FINANCIAL SERVICES The Transformation of Capital Markets: Forces, Implications, Actions kpmg.com
1 The Transformation of Capital Markets: Forces, Implications, Actions Foreward Under siege on the cost, return on equity (ROE), profit, capital, liquidity, revenue, and trading-volume fronts, banks in capital markets businesses are confronting a fundamental shift in their industry that is forcing the need to create a sustainably profitable business model. The levers most often used in times like these reduction of headcount, more automation, across-the-board expense reductions, accelerated offshoring/outsourcing of work already have been pulled, and there is a general acceptance within the industry that these efforts are not enough. A profitable and sustainable operating model must begin with the industrialization of the internal processes that cross the distinct boundaries inside a bank s capital markets businesses. This industrialization of processes such as client onboarding, and trade confirmation/trade settlement is designed to simplify, standardize, and consolidate as a means to reduce the complexity of operations, cut costs, enhance client service, and deliver bottom-line improvement. Industrialization already installed or underway with a degree of success in other industries such as automobile, pharmaceuticals, computer manufacturing, and insurance will likely require a significant investment in time by people throughout the capital markets businesses. Inevitably, there will be resistance. It is a business of legacy asset classes and geographic silos, where operational change is slow and the culture is not easily altered. If we do not take change by the hand, it will surely take us by the throat. Winston Churchill The capital markets business is hardly unique when it comes to placing hurdles in the way of transformation. Asked what part of his job made him the angriest, the chief executive of an automaker said in a news article on transformation, 1 GM CEO Dan Akerson: Our Company Has a Resistance to Change, The Associated Press, December 11, 2011 resistance to change... You have to create a culture that not only accepts change, but seeks out how to change. It s critically important that we inculcate that into our culture. 1 Above all, the new operating model in the capital markets industry will need to reflect the reality that capital markets primarily must be an information-technology-enabled, highly automated industry with many fewer people and an almost total reliance on electronic and algorithmic trading. Competitive advantage in this industry is now defined by scale and technology capability, where a more-concentrated, morecompetitive business has developed. In one sense, those who manage the capital markets industry are being asked to change the tires on a moving car. Trade volume has declined, margins are thin, and the regulatory environment is unsettled, with many new rules that will affect products and processes remaining unwritten. But the pressure to produce is at a sky-high level. Investors have made clear their unhappiness with single-digit return on equity, which is now about equal to the industry s cost of capital. In a more benign economic environment, this model-change might be put off, or left for further study. For the foreseeable future, though, the capital markets industry will likely be marked by an emphasis on lower risk, lower profit transactions. Fewer people will likely be needed to make and clear trades, and better systems coordination will likely be imperative to meet increasing demands for real-time transparency. With those circumstances virtually unalterable, the only option available is a change in the operating model. Our purpose in presenting this issues briefing is to offer ideas and provoke debate about strategies to address the imperatives of building a better business in this important industry. We recognize that each organization has unique circumstances requiring specialized solutions, and we encourage your feedback for our mutual benefit.
The Transformation of Capital Markets: Forces, Implications, Actions 2 Forces Viewed strictly from a numbers perspective, capital markets businesses are under severe stress. Consider: Costs: The expense of regulatory reporting requirements and the cost of complying with higher capital requirements to address market and counterparty risk is expected to lower ROE in 2013 to about half the precrisis ROE level, meaning that ROE will be almost equal to the banks cost of capital. 2 Capital requirements are now more than twice precrisis levels. 3 Revenue: While global industry fees in 2012 were flat to slightly lower compared to 2011, fees in the first quarter of 2013 resulting from trading and services related to fixed income, currencies, and commodities; derivatives and equities; lending and borrowing of securities; and mergers and acquisitions (M&A) grew by about 6 percent compared to the first quarter of 2013. 4 Headcount: Investment banks in the United States eliminated an estimated 100,000 jobs in the past three years. In London, another 100,000 jobs have been eliminated from a peak of about 350,000 in 2007. 5 Taken together, these facts underscore the notion that we are witnessing something much more than a confluence of cyclical industry trends, and they add urgency to the task of reshaping the operating model. The constraints created by existing and pending regulation in the United States and Europe have opened opportunities for competitors elsewhere in the world, where the regulatory landscape may be significantly different. That development adds meaning to the idea in this industry that capital is fungible and will fill voids created by restrictive regulatory environments. Not surprisingly, the continued shift of revenue pools to rapidly developing economies especially in parts of Asia and South America is creating new hubs of capital markets activity. Though these markets are still fragmented, investment banks, asset servicers, and technology vendors increasingly are creating or studying new partnerships and joint ventures to address higher posttrade expenses. These markets also have highlighted the tremendous competition for order flow, which puts new pressure on liquidity and capital planning. 2 Global Investment Banks: IB Landscape Changes Across the Globe, JP Morgan/Cazenove, March 13, 2012 3 Day of Reckoning? New Regulation and Its Impact on Capital-Markets Businesses, McKinsey & Company, September, 2011 4 Global Investment Banking Fees Rise 6 Percent in First Quarter, Reuters, April 4, 2013 5 Dream Turns to Nightmare, The Economist, September 15, 2012
3 The Transformation of Capital Markets: Forces, Implications, Actions Implications Those organizations that look inward, choose to adapt, and make the necessary investments and commitments to rebuild stand a much better chance of survival than those that hang on to the past and wish for a return to normalcy. Success is predicated on accepting the notion that the industry s recent swift structural change is here to stay at least in the foreseeable future. The creation of new operating models to address declining revenue and profits is not new, and often the attempts have netted poor results. When an attempt to transform an operating model fails, it typically is due to resistance to change and a lack of commitment at the executive level. Therefore, a good plan and a robust execution strategy are not necessarily enough. The propensity for failure places enormous emphasis on enhancing behavioral-change skills, where the goals and values of change are understood, realistic, and measurable. Today, operational transformation involves everything from information technology (IT) processes to internal controls to product development to regulatory compliance reporting. Capital market firms may not make profits in operations, but that is where they can lose them when duplication of processes are not addressed and risk management and control functions are not adequate. The cost of lapses and the public transparency of failures in these areas are now far greater than in the past.
The Transformation of Capital Markets: Forces, Implications, Actions 4 Actions The idea that there are untouchable businesses and processes inside a capital markets organization will need to be set aside. An organization s leadership team must evaluate all front-, middle-, and back-office processes across legacy asset class and geographic silos with the goal of streamlining processes to the greatest degree possible in a less product centric and more process centric manner. Leaders in the capital markets industry should look to consolidate operations, diversify product portfolios, and enter into strategic technology-focused alliances to gain a foothold in new businesses and obtain new market entry. Operational efficiencies can be secured internal to a firm as well as externally in the form of industry utilities from which the entire industry at a macro level can benefit. Select examples of that strategy include: Leveraging operational economies of scale and, where possible, combining operations across investment banking and private banking businesses with a view toward enhanced client service Using organizations prime brokerage infrastructures to provide clearing, settlement, and financing services to their execution clients Consolidating local custodial, transfer agency, and hedgefund servicing businesses into global or regional groupings Restructuring outsourcing relationships into partnership models with key service providers. These may include two or more banks in partnership with a service provider in order to develop a key-product capability, using technology as an innovation enabler. This is true in emerging markets, where collaborative models (joint ventures, consortia) are being considered as a way to lower transaction costs in Asian, European, and Middle Eastern markets. Expanding into custody service offerings by standardizing and industrializing support infrastructures, especially in Europe and Asia, due to the fragmented nature of market and client needs Offering clearing offerings to high-frequency clients as an accommodation in order to make relationship more sticky Driving aggressive expansion of outsourcing services, moving beyond traditional areas to include the value-added areas such as tax reporting, valuation, and the provision of white label technology to support third parties Increasing the focus on emerging markets, particularly developing Asian, European, and Middle Eastern markets, and creating new partnerships and models in order to lower the costs of transacting in these markets Considering joint ventures to provide more cost-effective comprehensive posttrade solutions Consolidating asset-servicing networks, including moving to self-clearing and/or self-custody in selected markets, including forming strategic partnerships brokers/ correspondent clearers and global custodians These actions would indicate that firm leaders are thinking differently about their organization and challenging the status quo. They require the establishment of a collective, agreedupon set of guiding principles or norms that help the firm s units work collaboratively to successfully accomplish the goal. Leaders who want to start down this path should begin with an assessment of the current condition, and then an articulation to the entire organization of the overall end strategy, risk considerations, and the investment required. Leaders must also solicit and respond positively to stakeholder feedback to help ensure organizational buy-in. After the goals have been set, leaders should develop a high-level execution roadmap, including change management and communication plans. They should possess a formal process that communicates the clear steps to success, and it should identify dependencies with other ongoing related initiatives.
For information on how we can help inform your transformation initiative, please contact: William F. Cline Principal T: 704-335-5552 E: wcline@kpmg.com Atul Subbiah Principal T: 212-954-3136 E: asubbiah@kpmg.com kpmg.com firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. NDPPS 181745