Investment Banks: From The Ashes Rebuilding A Challenged Industry by EY
The industry’s current approach to change is tactical and piecemeal. It is not enough to rebuild the industry.
Investment banking is an industry in turmoil: it faces an efficiency and productivity crisis, with low ROEs, rising costs and stagnant revenues. It faces a cultural crisis, with little evidence banks have taken all the necessary steps to address controls issues and change employee behaviors to prevent future charges of misconduct. It faces a crisis of trust, with claims that banks have put their profits before the needs of their customers.
A raft of incremental change programs has done little to address these issues, and investment banks are a long way from solving the complex array of challenges they face. To do so, they will have to be more strategic and sharply focused on transforming their business.
The boost to industry ROEs in the first half of 2015 — a result of temporarily increased market volatility and quantitative easing by the European Central Bank — may prove short-lived. In fact, ROEs may fall further still, with regulatory pressures driving up costs and little prospect of sustained revenue growth. At the same time, competition is intensifying as commoditization and technological advances open the market to new, more nimble institutions able to deliver better service to clients that are now less loyal, more demanding and more sensitive to price.
By focusing on the four pillars of change, the leading investment banks of tomorrow will be:
- Efficient — with industry-leading costefficiency and productivity levels and optimized use of capital, liquidity and leverage
- In control — minimizing fines and losses, with leading compliance and risk capabilities
- Trusted — with a reputation for exemplary conduct and putting clients first
- Digital — with improved client technology and more digitalized processes, enabling superior service levels to win new clients, and increasing the profitability of existing clients
Only by adopting a more transformative approach will it be possible for the industry to thrive once again.
We believe the industry should be able to achieve sustainable returns on equity of 12% to 15%, but delivering this will require an unremitting focus on transforming existing business and operating models, focusing on four pillars of change:
- Optimize — both assets and operations — by better utilizing balance sheets and radically reducing costs
- Transform culture — by providing incentives for the behaviors that will deliver value for shareholders and clients while meeting regulatory expectations
- Become client-centric — moving away from product-centric approaches by putting the client at the heart of business and operating models
- Be technology-led — embracing innovation that will enable the transformation of legacy processes, re-architecting to support business model change and enabling a central focus on clients
From the ashes Rebuilding a challenged industry
Achieving 15% ROE through cost reduction or revenue growth alone is virtually impossible. Banks would need to:
- Reduce their costs by around 34% if there is no increase in revenues
- Boost their revenue by around 24% if there is no reduction in costs
- Simultaneously cut costs by around 15% and grow revenues by around 10%
Achieving 15% ROE through cost reduction or revenue growth alone is virtually impossible.
The halcyon days of investment banking are over
The days of leverage-inflated, 20%-plus returns on equity are long gone [see Figure 2]. The once-lofty ambitions of management teams to deliver ROEs in excess of 15% have been moderated considerably. In some instances, banks are now targeting a 10% ROE — barely above their cost of equity. In others, banks have moved to a softer return on tangible common equity (ROTCE) measure.
Profitability is being destroyed
The commoditization and the move of many products to exchange trading are squeezing margins, while complex, highmargin products are falling out of favor and proprietary trading has diminished. Although investment banking revenues have stabilized around pre-crisis levels, a return to a more normal macroeconomic environment may see a further drop in revenues in business lines that have benefited from the extraordinary monetary policies of major central banks. Moreover, there is limited scope for growing new revenues to compensate for this. For example, new, non-modelable, products are virtually out of the question from a capital perspective.
Regulatory and compliance change has resulted in a structurally higher cost base
Aggregate costs for major investment banks were 25% higher in 2014 than they were in 2005 [see Figure 3]. Much of this additional cost has been driven by a tougher regulatory environment. Banks must adapt to a new capital and liquidity regime, over-the-counter (OTC) derivatives reform, structural change and transparency requirements, and to new investor protection provisions. The implementation costs of the Volcker Rule alone could be up to US$4.3b.2 Regulations are having functional impacts on legal entities, business conduct, trade execution, reference data and trade reporting, yet all too often these new rules are not consistent across national borders.
In addition, banks have faced increased costs due to fines and significant trading losses as a result of a historically weak controls environment. Reducing costs by one-third would be an immense task.
And major investment banks are threatened by new competition
Institutions are now competing with buy-side clients such as hedge funds and private equity houses. They are also competing with boutiques and global custodians, and with financial markets infrastructure in the trading, clearing, settlement and reporting spaces.
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