A March 19th Blue Paper from Morgan Stanley Research highlights that recent regulations and quantitative easing on both sides of the pond driving interest rates into negative territory have created a trying “brave new world” for investment banking industry, and that only the strong (and well prepared) are likely to prosper.
Morgan Stanley and Oliver Wyman analysts Huw van Stennis, Christian Edelmann and team offer an overview in support of their thesis: “Financial regulation and QE are at the heart of a huge shift in liquidity risk from banks to the buy-side, which is increasingly a concern for policy makers. This shift is far from over: we expect liquidity in sell-side markets to deteriorate further, as regulation shrinks banks’ capacity another 10-15% over the next two years. Our interviews with asset managers highlighted their concerns over scarcer secondary market liquidity, particularly in credit and in Europe.”
The report mentions “trench warfare” stating further:
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Trench warfare in the rebuild of returns in wholesale banking
For the banks, the diminishing returns on capital from market making call for more and faster structural change. An uneven global recovery and increased volatility bring a mix of tailwinds and headwinds for wholesale banking revenues. We expect re-pricing for capital, policy divergence, and an improving real economy to be key tailwinds. But capacity withdrawal, tougher conditions in credit, lower leverage and turnover on the buy-side, and increasing electronification are all headwinds. Under our base case revenue forecast of ~3% growth until 2017, management teams will need to deliver a 2- 3% RoE uplift through business restructuring to hit 10+% returns on capital.
Shift of liquidity risk to the buy side
The key issue here is the giant shift in liquidity risks to the buy-side and asset owners, a shift created by both financial regulation and ongoing global QE. New regulations in the U.S, and Europe (and the potential for more) have led to a major reduction in sell-side balance sheets and liquidity. Van Stennis, Edelmann et al. point out: “Wholesale banking balance sheets supporting traded markets have decreased by 40% in risk-weighted assets terms and 20% in total balance sheet since 2010.
Furthermore, credit markets are booming as firms increasingly turn to bond finance and investors look for income. Credit market issuance is 2.4 times greater in 2015 than it was in 2005. Moreover, AuM in daily redeemable funds are up close to 10% a year, and are 76% higher than 2008 levels. Cash in mutual funds is also up relative to pre-crisis, and is actually above redemptions experienced in during the crisis, meaning asset managers are at least aware of the emerging risks.
Liquidity of secondary fixed income markets is likely to worsen
The MS and Oliver Wyman teams also argue that these growing regulatory costs will continue to hold back fixed income returns, and they “expect another 10-15% shrinkage of fixed income balance sheet from the largest wholesale banks in the next 2 years. As much as 15-25% could be taken out of flow rates, we think, given the huge returns pressure on that business.”
Regulatory risks and earnings risks in investment banking industry
When you look at the big picture, it’s clear that regulatory risks as well as earnings risks are increasing for asset managers as politicians and policymakers start to focus on “the transition out of U.S QE and interest rate hikes.”
In concluding, van Stennis, Edelmann and colleagues highlight the profound value shift we have seen in the capital markets since the financial crisis. They point out that QE has driven/is driving asset prices higher but also minimized volatility, and that “regulatory change has driven capacity out of the sell-side.”
The authors of the MS report end with a warning: “Since 2006 sell-side revenues have fallen by 20% ($55 billion), whereas buy-side revenues have risen +45% ($135 billion). However, the risks have shifted too and we now see concerning trends on the horizon for asset managers.”