drummond believes up to 75 per cent of share execution will be electronic within three to five years, compared with 25 per cent now. "This means lower fees," he said. This translates into lower revenue, which means banks have to cut costs to retain their all important revenue-per-head ratio.

One bright spot is that lower fees will stimulate trading volumes. However, Drummond said companies that could afford to make the significant investment in technology would benefit.

Several fund managers Weekend Business spoke to said they were now switching to electronic desks to run most of their trades. This meant large equities transactions could still be pushed through the market at twice the speed for a fraction of the cost.

There is also pressure from the superannuation industry to lower fees, as it is in turn being pressured to reduce commissions. And there is a change in the mix of investors dominating the market.

A few years ago, the market was dominated by historically long-only institutions today you have high-frequency traders, hedge funds and global long-only institutional investors driving the fees down.

And in corporate land, there are few deals thanks to a wave of conservatism, with boards preferring to use excess capital for share buybacks or dividends, as well as the growing power of the Australian Competition and Consumer Commission, which is preventing many mergers from taking place in an already concentrated market.

Added to the mix is the growing trend for dual advisers on deals, which means fees are being divided among many.

For instance, the $11 billion Foster's takeover by SABMiller had up to five investment banks involved in the deal.

Drummond says Australian companies have never been better capitalised, but there is little need for equity. This means less revenue from equity capital markets for banks.

"Boards have become cautious and less likely to entertain major transactions, so activity is slow," he said. "But it will pick up."

The severity of what is going on is a reflection of the size of the excessive credit boom of the decade preceding the global financial crisis.

As one former investment banker said: "The financial services boom we saw in Australia was driven by the illusion of cheap credit. It turns out all of the financial structuring and leverage tricks we were all playing was totally dependent on the "endless river of liquidity" promoted initially by Alan Greenspan.

"Babcocks and Allco have gone, Macquarie is shrinking dramatically. While we felt like masters of the universe we were actually nothing special and riding on the back of massive global credit growth."

The regulators, who had turned a blind eye to the practices taking place globally, are now playing tough, planning draconian legislation to keep investment banks in check.

As they do so, new pockets of shadow banking are emerging, with hedge funds thriving. Jokes are starting to creep back.

"We are like goldfish," Jon Macintosh, a Mayfair hedge fund manager, is quoted as saying. "We swim once around our bowl and when we complete the circle everything looks new."

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