Tightening the squeeze on investment banks

As regulatory obstacles to investment bank profits kick in, it's becoming clear the sector is set for a vast reshaping.


Across the western world, the public rhetoric about bankers is proving oddly durable. They caused our troubles, but are not sharing them. We suffer privations, they get bonuses.

That is somewhat behind events. Investment banking, at least, is in a slow-motion train wreck. The fact that some bankers are still in the buffet car squabbling over the last bottles of champagne is a distraction.

Among the anecdotal signs, take recent accounts of how Goldman Sachs is seeking to mechanise more of its trading operations. Time was when IT was a hugely expensive plaything for dealers and flash traders. Now, apparently, it is becoming the means whereby they – like others – are thrown out of work.

It is clear by now that the main pressures on the industry are secular rather than cyclical in character. The big investment banks are highly intricate and interdependent. And the more complex an organism, the more vulnerable it is.

One central weakness, of course, is that the banks are caught in the twin jaws of deleveraging. First, they must raise their regulatory capital. Second, lenders increasingly demand that loans to the banks should be secured against their balance sheets. So unsecured borrowing – the base metal of leverage – is more expensive. And simple arithmetic dictates that the less the leverage, the lower the return on equity.

Normally, we should expect the amount to rise in line with gross domestic product.

Other things being equal, it might – from today's meagre levels – do so in coming years. But as an excellent report from Oliver Wyman and Morgan Stanley points out, in 2003-07 leverage pushed it up five to six times faster.

Take that away, and all kinds of things start to unravel. Advisory work on M&A, for instance, is no longer so lucrative. That is true even if acquisitive companies can secure finance from the bond markets and investing institutions.

For the advisory function was mainly a way of hooking the client into fees from funding and hedging, typically worth several times more than the advice itself. And those require capital. Similarly, the dealing function – and here we come to the Goldman example – is sadly shrunk. A reasonable living can be made out of so-called flow trading, which does not involve much capital – but only for a handful of firms that will come to dominate it.

When it comes to the real meat of trading, regulatory obstacles kick in. One is, of course, the Volcker rule. Another is the forcing of derivatives on to exchanges.

The first means that dealers are no longer a source of market information for the firm's proprietary traders. Under the rules, they were never supposed to be. But no one seriously denies they were.

The second squeezes the fat margins from complex custom-built derivatives. Much will remain – the MS/Wyman study reckons that 75 per cent of derivatives volume will go to exchanges, but only 25 per cent of revenues. Even so, this is a risk capital business, and that now ties up expensive equity.

The plight of the analysts is arguably worse again. Here we see the intricacy of the model – and its vulnerability – on full display. The analyst's function is threefold: to attract corporate clients, to increase deal flow and to come up with market-moving ideas from which the dealers can profit in advance. Remove those, and all that remains is the ostensible purpose of research – to advise the investing institutions. The value of that is evident from the fact that the service is provided free.

In any other industry the natural response to all that would be amalgamation, as a means of taking out cost. But since that would worsen the problem of banks being too big to fail, it is not to be hoped for.

In any case, it has long since been clear that size is the problem, not the answer. Some of the boutique investment banks, such as Greenhill, have done rather better than their lumbering opponents in the post-crisis era.

One reason is costs. Citigroup, for instance, spent $5.1 billion on IT last year. That might seem modest beside a wage and bonus bill five times bigger. But in the context of pre-tax profits of $11.1 billion, it is rather more material.

This points not only to a shrinking of the industry, but to a reshaping. On the one hand we will have a handful of very large trading operations, highly mechanised and working on wafer-thin margins.

On the other will be small independent outfits providing specialist advice. We had these in the old days, when they were called merchant banks and brokers.

But the employees of those firms will have to get by on what their advice is worth. That, from the public perspective, may be the biggest change of all.

Copyright The Financial Times Limited 2012.

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