Turning around investment banking: An agenda for reviving profitable and sustainable growth

Published: March 22, 2016

Executive summary

Investment banks have faced a series of challenges over the last several years. The new regulations that followed the financial crisis have changed the industry in a number of ways, making it difficult to profit from many traditional lines of business by creating onerous capital, funding, and liquidity requirements and increased costs and operational complexity. Although investor confidence and deal flow have recovered somewhat, the trading environment for previously very profitable business lines in fixed income, currencies, and commodities has remained challenging.

At the same time, advances in technology have upended client interaction models, execution platforms, and operational processes. Competitors and new entrants have seized ground across the banking industry’s value chain. Innovative technology applications have reduced the barriers to entry for challengers, resulting in a real competitive threat. Although in principle established banks can retaliate, their existing technology platforms, outdated and inflexible as they are, can hamper the timely incorporation of new technologies.

These external forces notwithstanding, we believe that investment banks can regain profitability and competitiveness, but to get there they need to transform their business and operational strategies from within. Though nearly all investment banks have taken steps to revamp their business portfolios, build on their core strengths, and streamline operations, many of these efforts have been incremental. Few banks have undertaken genuinely transformational changes in the most important areas. We have identified five specific fronts that we believe will be the source of a winning strategy for most investment banks in the years ahead. Failure to enact an internal transformation, on the other hand, will lead to unsustainable business models and balance sheets.

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The state of the industry

In the post-crisis environment, global banks — investment banking divisions, in particular — have struggled to make ends meet. In our most recent annual study of bank performance, we estimated that in 2014 the 29 global systemically important banks (G-SIBs) collectively missed their cost of equity thresholds by about 3 percent, thereby incurring an aggregate economic loss of about US$90 billion. (See “Appendix: Key findings from a review of banking industry performance in 2014.”)

At the segment level, their investment banking businesses suffered the biggest profit slumps, with a weighted average economic spread (return on equity minus cost of equity) of –6.2 percent. In dollar terms (economic spread times equity), these businesses were the second-biggest economic loss makers, accounting for $27 billion of the total G-SIB economic loss. (Retail banking was the biggest dollar loss maker because of its scale.)

For this reason, through announcements of strategy, organizational, and leadership changes — most recently by the likes of Deutsche Bank, Credit Suisse, and Barclays, preceded by an earlier move at UBS — one question has framed the discussion for all global banks, at least in the minds of their audiences: What is their strategy for the investment bank?

The answers from the banks are starting to go beyond the post-crisis patter of risk-weighted assets and cost reduction. For the past seven years, nearly all banking organizations have continued to take steps to de-risk, de-lever, refocus, simplify, and drive out cost. But now they are also starting to look at more fundamental transformations.

Some have chosen to pare their investment banking businesses back to the bare minimum needed to service the private, corporate, and institutional clients on which their core franchises depend.

Others — including those for whom investment banking essentially is their core franchise — see more of a future for investment banking in its own right. These banks are concentrating on the product, service, operational, customer, and regional niches where they believe they can win in the medium to longer term.

Those still committed to a universal banking model that offers a full range of products and services are looking to offer something that their more specialized peers cannot: a combination of best-in-class advice, global multi-asset execution capability, and aggressive pricing, all underpinned by technology and scale efficiency.

The regulatory demand for higher levels of capital continues to be both a focal point and a general concern of the sector, and is a particular handicap for certain investment banking product and service categories. However, there is an emerging dichotomy between, on one hand, the continued focus on capital efficiency and, on the other, a willingness to deliver strategies based on an unquestionably strong balance sheet. As Tidjane Thiam, CEO of Credit Suisse, has put it, “The penalty for having too much capital today is limited; the penalty for having too little [capital] in the banking sector is very material.”1

In light of this, the capital efficiency agenda is less about maximizing return on equity through leverage — that game is up — and more about creating the balance sheet capacity, in combination with fresh capital issuance when necessary, to grow in areas where sustained economic profits can be made.

Though the best strategy for growth will, of course, differ from one bank to another, all investment banks are going to need to restructure and reposition their business if they are to achieve sustainable growth and profitability in the current environment. In the following pages we discuss the five key areas of transformational change that we believe are critical to all investment banks:

  • Building strategic coherence
  • Progressing from technical to strategic optimization
  • Rethinking client profitability
  • Accelerating operational efficiency and organizational change
  • Focusing on change execution

Banks are starting to look at more fundamental transformations.

Conclusion

Over the past several years we have published a series of reports on the challenges facing capital market participants. Recent reports include “Banking industry reform — a new equilibrium,” “De-leverage take 2: Making a virtue of necessity,” “Capital Markets 2020: Will it change for good?,” and “Post-trade services in financial markets: Moving from backstage to center stage.”

In recent months, based on our analyses of market conditions, regulatory initiatives, and discussions with clients, it has become clear that the challenges confronting the industry have increased in severity. We believe that banking organizations need to change in ways that are more structured and more complex than at any time in the past, and we have reached several conclusions about the transformation imperatives for 2016 and beyond.

During the next year we will follow through with a series of more in-depth studies on the different constituent issues, challenges, and potential solutions.

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Turning around investment banking: An agenda for reviving profitable and sustainable growth