Wholesale and Investment Banking State of the Nation

Transcription

1 Financial Services Wholesale and Investment Banking State of the Nation Part 1: Industry Context Autumn Series 2009

2 Series introduction It has been a remarkable two years for the Wholesale and Investment Banking industry: four quarters of severe writedowns between July 2007 and July 2008 followed by two quarters of cardiac arrest and then by three quarters of strong results. The industry is not out of the woods yet. The trading conditions that have supported capital regeneration are weakening, margin repricing is reverting and there is continued reliance on government sponsored liquidity. Most regulatory change is yet to come with a high degree of uncertainty around the outcome. Serious challenges lie ahead. This article is the first in a three part series on the state of the Wholesale and Investment Banking industry. Here we provide an overview of the industry s current situation and the challenges its participants face. In subsequent articles, we examine what we see as the solutions in more depth. Part 1: Industry context (this article) Part 2: Strategy and transmission Re-setting organisational transmission Strategy in the face of regulatory and outlook uncertainty Part 3: Financial resources and infrastructure A new model for financial resource management Resolving infrastructure investment priorities 2 Copyright 2009 Oliver Wyman

3 Part 1: Industry context Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning Winston Churchill, 1942 The pre-crisis addiction The industry has been forced to wean itself from bad habits. A high reliance on gearing, opaque balance sheet risk profile, developing product structures faster than the supporting risk processes, hereand-now compensation, clients as a secondary priority to principal activity: through the boom of the last two cycles the industry had developed a host of bad habits that only a painful period of remediation can unwind. Counter-cyclical public policy is helping the industry back to its feet Wholesale and Investment Banking should have advantages at this point in the cycle. First, the sector typically benefits from a more geared response to renewed global GDP growth (though this has been dampened by deleveraging). Second, barriers to organic international growth are lower than in some sectors (though localisation of capital and the increasing regulatory cost of operating in new countries have diminished this advantage). Finally, the sector enjoys a natural counter-cyclical hedge in the treasury benefits from loosened monetary policy. Supportive public policy is currently compounding these natural advantages and has helped the industry back to its feet. Most regulatory change is yet to come. A policy of deliberate delay in regulatory response has helped to nurse the industry back to stability. In the meantime dramatic government monetary policy has provided the industry with a shot of adrenaline through a historically steep yield curve and massive direct injection of liquidity through collateral windows. Quasi-managed consolidation has reduced competition and thereby contributed to margin expansion. Copyright 2009 Oliver Wyman 3

4 Retained earnings rather than RoE has become the relevant short term measure of success. Rebuilding capital is the current strategic focus. While overall returns remain weak, banks are looking at Wholesale and Investment Banking as the saving grace given impending losses in other sectors over the near term. It is one of the few business lines that can deliver sufficient profit to regenerate capital quickly, supporting the painful deleverage process. The industry has begun to attract private capital investment again on less dilutive terms. Capital raising for the industry since the start of the crisis shows dilutive public capital raising has begun to give way to slightly more robust private sector terms (see Figure 1). Capital costs for the industry are beginning to revert to long running norms, with high short-term valuation and discounted longer-term valuation due to earnings uncertainty. Exhibit 1: Capital raised through the crisis Capital raised US$BN 500 Price-to-book ratio (year to Aug) Pre-crisis Government funds Private funds Price-to-book (RHS) 0 Source: Oliver Wyman analysis, Bloomberg, Dealogic, press releases Note: Based on a sample of 16 large wholesale banks Significant challenges lie ahead Organisational transmission for most banks remains to a greater or lesser degree broken. Before the crisis a flawed but stable transmission mechanism had formed between the shareholders, boards, executive management and front line practitioners of Wholesale and Investment banks. At most banks the majority of these interconnections are now defective. Trust is severely depleted. Changes to shareholder powers, board composition and role, risk governance and cascaded risk management, compensation practices, and organisational structures are all underway. Risk appetite is at the heart of transmission. It is now rare that the various stakeholders have a common language in which to discuss risk appetite, let alone a shared view of medium term 4 Copyright 2009 Oliver Wyman

5 strategy. For 2010 this is making already difficult processes such as budgeting, capital allocation, investment prioritisation and bonus pool allocation descend into severe disagreement or become sidelined as academic. The industry is beset by regulatory uncertainty. By design or by process, most of the regulatory response to the crisis remains in the consultative or legislative phase. Some issues, especially compensation, are firmly in the political arena. In many areas the spectrum of mooted possible outcomes is wide, such as the structure of the OTC derivative markets, capital requirements in trading businesses, securitisation instruments, the size of required liquidity buffers, and clearing solutions. As a result the range of outcomes from regulatory change for the industry is wide in terms of income and returns. By way of example Figure 2 shows the possible deterioration in returns in the Equity Derivatives business line (selected as this has historically been a consistently high return business for most firms) as a result of regulatory change. Exhibit 2: Example of regulatory uncertainty: Range of potential evolution of returns for the industry in Equity Derivatives 35% 4% 2% 1% 2% 1% 2% 2% RoE down 10% to down 15% Bull: 25% Base: 23% Bear: 20% Average industry RoE Capital requirements OTC regulation Retail products regulation 2011 expected RoE Source: Oliver Wyman analysis Capital Requirements refers to pending regulations concerning the techniques used to measure risk, the levels of capital that banks will be obliged to hold against that risk, and the potential introduction of new leverage limits OTC regulation refers to the set of regulations that propose increased use of central clearing, standardised contracts and electronic or exchange-based execution in products that are currently traded OTC Retail regulation refers to the set of regulations pertaining to the manufacture and distribution of structured products that are sold to retail investors Dramatic changes in the OTC markets, the end of the party in Rates/ FX and the prospect of margin reversion present a challenging context in which to refocus on the client franchise. Conditions this year have certainly been supportive in many areas. However, the impact of regulatory change on demand in the OTC markets could be severe. There are dramatic shifts in wallet pools across product, region and client type underway, with major question marks over entire business segments. Client behaviour and bank selection criteria are changing Copyright 2009 Oliver Wyman 5

6 quickly. The yield curve induced boom and margin repricing are likely to have short legs. The macro-economic environment presents material risk of a credit induced second dip, with many banks concerned that signs of this could quickly induce crisis conditions again. In the face of all of this, most banks have committed to much greater client focus but remain unsure how to pay this ambition much more than lip-service given the constraints. Financial resources will remain a major constraint for the foreseeable future. To date, remedial actions have been reasonably decisive, including deleveraging balance sheets, de-risking positions, increasing liquidity, and some risk transfer. However many institutions which to the public eye are now posting good quarterly results remain structurally dependent on public funding lines, either directly or through subsidised financing of collateral. This is in an environment of historically low interest rates. Regulations that increasingly trap domestic liquidity will perpetuate global funding constraints. Finally, proposed and implemented changes to accounting rules, in particular to FASB in the US, are profound and need to be implemented fast, creating process risks. Opportunity is the upside of uncertainty It s not all bleak. Near term conditions look challenging, especially in the US where there is still no indication of when consumer spending will start to replace public spending. However, we believe longer-term growth trends are positive for the decreasing list of those who are, or who can become, well positioned to exploit them. To name a few we expect a return to cross border capital flows and global GDP growth, resilience in the Emerging Markets, long-term structural growth in Asia, deepening resource and commodity banking demand, long-term healthcare and ageing, a need for new credit delivery models. Performance skews are likely to increase. Over the last cycle the distribution of returns of Wholesale and Investment banks clustered around the high teens level (unlike most other industry sectors, where more skew is typically evident) as most firms rose with the tide of GDP growth, globalisation and increasing leverage. While the average industry returns will certainly be lower, we believe the skew will increase over the medium term as the winners respond to the challenges laid out and put clear water between themselves and the pack. The business model is not settled. Today s business model grew from the integration of lending, treasury services, equity brokerage and corporate finance. We are unwinding from the point where every Wholesale and Investment bank had evolved into an opaque mixture of (highly levered) on and off balance sheet exposure. After the regulatory overhaul, to stabilise funding structures and deliver 6 Copyright 2009 Oliver Wyman

7 attractive RoEs it remains likely the business model will have to evolve either towards combinations of: 1. Scaled intermediation ( flow monsters ) coupled with internalisation 2. Convergence of traditional credit origination with asset management ( originate-to-manage ) 3. Business models with increased emphasis on Transaction Banking and Securities Services to extract benefits of high barriers to entry and liability generation 4. In-market universal banking models focused on high growth markets In many cases we see bolt-on or transformational acquisitions (as opposed to mergers) accelerating the evolution. The early movers in this regard will take the strategic high-ground and close on the best of a small number of attractive acquisition opportunities. The window remains open for strategic repositioning of the regionals and domestics. As figure 3 shows, shareholders at global firms have not recently been well compensated for funding industry consolidation. In the current conditions there remains the rare opportunity to reposition within and across peer groups as some firms go on the offensive while others choose to bank the short-term profits and hold or retrench. Most of the regionals and domestics have enjoyed very beneficial conditions through the crisis, have materially strengthened their client franchises and have an advantaged business mix and funding. Many are well positioned for structural growth in the Emerging Markets and in Asia. Management teams face a once-in-acareer opportunity to capitalise. Exhibit 3: Market share and accumulated profit by peer group Accumulated profit , US$BN Global firms Regional firms Domestic firms Market Share % 22% 25% Market Share % 23% 20% Source: Oliver Wyman analysis, public filings Note: Global firms include of the leading 10 global wholesale banks; Regional Firms include 10 banks with significant footprints across one or two regions in wholesale banking; Domestics includes 20 banks with wholesale businesses that are heavily skewed to a small number of markets Copyright 2009 Oliver Wyman 7

8 A more complex industry structure is emerging. The systemically important institutions, the so called too-big-to-fails, will be hurt by pressure on compensation and increased capital costs. For these firms, the two tier regulatory regime being mooted is potentially very disadvantageous. On the other hand, there are land-grab opportunities for those among them that can leverage the primacy of the balance sheet and their future branding as safer-than-safe institutions. For niche firms, competitive fragmentation is likely to be sustained as talent migrates to less regulated entities. The combination of this and less onerous capital requirements is likely to create material growth in four key areas: Advisory boutiques and agency brokerage. Based on a compensation and infrastructure cost arbitrage Trading specialists. High capital requirements for trading businesses in systemically relevant firms may accelerate 1) the transition of proprietary trading businesses into asset management constructs and 2) the transition of client facilitation businesses to technology-driven specialists Capital providers. Non-bank entities have provided a significant amount of debt financing to the corporate sector, particularly in the US. In Europe, this was only in the early stages of development, but as bank capital requirements become more onerous, it will be economically viable for non-bank entities to have greater ambitions in debt financing Restructuring advisory and capital specialists. Combining elements of several of these models, we anticipate fund structures will increasingly be combined with advisory and corporate finance capabilities. What price optionality? Given the many uncertainties discussed, one of the main challenges now facing management and boards is the trade-off between optionality and decisiveness. Maintaining maximum strategic optionality is highly attractive but must be set against the scope to exploit the opportunity with bold strategic steps to gain first mover advantage. 8 Copyright 2009 Oliver Wyman

9 The remainder of our series will explore the steps we believe prospective industry winners must take from here Part 2: Strategy and Transmission Re-setting organisational transmission. We will explore the state of transmission across the market, and steps required to return organisations to high performance. We see this as a necessary pre condition to strategy setting and execution. Among other things, we will consider the role of the board and its relationships to shareholders and management, a top down risk appetite framework and appropriate risk management, risk-adjusted compensation structures, and how organisation and P&Ls should be set up to reflect the new business objectives. Strategy in the face of regulatory and outlook uncertainty. We will bound the bid-offer of outcomes for industry income and returns and explore how best to walk the line between retaining maximum strategic optionality versus decisively taking advantage of likely change dynamics, including aquisition opportunities. We will make the case for more scenario analysis, explicitly costing optionality, in the strategic planning process. Copyright 2009 Oliver Wyman 9

10 Part 3: Financial Resources and Infrastructure Embedding structural changes to the financial resource model. We will propose a new model for integrated resource management. This combines, first, structural changes to the management of capital and balance sheet, second, a fundamental rethink of intermediation, with a shift towards originate to manage, and third, business model evolution including through non organic transactions. Resolving infrastructure investment priorities. The crisis exposed weaknesses in the data, tools and MIS available for risk management. The regulatory changes underway will demand an overhaul of the trading infrastructure and of liquidity and collateral management tools. Operational STP and electronic trading will go through an accelerated wave of development. In the final article we will explore the challenge of reconciling the great demand for infrastructure investment with the severe downward pressure on budgets required to maintain attractive RoEs. 10 Copyright 2009 Oliver Wyman

11 Oliver Wyman is an international management consulting firm that combines deep industry knowledge with specialised expertise in strategy, operations, risk management, organisational transformation, and leadership development. EMEA Asia Pacific North America Ted Moynihan Matt Austen George Morris +44 (0) Copyright 2009 Oliver Wyman Limited. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by Oliver Wyman. This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. This report may not be sold without the written consent of Oliver Wyman.