Investment Banking: Industry Outlook

Today I would like to discuss the investment banking industry from the financial and strategic points of view. Where is it heading and how is it changing? Let me comment on these questions. I tried to make this short, but miserably failed.

Intro

It can be argued that, historically, the investment banking industry has been cyclical in its development. With the conception of the industry, there was little or no regulation for banks all the way through the Great Depression. The Glass-Steagall Act separated investment banking into a distinct industry governed by laws different from those of commercial banks. It was the first time that the investment bankers were put into a legislative framework that limited their capabilities, which led to a framework-reassessment by banks. The latter further shaped the industry until it became too different from the past that new laws needed to be put to action. I present to you a simple overview model of this process below. I will refer to this as an industry change model (IC-model).

As 2007 kicked in, the industry stumbled. The past industry changes had been no longer sustainable, and that cranked up the 3-step carousel again. I couldn’t be more artistic here, I’m sure.

Crime and Punishment

Bear Stearns and Lehman Brothers showed everyone what happens if you deviate from the laws of finance and common sense. The example was too good, however, and together with other financial troublemakers put into trouble the rest of the world. It brought economies to stagnation and underlined the danger of excessive debt.

Even though no major bank failed these years in Europe, all banks incurred massive losses, and some smaller banks did go out of business. In any case, investment banking became a tough industry to play in, at least in its 2007-2008 framework. High default rates of toxic derivatives in investment banks bit off a great chunk of bank assets and equities. Deutsche bank lost close to 30% of its equity in 2008 and only wrote down around $7.7 billion of its assets. For comparison, UBS lost $37.7 billion in write-downs, while HSBC lost in total $20.4 billion. And these banks are governed by thousands of extraterrestrially smart and presumably well-informed people.

Another reason the industry was tough was that, due to economic slowdown, business activity slumped and the markets turned bearish and highly volatile. Financial players put in question investment security and became reluctant to deal with the market the desired way. Apart from ill-fated mortgage bets investment banks had made previously, the ongoing business activity slowed down, bringing investment banks’ revenues further down.

Eventually, Greece, among other PIIGS countries, made matters impossible for regulators to overlook. The urge several years ago sounded to the tune of ‘Do something about your debt!’

Regulation: Thou Shalt Not Spend

I picked out three major reasons that brought investment banking to the first step of the IC-model I presented above. Below you can see the process, in which general economy problems trigger a regulatory tsunami (rhetoric used by Accenture in one of its reports), and the latter complicates the matters for investment banks.

Bankers hate regulation. In many reports and news releases regulation is viewed as a source of irritation by banks. One of the recent developments is an OTC Derivatives Reform; it implies spread tightening in trades and banks eventually having to compete on something other than price. Laws that restrict risk taking and set up new capital requirements are equally harming to the industry profits, as evidenced by Joseph Ackermann, Deutsche Bank CEO.

Even though the regulators certainly aren’t bankers, they aren’t complete idiots either. Problems are still evident in the investment reasoning of banks, and these problems may from time to time entail unpleasant news like the following. Some banks are still struggling to reap profits out of mortgage bets, while the mortgage market it still unhealthy. According to the DealBook of NYTimes, despite HSBC’s 2011 3^rd quarter profit rose, its investment banking branch saw a 50% fall in its pretax earnings. As a result of the losses, HSBC is planning on sale of some businesses, while exiting others. On top of it, HSBC is planning to cut 30000 jobs in an effort to cut costs. Stuart Gulliver, HSBC CEO, admitted that the sector is highly influenced by headwinds, such as financial regulation, market turbulence, political and economic uncertainty. Therefore, the need for increased capital requirements may be justified.

In any case, it seems that banks don’t know exactly in which direction the wind is blowing. On the one hand, the laws are trying to prohibit unreasonable risk-taking. On the other hand, they do it inconsistently and void of any coherent structure. Limiting profit opportunities and imposing direct and opportunity costs, legislators are wondering how to revive business activity and raise money. This is like yelling at your dog and wondering why it’s not happy with it.

Step 2: Framework Reassessment

Regulatory high tide essentially disturbs the status quo of the industry. Spurred by the various factors I mentioned above, the industry is undergoing a framework reassessment. I pointed out 4 areas where major reassessment is taking place.

It seems to me the industry is generally right here today, right on the second step of the IC-model. As more and more analysts are short on the markets, and less credibility is given to the sovereign debt, investment bankers are becoming wary of the increased risk factor of the investment bets.

Legislation is bringing in change into competition models and pricing of services. Accenture emphasized the necessity to re-focus on client needs, as the industry is getting tighter and allows customers to switch easier than ever among service providers. Some banks may have not grasped this need yet (as evidenced in a great article of a former Goldman Sacks employee that stunned the web), but they must do it. Value to customers is probably going to become a significantly more important benchmark for investment banks.

And, of course, the two points up there plus the re-assessed resources lead to re-formulating the strategy. Picking the right battles is up on the agenda of the Chief Whatever Officers today. Increased costs of risk taking influence the choice of business models and target markets. HSBC, UBS, Deutsche Bank, and several other banks in Europe alone are going to re-focus their activities on more stable and less risky business models.

Step 3: Industry Change

Senior bankers confirm that the industry will change as soon as the regulatory and the financial outlooks reach the equilibrium. Shifts in the business focus within some industry players will leave space for new entrants. On the other hand, existing players focusing on largely similar products will wound up offering new investment products and methods in order to compete effectively.

Joseph Ackermann confirmed in a recent speech the likelihood of a new M&A wave in the industry. Together with this, as profits become harder to reap, restructurings are going to happen, too.

Below I present to you my last graph reiterating my final conclusions on the industry’s near future and the 3^rd step of the IC-model.

Status as of Today

The status of the industry is such that it’s at its peak of uncertainty, maybe a bit over it. The bottom line is anyway the fact that a lot will be uncertain for investment banks in Europe and throughout the world in the short-run. Financial viability and strategic change will be a challenge banks will need to handle. All that is certain is that this is good news for consultancies who are going to service this change.