Not Out of the Woods Wholesale and Investment Banking in the Post-Crisis Era

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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

by Edward Moynihan, Matthew Austen & George Morris

It has been a remarkable two years for the global wholesale and investment banking industry: four quarters of severe write downs between July 2007 and July 2008, followed by two quarters of cardiac arrest, and then by two 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. There are serious challenges ahead, but opportunities too.

This industry brief provides an overview of the current situation and the challenges its participants now face.

Wholesale and investment banking should be attractive at this point in the cycle because of structural advantages. First, there has been a more focused response to renewed global GDP growth, though this has been dampened by deleveraging. Second, there are lower barriers to organic international growth, though localization of capital and the increasing regulatory cost of operating in new countries have somewhat diminished this advantage. Finally, a natural counter-cyclical hedge in treasury functions benefits from loosened monetary policy.

Supportive public policy is currently compounding these natural advantages and has helped the industry’s resurrection. However, 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.

Retained earnings, rather than return on equity (ROE), has become the relevant short-term measure of success, and rebuilding capital is the short-term 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 next 18 months. 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 has begun to move toward slightly more robust private sector terms. 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.

Before the crisis, a flawed but stable transmission mechanism had formed between shareholders, boards, executive management, and front-line practitioners of wholesale and investment banks. At most banks, many of these interconnections are now defective and trust is severely depleted. Changes to shareholder rights, board composition and role, risk governance, compensation practices, organizational structure, and front-line incentive plans are all underway. 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 strategy. As we move into 2010, this discord is making already difficult processes – such as budgeting, capital allocation, investment prioritization, and bonus pool allocation – either descend into disagreement or become sidelined as academic.

The industry is also beset by regulatory uncertainty. By design or by process, most of the regulatory response to the crisis remains in the consultative or legislative phase, and the range of possible outcomes and their impact on income is wide.

• Banks will face challenges to rebuilding their client franchise given dramatic changes in the over-the-counter (OTC) markets, the downturn in foreign exchange, and the prospect of margin reversion. The impact of regulatory change on demand in the OTC markets is creating wide shifts in spending across products, regions, and client segments. Client behavior and bank selection criteria are also changing quickly. Most banks have recommitted to a client focus but remain unsure of how best to realize this ambition.
  
  
• 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 remain structurally dependent on public funding lines, either directly or through subsidized financing of collateral. Regulations that increasingly trap domestic liquidity will perpetuate global funding constraints.
  
  
• Finally, proposed and implemented changes to accounting rules, in particular to Financial Accounting Standards Board rules in the United States, are profound and new processes will need to be implemented quickly.
  
  

While near-term conditions look challenging — especially in the U.S. where there is still no indication of when consumer spending will start to replace public spending ¡V we believe longer-term growth trends are positive for the decreasing list of those who are, or can become, well-positioned to exploit them. The trends include 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 health care and aging populations, and the need for new credit delivery models.

Performance skews are likely to increase dramatically. Over the last cycle, the distribution of returns of the wholesale and investment banks clustered around the percentages in the high teens: more skew is typical in other industry sectors. These returns were achieved as most firms rose with the tide of GDP growth, globalization, 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 before them and put clear water between themselves and the pack.

The window also remains open for strategic repositioning of regional and domestic firms. Shareholders at the global firms have not recently been well-compensated for funding industry consolidation. In the current conditions, there remains the rare opportunity to reposition both within and across peer groups, as some firms go on the offensive while others choose to “bank” the short-term profits, or retrench. Most of the regional and domestic players have enjoyed very beneficial conditions through the crisis, and many are well-positioned for structural growth drivers in the emerging markets and in Asia.

With all this, the business model is not yet settled. Today’s model grew from the integration of lending, treasury services, brokerage, and corporate finance. We arrived at a point where every wholesale bank was an opaque mixture of (highly levered) on-and-off balance sheet exposure, in some cases poorly understood by management, let alone investors. After the regulatory overhaul, in order to stabilize funding structures and deliver attractive ROE, it remains likely the business model will have to evolve either toward scaled intermediation, or to a convergence of traditional credit origination with asset management, or to business models based on high barriers to entry, like transaction services.

A more complex industry structure is clearly emerging. The systemically important institutions, the so-called “too-big-to-fails,” will be hurt by pressure on compensation and increased capital costs. 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 phenomenon and less onerous capital requirements for niche players is likely to create material growth for four specialist segments: advisory boutiques and agency brokers; trading specialists; capital providers (particularly non-bank entities); and restructuring and capital specialists.

More than usual, management and boards of wholesale and investment banks must be poised to make the difficult trade-off between “optionality” and decisiveness. Maintaining numerous strategic options – given the many uncertainties discussed – is highly attractive, but must be weighed against the opportunity for swift first-mover advantage that only bold steps will afford.

Edward Moynihan is a London-based partner and head of the Europe, Middle East, and Africa Corporate and Institutional Banking Practice of Oliver Wyman. He can be reached at .

Matthew Austen is a Singapore-based partner and head of the Asia and Pacific Rim Corporate and Institutional Banking Practice of Oliver Wyman. He can be reached at .

George Morris is a New York-based partner and head of the North America Corporate and Institutional Banking Practice of Oliver Wyman. He can be reached at .