Producing a gargantuan report into the prospects for the investment banking industry seems to be the de facto thing to do this year. J.P Morgan’s research team has done so, as has SocGen’s and now German bank Berenberg has produced a 128-page report after initiating coverage of UBS, Credit Suisse and Deutsche Bank.
James Chappell, a former Goldman Sachs banks analyst, joined Berenberg last year and has now penned this report, which suggests that European investment banks are broken, and in need of structural change. Understandably, therefore, it’s not overly positive. Here are some key take aways:
1. Investment banks need to separate, or shrink, but are terrified to do so
Investment banks, as you probably know, have expanded into ‘too big to fail’ behemoths, hard-wired into the financial system and cover as many product areas and asset classes as they possibly can. This is a mistake; the “all things to all people” strategy is paralysing the banks, says Berenberg. In an ideal world, those investment banks that are part of a larger financial group should separate, while others need to focus on their core competencies. Unfortunately, neither of these seems likely.
“They fear that the current environment is cyclical, not structural, and therefore no bank wants to be the first to cut business from its model and risk being left behind. IBs justify this all-encompassing strategy by saying that clients tend to give the majority of their business to their main bank, which consequently needs to offer a comprehensive range of services to capture these revenues, and which leads to a “winner takes all” mentality,” says James Chappell.
2. Revenues will be capped at 2005 levels
Investment banks are facing three major headwinds that are inhibiting growth – too much debt, money/collateral flows slowing down and long-term yields at all time lows. The result, says Berenberg, is that revenues will be stunted at 2005, with the potential to be driven lower by regulation.
3. “Premier League” syndrome means that comp ratios will stay high
All investment banks are battling with the competition in order to make it to the top of the league tables, which are still the main way that banks judge themselves. All banks want to be in the top tier and if they fall down the rankings, this necessitates a need to re-invest in the people to try and claw their way back up again. If one bank increases pay, the others will have to do the same to compete.
“This can also be termed the Premier League syndrome, as England’s Premier League football clubs exhibit similar behaviour in the way they over-pay players in order to maintain their top-league status (relegation renders the clubs’ business models unviable),” says the report. This trend will, however, be restricted to the ‘flow monsters’, which anxiously covert the top spot.
4. Investment banks’ employees have been the main beneficiaries of growth
Yes, bonuses have been slowly declining over the past five years, but as the chart below shows, pay has been expanding too rapidly. “The only thing that the IBs have achieved following their sustained growth over the last 15 years is an outsized wage bill,” says the report.
5. Bonuses should be used as the first ‘buffer’ in the event of a loss
Bonuses should be the first thing to go if a bank incurs a trading loss or (another) fine or scandal, suggests the report, in order bolster capital ratios. If this had been in place in 2007, with five years of variable comp in the pot, capital ratios would have been more than double the reported levels at the time.
6. OTC derivatives reform could hit revenues by 25%
As Dodd-Frank, EMIR and MiFID look to reform the OTC derivatives landscape, investment banks – which rely on derivatives for up to 45% of their FICC revenue – could be hit. “Dealers at the major banks expect: (i) trading volumes to contract and (ii) additional costs for trading (such as clearing connections, platform connections and capital) to be only partially passed on to customers. This will weigh on both revenues and operating margins,” by up to 25%, says the report.
7. There are three options for reducing costs by 30% - none of them are good
As we mentioned, the suggestion is that investment banks are still paying too much for their employees, and Berenberg recommends stripping out costs by up to 30% going forward. The first option for this is to return to the old model – namely, lower fixed costs and the ability to trim bonuses back during lean times. Unfortunately, this would require a first mover, and no investment bank is prepared to make go out on a limb.
Secondly, they could cut more employees than planned in the second half of 2012 (but not enough to ‘materially’ alter their businesses) – this seems the most likely, says the report. It's also already started happening as cuts by Deutsche Bank, Credit Suisse, Citi and Morgan Stanley last week showed..
The other option is to exit certain businesses entirely, which would obviously hit headcount. This is radical, however, and therefore unlikely to happen any time soon, even if Berenberg thinks it necessary.
8. J.P Morgan and Deutsche Bank have the most productive employees
One key way for employees to avoid the axe, rather obviously, is to remain productive. J.P Morgan, Deutsche Bank and Barclays lead the way in this regard, but as Deutsche’s cuts last week demonstrate, this doesn’t always work out.