Analysts Brad Hintz, Luke Montgomery and Anojja Shah of Bernstein Research examine the outlook for capital market banks in general, and Morgan Stanley (NYSE:MS), Goldman Sachs Group Inc (NYSE:GS) in particular.

Goldman Sachs

Tighter regulatory supervision

In their report dated September 16, 2013, they point out that the implosion at Lehman Brothers Holdings Inc Plan Trust (OTCMKTS:LEHMQ) and the financial crisis precipitated a slew of changes in the financial industry, all for the better. Tighter regulatory supervision (the Dodd Frank Act and the Financial Stability Oversight Council), a Federal Reserve with more teeth, revisited ratings for the capital market banks and higher capital adequacy stipulations are just some of the changes afoot.

The impending Volcker Rule is likely to curtail proprietary trading and investments in private equity, and change the landscape for fixed income trading. Meanwhile, banks have managed to improve capital ratios, reduce balance sheet leverage and curtail their dabbling in proprietary trading.  These changes are welcome, but are having a detrimental impact on ROEs at capital market banks, as apparent from the a comparison of Pre- and Post-Crisis ROE at Morgan Stanley (NYSE:MS) and Goldman Sachs Group Inc (NYSE:GS):

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Capital market banks interrelated

More importantly, banks would be faced with the highly complex question of how to reorganize or allocate capital to their businesses in this scenario of lower ROEs. A key point Bernstein makes is that banks’ businesses are extremely inter-related (“multi-faceted client relationships”). How do you discontinue one business without impacting another? “The Street faced a massive multidimensional optimization problem amid dynamic changes in product prices and segment returns,” says the report.

How would this resolve?

In the long run, attrition would probably trigger improvements in pricing. Weaker firms would be weeded out and liquidity would be king – only the larger firms would remain competitive. Efforts to reallocate capital, re-size and optimize business units, and automate execution would also bear fruit—again, probably only at the larger firms.

However, the long-term outlook for those banks left standing is good, on the assumption that capital market growth is highly correlated with economic growth. On this basis, capital market firms could hope to achieve a growth of 7-8 percent over the next five years. That is positive for firms such as Morgan Stanley (NYSE:MS) and Goldman Sachs Group Inc (NYSE:GS).

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Given the above scenario Bernstein have assigned an Outperform Rating to Morgan Stanley (NYSE:MS) and Goldman Sachs Group Inc (NYSE:GS) as follows:

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