The tide has gone out on the financial services sector but those in it are hardly gasping for breath, write Adele Ferguson and Eric Johnston.
IT'S a sign of the times. Just hours after Macquarie Group this week announced it had slashed 1000 staff and said it was shrinking to greatness, the country's investment bankers turned up to their annual awards bash. But for the bankers once dubbed "Masters of the Universe", this year was different.
The venue was no longer the salubrious Sydney Park Hyatt, most of the "A" team sent their underlings in their place and the usual bragging session was replaced with speculation about which bank would be next to pull the pin.
For attendees from British-based investment bank RBS, the reality was even starker after its local boss, 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 that had been widely expected.
The troubles at RBS and the downsizing of the once dominant Macquarie are symptomatic of a trend in investment banking globally. But the real bloodletting will begin after most banks draw a line under their accounts for the March quarter, which will show the real state of affairs.
But there is little sympathy for an industry that fed on fat bonuses and played such a big role in the abomination of financial markets that led to the GFC and forced governments to spend trillions of dollars in bailouts to stop the system collapsing. Three years on, they are desperately trying to stop the wheels from falling off.
Nobel prize-winning economist Paul Krugman estimated financial services doubled its share of US gross domestic product (GDP), and along with it jobs, in the years leading up to the GFC.
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 jobs will go.
If RBS and Macquarie aren't evidence enough, take a look at the fees in Australian equity capital markets (ECM), which are a key indicator of investment banking activity. In 2011 ECM activity was the worst since 2002. If mining boom equity issues were stripped out, the result was a catastrophe. As an indicator, RBS made $92 million from ECM in 2009, which was a boom year for equity issues, but last year is believed to have made just $14 million.
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 consulting firm McKinsey warned of structural changes in the sector. McKinsey reasoned that, as the huge government support programs put in place around the world at the peak of the financial crisis are withdrawn, markets will accelerate efforts to pay down debt. This will 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 a study titled Investment banking in transition.
The demise of investment banks was predicted in 2008 when Bear Stearns collapsed, Lehmann 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. They 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 corporates raised $90 billion in fresh equity, which lined the pockets of investment banks to the tune of $1 billion. The banks collected a further $200 million in fees from arranging and managing the sale of more than $53 billion in bonds.
So, the main investment banks argue reports of their death have been greatly exaggerated. Even RBS, an offshoot of Royal Bank of Scotland, is determined to retain a stake in the Australian market, despite a retreat from investment banking by its parent.
In January, under intense pressure to cut costs, RBS said it would exit cash equities, capital markets and merger and acquisition businesses. 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 . . . No other decisions have been taken so it would be premature to speculate on the size of the business going forward," an RBS spokeswoman said.
Industry veteran Craig Drummond, the Australian head of Bank of America Merrill Lynch, argues the industry will survive the downturn, although it is likely to emerge on the other side 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)," says Drummond.
Before he joined Merrill Lynch, Drummond ran the local arm of Goldman Sachs.
Deutsche Bank's head of corporate finance, Scott Perkins, acknowledges investments banks are changing the way they do business.
"Yes some fundamental changes are under way more capital and potential lower activity levels arising from global economic uncertainties," Perkins says. "The industry is incredibly resilient. Meanwhile, we try and make our businesses more productive and ensure they are appropriately capitalised."
Swiss-backed UBS said it had a good 2011 in Australia. Deutsche Bank, too, and Merrill Lynch. But the league tables say everyone is feeling the squeeze of fee revenue and that means expenses have to come down.
This week, Macquarie chief executive Nicholas Moore warned of tough times ahead for his bank's traditional powerhouse businesses corporate advisory and securities trading. The securities business is expected to make a loss this year while investment banking profit will be a lot lower than last year.
"We don't know if 2011 is the bottom, 2012 could be the bottom 2013, could be the bottom," Mr Moore said.
Macquarie is not alone. The investment banking unit of UBS this week reported a pre-tax loss of 256 million Swiss francs ($A260.1 million) in the fourth quarter and foreshadowed a 40 per cent cut in its global bonus pool.
Credit Suisse, another Swiss-based investment bank with operations here, this week said it was pushing back the equivalent of $545 million in global bonus payments to avoid falling into a pre-tax loss.
The message is the same throughout the industry, with few bankers in line for bonus payments. Investment banks typically reserve about half of revenue for compensation and bonuses, although total payments vary dramatically depending on a person's ranking. A first-year analyst can get a bonus in the tens of thousands of dollars and a director get several million.
But few outside the industry have much sympathy over the bonus squeeze.
"Some bankers out there are squealing because their bonus is down 70 per cent. Why are they even getting the bonus?" one former director at a large Wall Street investment bank asked.
"Shareholders of investment banks have been kicked up the arse for the last three years with just horrendous returns," he said. But shareholders were now pushing back, prompting banks to cut costs and consider capital returns.
Investment banking won't die, but it is undergoing a deep change and the patient will come out looking radically different. Those that don't have a global footprint or strong balance sheet will die.
Whatever happens, the days of huge salary packages and bonuses have gone forever.
"There is a lot of dislocation, a lot of internal naval 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," Drummond says.
In the meantime, there will be plenty of cutting and not much growth. One Wall Street bank is believed to be considering casting its Australian offshoot adrift in the next 12 months. There is also speculation that two of the biggest investment banks in Australia are considering shedding 200 to 300 jobs each, while offering their services for virtually nothing.
It is not hard to see why. The key sources of investment banking fees, corporate activity and cash equity markets, have either dried up or flatlined.
Drummond, who recently hired high-profile economist Saul Eslake and completed a $550 million debt capital market raising for Computershare in the US, said 2011 was one of the toughest years in his banking career.
"We finished number five in terms of fees," he said. UBS was number one. "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. Drummond believes in three to five years up to 75 per cent of share execution will be electronic, compared with 25 per cent today. "This means lower fees," he said. Lower fees, means lower revenue, which means banks have to cut jobs to retain their all-important revenue-per-head ratio.
One bright spot is the lower fees will stimulate trading volumes. However, Drummond quickly adds it is those players that can afford to make the significant investment in technology that will benefit.
Several fund managers The Age spoke to said they were now running most of their trade through electronic desks, meaning large equities transactions could still be pushed through the market, and at twice the speed and at a fraction of the cost.
There is also pressure from the superannuation industry to lower fees, as they are also being pressured to reduce their 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 it is dominated by high-frequency traders, hedge funds and global long-only institutional investors, which are driving the fees down.
And in corporate land, there are few deals due to a wave of conservatism sweeping the boards of Australia, who would prefer to use excess capital for share buybacks or dividends, as well as the rising power of the ACCC, which is preventing several mergers 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. Which 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," he adds.
The severity of what is going on is a reflection of the size of the excessive credit boom of the decade preceding the GFC. This "infinite" liquidity view of the world encouraged excessive gearing and enormous funding maturity mismatches by financial institutions. On the back of this credit boom the financial services sector expanded hugely around the globe. The bank which grew to the biggest bank in the world by assets and ran the biggest maturity mismatch was RBS, which was ultimately bailed out by the British government to the tune of #45 billion.
The regulators, who turned a blind eye to the practices taking place globally, are now playing tough, planning draconian legislation to keep investment banks in their box. As they do, 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."
Hedge funds are coming up with new products, institutional investors are increasingly trading in dark pools and shadow brokers are growing like topsy. It seems the more things change, the more they stay the same, as the old proverb goes.