Investment banks need to transform themselves to compete in tomorrow’s capital markets industry.
Global Capital Markets 2016
In our view, six pillars—vision, distribution, client centricity, IT and operational excellence, organizational vitality, and financial and risk control—are critical to building a comprehensive strategy for business model transformation.
Vision. Banks must identify which parts of the capital markets revenue ecosystem they wish to participate in. They must harness the resources and potential sources of competitive advantage at their disposal, then figure out the most effective charging mechanism to optimize revenues. Leadership and vision can come only from the top, and clarity of purpose will be imperative for transformational success.
Distribution. Explicit charging models for both research and value creation are needed. Banks must also explore dynamic pricing for capital-light agency services versus balance-sheet-intensive principal-based services. Digital functionality will be needed both to improve the customer experience and to invigorate distribution. Areas of primary markets that depend chiefly on human talent—such as high-margin, low-capital-intensive M&A teams—are under less of a threat than more capital-intensive trading businesses.
Moreover, front-office head count, compensation, and technical specialization must all be aligned with client-coverage strategies and product-offering needs. With trading head count representing 30% to 50% of costs (depending on the asset class), aggressive front-office reduction will be required as markets become increasingly electronic. Distribution via electronic channels, which in turn should be consolidated with standardized connectivity, must also be pursued. Moreover, since shifts in trading execution can also impact revenue-model dynamics, serious thought will be required about whether, for certain asset classes, a move toward an agency model—as opposed to an outright exit—would be beneficial. Commitment to a few key asset classes and to building electronic scale through powerful internalization engines will be critical, as will big-data-driven customer analytics in those areas. Broker, clearing, and exchanges costs will need to be tightly controlled in order for an electronic market-making business to succeed.
Client Centricity. An improved understanding of client profitability, share of wallet, and segmentation will significantly help firms understand the balance of trade between themselves and their customers. Banks will have to move away from supplying products to providing services. Only by helping their clients to succeed can they expect to generate revenues.
At the same time, by focusing on how best to serve the client tail and conduct share-of-wallet analyses, firms will be able to ensure that they are being adequately rewarded for the services and resources they provide. Best-in-class banks are already implementing predictive modeling to trigger cross-selling opportunities and developing fully tailored product solutions. Further, to minimize costs, banks have started to simplify their client onboarding processes. Smooth onboarding, amid growing compliance and regulatory requirements, has become an important part of successfully serving clients.
IT and Operational Excellence. Simplifying IT, as well as exploring more advanced financial technology (fintech) alternatives, will enable banks to modernize their operations and reduce costs. This means streamlining legacy systems and eliminating non-value-creating complexity. Focusing on governance, location strategy, and sourcing optimization allows for more rational and efficient architectures. Many banks have complex, highly customized legacy platforms that have evolved to meet changing business requirements. Establishing a target process and technology architecture, as well as a strong governance process to make sure that new development and customization adhere to target architectural standards, can help reduce complexity and the long-term cost of ownership. What’s more, utility models offer the opportunity to share the cost of new development across parties for greater efficiency and return on investment. Some players may opt to leverage a two-speed approach to IT in order to ensure that the digital agenda can still be pursued in an agile fashion alongside IT development programs that require longer lead times. Partnerships with fintech firms can offer significant efficiencies, depending on where institutions are in the process of transforming their technology operations to support the front office. The deeper this process goes, the greater the potential savings. For the moment, the focus of the industry is primarily on data and analytics, as well as on trading software and platforms. (See the exhibit.)
Within operations, process and organizational simplification will play a key role. Model optimization and redesign, together with a digital process layer, can improve efficiency and accuracy. With regard to structure, several banks have been aligning functions with physical locations and have become increasingly savvy on their sourcing strategies. Shared functions across the entire group are highly correlated with below-average cost per trade. Combined with significant use of utilities, firms can expect to generate IT and operational cost savings of up to 70%—currently equivalent to approximately 17% of total operating costs.
Organizational Vitality. It is also imperative that investment banks reshape their organizations according to their target operating models. Delayering across the entire organization, for example, will ensure shortened hierarchical lines. In the front office, organizational effectiveness requires a lean structure for both producers and nonproducers, as well as across electronic trading and in coverage sales. To ensure that banks attract and retain talent—particularly technology talent—they should continue to align compensation with new roles and responsibilities. A change in behavior and culture is also required. A set of smart rules must be defined and integrated into leadership, engagement, and cooperation models, as well as into rollout plans. These rules can involve training, coaching, incentives, and organizational adjustments.
Financial and Risk Control. Regulatory mandates continue to impact investment banking businesses, making it harder to develop consistent governance. Banks must also explore cost mutualization opportunities—outsourcing duplicated back-office functions that add little value—and accelerate capital mitigation efforts to offset the impact of FRTB. To be sure, investment banks have still not done enough to reduce their capital exposure. They must also achieve efficient allocation of group costs—such as litigation, finance, and cybersecurity—in order to reduce their own overhead. (See the sidebar.)
Fines and litigation have become persistent and onerous operating costs for banks. Fines related to capital markets activities have generated 38% of total fines over the past eight years—about $108 billion, compared with $176 billion at the group level. It appears that such charges can no longer be viewed as one-off events but must be considered as ongoing, annual costs. (See the exhibit below.)
The good news is that the amount of fines related to US mortgage activity, totaling $51 billion since 2008, has tailed off as the majority of cases have been settled. Nonetheless, a new wave of fines related to market manipulation (for example the FX and LIBOR probes), a total of $26 billion for 2014 and 2015 combined, is now likely as individual prosecutions and bank fines make their way through legal and regulatory systems.
Regulatory fines related to capital markets activity remained significant in 2015, making up 10%, on average, of top-line investment banking revenues for 2014 and 2015 combined. In addition, overall costs for investment banks have risen by 4% since 2010 despite a reduction of $8 billion in operating expenses. Once again, the combination of regulatory capital requirements and a renewed focus on market enforcement—including compliance, tighter oversight of trader behavior, and the like—has mitigated much of the savings achieved by investment banks.
Needless to say, transformation does not happen overnight. Banks must decide on their vision and explore initiatives that will result in quick wins to fund the journey. Medium-term success must be realized through a series of transformational steps. A leadership team that personifies the target organization and culture, combined with a sense of urgency, will ultimately enable full-scale transformation and long-term success.