Embattled Investment Banks Need New IT Strategies to Meet New Storm Clouds
24 May 2016
If the importance of fundamental and strategic overhaul of current IT infrastructure and capabilities has not yet permeated investment bank boardrooms it either will soon, or the chances are they won’t be in business much longer.
The confluence of several existing and new threats means that the outlook for battered investment banks, already reeling under a barrage of new regulations, tighter capital controls and tough trading conditions looks set to get even worse. Whichever way they look costs are rising, revenues are harder to find and smarter and more efficient IT will have to be at the heart of any new strategy that even begins to mitigate these challenges.
This time heat is coming from their erstwhile buy side customers, many of whom are also being forced to re-think existing business models. Asset managers have already picked up some slack in spaces vacated by the sell side. But they now face a major revenue squeeze of their own, due to changing investment patterns, which will severely limit what they are able (or prepared) to pay the sell-side for services going forward.
Global investment bank revenues from FICC markets (Fixed Income, Currencies & Commodities) have plunged in the last six years from over $200 billion to under $100 billion, with no sign of a recovery around the corner. It is estimated that total sell side revenues are down by some 20% (or around $55 billion), while buy side revenues have increased by 45%, (around $135 billion). It is becoming clear how the balance of power is shifting.
This is the main reason banks are struggling to make profits, with Returns on Equity set at 6-8%, while costs of capital remain stubbornly at 10-12%. It is not a sustainable business model. Many already realise that and are exiting asset classes, markets or geographies. Probably only 3 (Goldman Sachs, JP Morgan Chase & Citi) are still standing as providers of universal services.
So, if there were not already sufficient reasons to transform businesses and cut costs, banks look headed towards another major revenue crunch, as a potential $100 billion worth of US buy-side commissions are forecast to disappear over the next decade. And, apart from creating a dilemma for fund managers, that is going to have a serious knock-on impact on what they have left to pay for services from their banks and brokers.
The timing could not be worse. Banks are already being effectively forced out of previously lucrative “market making” activity, due to the way new capital allocation requirements have effectively ended their ability to hold inventories. Some banks, like UBS, have exited fixed income trading completely and are focusing on wealth management.
According to a recent Bloomberg report, the impact of these new “fiduciary rules” is set to force an acceleration of what is so far only a drift of funds under management away from actively managed to passively-managed Exchange Traded Funds (ETF) and index funds. It warned that “when the dust settles in this sea change, the industry may be half what it once was, simply because their revenues will be half what they once were.”
And if that’s the case for the buy side fund managers, the first place they will look to offset this will be to seek to further reduce costs from their sell side intermediaries. The shock to the financial system could be considerable, with the buy side using the likely disruption that occurs to further disintermediate large swathes of the existing market as it looks to cut middle-man costs.
That process of disintermediation is already evident in the ability of asset managers to engage directly with each other to transact large holdings of liquid equities or investment grade sovereign debt. The use of new technology and trading platforms is making it much easier for this to continue.
But the catalyst for the latest upheaval is new rules, driven by the US Department of Labor, to provide further protection for investors. In simple terms this will mean that brokers will need to demonstrate they are putting savers interests ahead of their own. As these are phased in over the next two years what has so far been a trickle out of active funds into passive ones looks set to become a tidal wave. And the impact on buy-side fees is going to be massive.
According to a recent study, it is estimated that traditional ETF’s and Index Funds have around $2.1 trillion each under management, generating annual fees of $5.5 billion and $2.2 billion respectively at their asset-weighted fees of 0.27% and 0.10% each. However, there are $10.4 trillion in assets under active mutual fund management, which earn asset-weighted fees of 0.72% and generate current annual revenues for asset managers of some $74 billion.
Since the start of 2015 some $250 billion has been moved from active to passive funds and if this trend is extrapolated (as it is expected to be) some $1 trillion of assets shifted, reducing revenues from 0.79% to around an average of 0.20% (based on an expected split of 40% into index funds and 60% to ETF). This would see client investments that would have produced $18 billion in revenues per annum over the next decade only returning an estimated $5 billion, taking a potential $13 billion in fees out of the system each year for a total in excess of $100 billion over the next decade.
Bank trading revenues are already under considerable pressure, with Q1 2016 results from Goldman Sachs, Morgan Stanley and Citi reporting respective 47%, 50% and 27% falls from a year earlier. As Goldman CEO Lloyd Blankfein observed “The operating environment presented a broad range of challenges, resulting in headwinds across virtually every one of our businesses.” And that situation is set to get tougher, particularly as Goldman’s 6.4% return on equity below its cost of capital.
Ironically, Morgan Stanley’s results were slightly better than expected, but were mainly achieved by more cost-cutting. But, “growing by getting smaller” is also not a sustainable business proposition.
American banks are nevertheless generally in a stronger position than their European counterparts due to rigour applied to tackling problems when they first surfaced. They are also further ahead in recognising the benefits of technology, combined with more collaborative business models to bring down costs, satisfy stringent new regulatory demands and drive new revenue capabilities.
But even they acknowledge there is a long way to go. JPM said in its recent 2015 earnings review that while it is increasing (slightly) its current $9.5 billion annual IT budget, it is seeking to re-purpose a large chunk of that spend. It estimates some 70% of that money is spent just keeping the lights on. Its target is to reduce that to 60% and enable the 10%, or around $1 billion, to be re-directed to IT projects that make a competitive difference. In reality they should be able to go much further if IT transformation is embraced across the organisation.
So why are more banks not rushing to join in? Well the easy answer is fear. That is fear of change, fear of disruption and fear of the cost involved. But some of those 30-40 year old IT systems are as good as broke and held together by proverbial sticking plasters that are not going to be strong enough to withstand the challenges ahead. The starting point has to be an injection of much better IT knowledge and leadership at the very highest level in banks that is prepared to take a much longer-term, strategic view of where it is going as a business and how it is going to get there.
But they will need to be nimble. Not only is the buy-side looking for savings to compensate for its own fall in revenues, it is looking at fresh areas to grow by eating the lunch of its erstwhile sell-side partners. One area where this is already gaining traction is in prime brokerage, a service traditionally provided by the large investment banks to hedge funds and other investment managers to facilitate/maximise trading capabilities.
New capital requirements are making many of them re-think the viability of offering these services and global custodians are weighing up the opportunity. One such visionary is State Street with its Enhanced Custody offering, but others are also picking up the baton. They certainly have the capacity of massive inventories to lend to hedge funds, without having to make the same capital provisions as the banks. That might change, but in the meantime it is certainly already delivering a handy new revenue stream for State Street.
But, despite all the turmoil and uncertainty the capital markets are not going to go away and investment banks are going to very much be part of them. What is going to be interesting is which investment banks, providing what services and products and with what sort of returns. What is not in doubt is that the banks that emerge as leaders in this new universe will have a much more sophisticated and lower cost IT infrastructure at its heart, which delivers integrated data and analytics and leverages wider collaborative and cloud-based or shared utility services.
Some are already showing their hand with new initiatives. Goldman Sachs recently launched one called its FICC Systematic Market Making (SMM) unit. It is aimed at consolidating its e-trading assets and capabilities across businesses to reflect changes in market structure and client needs. Group CIO Martin Chavez, said, “Our ability to innovate and provide a range of execution alternatives is essential for our clients who increasingly depend on firms that are able to integrate deep market expertise with cutting edge automation across interest rates, currencies, commodities and credit.”
More importantly, he also said, “Our technology, market understanding and client franchise uniquely position the firm to realise this important opportunity and establish SMM as the leading electronic business across FICC globally.” Goldman is by no means alone in bringing new IT-led initiatives to the market.
They are all a step in the right direction and a sign of things to come. The interesting thing to see will be how competitors respond. Whatever happens, leadership will required and there certainly won’t be room for the timid or faint-hearted.