Rewriting the rulebook
Despite the various challenges still facing the investment banking market, and the ongoing proliferation of regulation, 2015 has so far been a surprisingly good year. More prosperous times may well lie ahead
Since the 2008 financial crisis, a variety of regulatory initiatives have been introduced to improve the areas that enabled such grand-scale errors to take place. Consequently, a more robust and safe financial system has been created. During this development period, the investment banking sector has struggled more than other areas of banking. In the US, for example, the biggest investment banks are still grappling with the Federal Reserve’s low interest rates, in which savers are paid little for their deposits and low interest is earned from borrowers. Consequently, markets are squeezed and aggravated further by capital charges applied to lending, and in some cases on actual deposits. However, that being said, there are numerous positive indications for the industry this year.
Click to enlargeYes, regulations have taken their toll on fixed-income products, as have more arduous capital requirements and declining customer demands, but all-in-all, there has been a transformation in the landscape of the industry, creating a system that is more efficient and reliable; a new system is taking shape that is arguably superior to what existed prior to the crisis.
Some banks, for example Morgan Stanley and UBS, have reduced their investment banking activities to focus on other areas, such as wealth management. On the other hand, some firms have bolstered their operations in investment banking, while a small amount have left their previous business models intact. Investment banks are thus at different stages of their strategic realignment, but for all players, the process is far from complete. Those enforcing drastic changes to their business models face a sizeable challenge ahead, as they do so over various platforms, countries and continents. The execution of new strategies requires careful planning and close monitoring if institutions are to thrive in the new environment.
Equity market boom
Through the decade-long period of transition that investment banks are undergoing, the average return on equity has fallen from between 15 to 25 percent to levels that are currently below 10 percent. This drop is partnered with profits that are no longer as famously high as they were prior to 2007. Yet, following this long, drawn-out decline, and in spite of macroeconomic conditions still affecting confidence levels and risk appetite in general, it seems that equity turnover is finally bottoming out in 2015. Even though the industry’s return on equity is still underperforming, the global equity market has had a spectacular first quarter this year. According to Thomson Reuters, more than $242bn has been raised through IPOs and follow-on offerings in Q1 2015 – a record for the period (see Fig. 1). Modest growth is expected to continue in the US for 2015, while in Europe the scene is slightly more precarious due to deflationary pressure and a weaker equity capital market, despite low volatility. The outlook for equity revenue for Asian markets is robust, but faces its own challenges, namely, increasing tail risk.
Click to enlargeAfter years of decline, the M&A cycle began improving last year and has continued to strengthen through the course of this year too. Following the last slump, the latest boom is driven by a trend for efficiency and cost-reduction efforts in order to overcome flat sales and stagnant consumer prices. The first quarter of 2015 has been the best since 2007 for announced deals, totalling $854bn in deals declared and $667bn in deals completed (see Fig. 2). Large cash balances in the US and the deployment of corporate balance sheets are continuing to drive M&A activity, with technology, healthcare and energy sectors in particular showing large gains (see Fig. 3). Stronger M&A activity can also be expected in Europe, given the positive impact of QE on the region’s economic growth and asset prices.
In spite of this positive trend, fees currently remain sluggish. In the Americas, fees in the first quarter of this year totalled $11.5bn, remaining flat from the first quarter of 2014. Those in Europe decreased by 14 percent, while fees in Asia-Pacific fell by 18 percent, and in Japan by 28 percent. The Middle East and Africa region, on the other hand, saw an increase of 18 percent from the same period last year.
Click to enlargeTime for reform
One of the most notable trends for the market in 2015, which has resulted from new regulations and QE, is the shift in liquidity risk to the buy-side, coupled with the deterioration of sell-side markets. It appears that a greater tendency towards offering more risk management solutions is set to continue this year, particularly as the capacity of investment banks shrinks due to regulatory pressures. Nonetheless, the disturbance to the industry caused by more strict regulations appears to be easing in 2015 – as are litigation pressures.
According to Accenture, other reforms to the investment banking sector include increased capital constraints, which have arisen from a new, in-depth focus on capital. Consequently, it is essential for banks to continue their efforts to become far more efficient in terms of their capital allocation. As some asset and product types are struggling to produce profit-making margins, banks are reverting to risk-weighted assets as a measure of business performance.
Click to enlargeAnother change to the market is the increasing rate of commoditisation as a consequence of new technology, which has been further advanced by regulatory rules that see margins collapsing at the same time that investment in new technology is needed. This may lead to greater standardisation across the board over the coming years, as many clients decline higher payments for bespoke products and services.
Currently, extreme regulatory oversight is inflating the cost of compliance through more financial taxes and the need to hire specialised personnel. Although transforming the regulatory framework is expensive and radical in terms of its impact on individual firms and banking culture in general, it is a necessary aspect of the sector’s maturity and should not be overlooked. Furthermore, it is also essential for banks to understand and comply with the regional disparities in regulations as the industry maintains its course for global alignment.
The future of investment banking is an integrated global marketplace. When this point is reached, banks must be in a position to offer their clients both region-wide and global-scale opportunities, while also providing 24-hour trading capabilities. The possibilities for the industry are endless given this worldwide vision, which is in closer reach than ever before. The financial crisis may have highlighted flaws in the system and set it back in terms of growth, but from its former errors and weaknesses, a stronger and more developed sector is now rising (see Fig. 4). On the following pages, we highlight the best investment banking organisations around.
