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The Right Partnerships Can Help Investment Banks

May 6, 2014 By Philippe Morel , Nick Gardiner , Gwenhaël Le Boulay , James Malick , Pierre Paoli , Sukand Ramachandran , Shubh Saumya , and Astrid Woloszczuk

Historically, investment banks have seldom managed to forge fruitful partnerships, whether in shared operating models (sharing infrastructure and costs by setting up utilities to be used by a consortium of banks) or in commercial partnerships. Most partnership discussions hit a snag over issues such as governance, legacy systems and processes, accountability, and even a reluctance to make overtures.

Nonetheless, we believe that a combination of factors has increased the pressure on investment banks to reconsider partnerships, with goals such as mitigating the effects of retrenchment in certain regions and products, reducing fixed costs, tackling overcapacity, and—with many products becoming commoditized—adapting to the shift of revenue sources in the value chain.

Operating-Model Partnerships

The areas in which capital markets and investment banking (CMIB) players can collaborate will continue to expand. Such areas cover a broader scope of pre- and post-trade value-chain activities and a wider range of products (as more over-the-counter offerings are being cleared and listed). Each bank’s size and specific value proposition will dictate its approach to upgrading operating models.

Tier 1 Institutions. We expect the largest players, which we call powerhouses, to continue focusing on achieving scale in-house and on potentially being insourcers. However, they can benefit from looking beyond siloed asset-class optimization and breaking down their indirect cost bases into four layers:

  • The first layer (estimated at 20 percent of total indirect costs) consists of costs (such as front-office IT and pricing-engine costs) that are specific to each CMIB asset class because they are a key component of the client value proposition and therefore of the bank’s competitive edge.
  • The second layer (20 percent) consists of costs that can be shared across certain CMIB asset classes. These costs (such as costs related to electronic platforms, collateral management, pricing algorithms, and trade management) are driven by cross-asset commonalities but whose close links to the CMIB segment are necessary given specific customer needs.
  • The third layer (25 percent) consists of costs (such as those related to static market and customer data, payment systems, and treasury functions) that can be shared beyond the CMIB division with the bank’s other divisions. Such costs have overlaps in client bases and processes.
  • The fourth layer (35 percent) consists of costs (such as costs related to confirmations and reconciliations, IT infrastructure, and know-your-customer processes) that can be outsourced to third-party vendors or shared through industry partnerships. Such activities lend themselves to scale benefits and are not competitive differentiators. Sharing or outsourcing these costs could involve existing utilities or outsourcers or even new providers (such as e-retailers for cloud data warehousing).

For Tier 1 institutions, breaking down costs in this fashion should be aligned with a better balancing of operating-model investments: front-office versus (neglected) back-office, IT versus (neglected) operations, short-term versus (neglected) long-term, and single-asset-class versus (neglected) cross-asset-class investments. The goal should be as much about designing the operating model as about executing it. Relatively few Tier 1 institutions have a commendable track record in large, cross-divisional, transformational programs. Strong governance and the attention of top management will be required for successful execution.

Tier 2 and Tier 3 Institutions. Utility providers are slowly emerging from the ranks of third-party vendors and business process outsourcers, as well as from exchanges, custodians, derivatives-clearing organizations (DCOs), and central securities depositories (CSDs). Only a few partnerships are up and running, but there are plenty of ongoing discussions led by a few vendors fighting to build scale. Early CMIB adopters will bear high execution risk, but they will have more opportunity to shape the solutions that vendors are in the process of designing with regard to IT capabilities, data integration, protocols, and processes.

We see three very different types of utility providers emerging. First are those with niche offerings in specific functional areas such as regulatory reporting, aspects of collateral processing, know-your-customer measures, and legal-entity-identifier (LEI) management. Second are those with offerings in the complete CMIB processing value chain. Third are those with broader offerings that incorporate any other business-line adjacencies for which the concept of a utility makes financial sense. Banks will have a strategic choice to make here.

A number of key operational considerations must also be carefully assessed by CMIB institutions when evaluating potential partnerships. These include the scope of products involved (such as structured over-the-counter products); the scope of activities beyond pure operations (such as pretrade IT, risk, and finance); the type of IT solutions (among the handful that seem to have leading positions); the complexity of connectivity to downstream systems (such as general ledger and pretrade IT); and potential interdependencies among other parts of the bank (such as the asset and liability management function).

For Tier 2 and Tier 3 banks, partnerships could promise cost savings of up to 40 percent of IT and operations costs (or about 10 to 15 percent of total costs)—although the costs of transition and, more important, interfaces with other bank processes tend to be underestimated. This level of savings would help some Tier 2 and Tier 3 banks improve their cost positions, but it might not always be enough to turn around unprofitable asset classes.

Commercial Partnerships

We expect commercial partnerships to emerge as a tactical option. On the one hand, Tier 1 institutions such as powerhouses and what we call advisory specialists will attempt to capture new volume and position themselves ahead of new competitors’ exits. On the other hand, Tier 2 and Tier 3 institutions pursuing what we refer to as haute couture and relationship expert models (described in The Quest for Revenue Growth) will attempt to secure their client bases by continuing to provide an appropriate spectrum of products and coverage.

Two types of partnerships are likely to gain momentum: regional partnerships and product partnerships.

  • Regional Partnerships. These will involve partnering with an institution that has a complementary local or regional footprint in order to offer clients access to local products—or “bringing one country or region to another bank’s clients.” Because these partnerships are likely to be forged exclusively among Tier 2 and Tier 3 players, there are clear first-mover advantages. Key considerations include the partner’s local franchise strength, appetite for new counterparty risk, and clarity of the value proposition for clients.
  • Product Partnerships. These will involve partnering with another bank or an independent boutique that has a complementary product offering. Typical examples include seeking access to cutting-edge FX single-dealer platforms, electronic execution in cash equities, primary dealership for government bonds in nondomestic markets, M&A capabilities, and a partner’s retail- and private-banking network. Key considerations include the partner’s strategic fit (especially the degree of overlap in target client bases so as to avoid competitive risk), the impact on brand, the ability to enable business reciprocity, the nature of the operating model, and the model’s capacity to reduce indirect costs.

Ultimately, in both operating-model and commercial partnerships, banks are typically looking for greater agility (rather than direct ownership of all elements of the processing model) and variable cost structures that flex down as well as up.

The Right Partnerships Can Help Investment Banks
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