Shrinking margins and higher costs drive down returns

There are gathering storm clouds over some banks Keystone

Banks are already cutting jobs but may have to alter their business models permanently to counter growing disruption.

Disruption: it might sound like a hollow buzzword but it has become far too real for the investment banking industry.

Executives are being forced to rethink, redesign and shrink their trading operations in the face of much tougher regulatory requirements and against a backdrop of revenue declines and cost pressures.

Investment banks have not only had to comply with stricter capital rules, and deal with much higher compliance and information technology costs, they have also seen high-margin complex products make way for simpler less profitable instruments.

As a consequence, most banks are continuing to cut jobs, many are pulling out of trading certain assets and some are outsourcing whole areas or teaming up with others.

Colin Fan, co-head of Deutsche Bank’s investment bank said in an interview with the FT in October: “The old FIC business model didn’t work anymore,” referring to the business of trading fixed income and currencies products.

“In fact you could even go back to the pre-crisis heydays, take whatever earnings and revenues you like, but if you added the cost and capital of new regulation, it still wouldn’t work.”

One of the key changes has been that stricter capital rules prevent investment banks from relying on high leverage to boost their returns. This was one of the main factors driving down returns in the past few years.

Return on equity for European lenders’ investment banking divisions has halved from 21-25% pre-crisis to 10-12% last year, according to a Barclays report called RoE Challenges published in January.

“The nature of the problem is fairly straightforward. Capital requirements have doubled over the past few years relative to the volume of business. Meanwhile, to date, there has been no material evidence of structural adjustment in either pricing or in costs,” the report says.

Bond trading – traditionally investment banks’ main profit engine – has been hit particularly hard amid the low interest rate environment, depressed volatility and a drive towards simpler and centrally cleared products. While equities trading has recently staged a comeback, it has not been sufficient to compensate for the weakness in fixed income trading.

One of the primary areas banks have been looking to make savings is in headcount. In Europe, for example, Deutsche Bank, Société Générale and Crédit Agricole have reduced the number of employees in their investment bank divisions by up to 30 per cent, according to Barclays. Bonuses have also been slashed, and there has been a decrease in average pay per head.

Many investment banks are also shutting down business lines that prove too costly and capital-intensive or that – in the case of proprietary trading – conflict with the new regulatory regime.

UBS, the Swiss bank, is a prime example. Two years ago, it decided to close a sizeable part of its fixed income business, cutting many thousands of jobs in the process.

Barclays this year embarked on a similar strategy. It slashed thousands of investment banking jobs and withdrew from large parts of its bond, currencies and commodities trading business by moving more than half of the trading arm’s assets into a new “bad bank”.

Banks are also routing more and more business through electronic channels. The prime examples for this trend are the bonds and currencies businesses, which are rapidly becoming more like equities trading, where transactions are executed electronically for a fee instead of banks acting as market makers and charging a spread for the risks they take.

But while bank executives have spent many hours seeking ways to bring down costs, they are running to stand still. Cost-income ratios, which show how much money a bank spends for every dollar it earns, were stuck at 77% last year, the same level as in 2011 according to data from the Boston Consulting Group.

The cost cuts have simply not been enough to compensate for falling revenues and a rise in expenditure for compliance, information technology investments and, in some cases, fines for misdemeanours.

For some, the response to these challenges has been far too moderate. They say banks need to counter the disruption to their business models with equally radical strategies that would see them rid themselves of a legacy structure in which each bank has its own IT department, trading platform and back office infrastructure.

“The end game may see firms merging FICC [fixed income, currencies and commodities] and equities franchises to create execution factories,” consultants at McKinsey argued in a report called The Return of Strategy, published at the end of last year. 

Copyright The Financial Times Limited 2014