Investment bankers and traders are unlikely to fondly recall 2012.
Regulators in Europe and the US began leaning on global investment banks to slash risk-weighted assets during the year, ratcheting up the capital needed to support businesses, particularly in fixed income. That impacted profitability and drove down return on equity (RoE) ratios, making shareholder patience razor-thin.
At the same time, Asia’s traditionally strong equity trading market had its second consecutive trying year, with volumes at near four-year lows, according to consultant firm Roland Berger. China initial public offerings (IPOs), a core revenue earner for investment banks, collapsed over fears of eurozone credit issues and a sustained slowdown in China.
Equity capital markets (ECM) issuance in Asia ex-Japan tumbled to US$156 billion between January and December 14, the lowest since Lehman Brothers collapsed in 2008, according to Dealogic.
Even completed deal volumes in mergers and acquisitions (M&A) fell 31% year on year to US$300 billion between January and early December. And banks were accepting lower fees while would-be buyers and sellers increasingly mandated multiple advisers.
The only bright spot was Asian debt issuance, a relatively lower-margin business, which reached a record US$808 billion in 2012, according to Dealogic.
The combination of regulatory tightening and plummeting volumes is prompting an overhaul among global investment banks. In the past few months Citi, Deutsche Bank, Credit Suisse and UBS have announced plans to cut a total of 26,500 jobs globally, while Nomura has revealed an Asia-focused strategy that essentially means a withdrawal from much investment banking activity in Europe and the US.
Royal Bank of Scotland’s announcement to forfeit cash equities and equity research was an ominous start to 2012. As a recipient of government bailout funding and a bank deemed a systemically important financial institution (Sifi), it was no longer able to keep loss-making businesses at the expense of UK taxpayers.
“The cost of running the business was very high and it wasn’t sustainable,” recalls John McCormick, CEO of Asia-Pacific for RBS, who describes the unwinding process as akin to a “heart attack”.
RBS wasn’t the only one to drop the axe. On October 30, Zurich-based UBS announced it was largely exiting its global fixed income business, and its investment banking capabilities would mainly cater to its private-banking clientele. Deutsche Bank and Citi respectively cut their equities and fixed income, commodities and currencies (FICC) departments in Hong Kong.
Investment banks have weathered previous downturns. But this time the pressure is more intense due to simultaneous regulatory changes, which are eating into profits. More staff cuts are needed.
“There is currently overcapacity in the industry and that will need to be addressed further, even if we don’t see any further shrinkage in fee pools,” says Bhupinder Singh, head of corporate finance and structuring for Asia-Pacific at Deutsche Bank.
Asia, a region with big potential but relatively little in earnings, is not immune.
FICC trading troubles
The combination of bad markets and heavy capital requirements has hit FICC particularly hard.
The Basel Committee’s new capital requirements look dimly on trading over-the-counter (OTC) derivative products such as credit default swaps or complex instruments. They require banks to increase the amount of capital they keep when trading them with other financial institutions or hedge funds, particularly if they are non-investment grade or unrated.
Under Basel III, the risk weightings of some instruments will jump as much as five times compared to Basel II, according to the Boston Consulting Group (BCG). As a result, banks’ risk-weighted assets will rise by up to 105% post mitigation, at least half of which will come from FICC, according Morgan Stanley estimates.
“The regulators are much more aggressive, much more intrusive and much more demanding or commanding of the banks. They are learning the lessons of the 2008 global financial crisis and they’re also going back to the issues the Asia Pacific faced in 1997-1998,” observes the head of a European investment bank.
This means that trading such instruments has become more expensive. Analysts estimate the new capital rules will cut the RoEs of flow trading products (such as simple currency or interest-rate swaps) by 20% while the RoE of FICC OTC derivatives (such as synthetic products involving more than one type of risk or underlying asset) will fall by 40%.
The new capital charges are likely to impact pure-play investment banks in particular, which tend to focus more on OTC-type business. As a result, they will reduce trading in Basel III-impacted derivatives except in specific areas where they are major players.
Credit Suisse slashed at least 17 people in its FICC division, including Singapore-based staff in foreign exchange and rates sales, according to market sources. Bloomberg reported that the bank intends to cut the risk-weighted assets of its investment bank by 37% of their end-September level, and reduce costs at the investment bank by CHF550 million (US$602.21 million) through unspecified cuts.
Morgan Stanley has embarked on similar measures, cutting its trading assets from US$341 billion in the third quarter of 2009 to US$231 billion in the same quarter of 2012, according to a December 13 Credit Suisse report by research analysts Howard Chen, Christian Onwugbolu and Ashley Serrao, which followed a dinner with Morgan Stanley CEO James Gorman.
The report ascribes the drop in a large part to Morgan Stanley reducing its Basel III-impacted securities, leaving its trading assets roughly 36% below peers such as J.P. Morgan, Goldman Sachs, Citi and Barclays.
“In light of recent competitor announcements to exit certain or all of their fixed income trading businesses, Mr. Gorman believes the MS [Morgan Stanley] pathway to re-tooling its fixed income franchise is the optimal route for MS shareholders,” said the report.
The bank is likely to cut further. Credit Suisse estimates Morgan Stanley had US$46 billion in non-productive FICC assets (or assets with a 0% yield) as of September.
UBS has been more extreme. On October 30 it announced that it would close most of its FICC operations, including commodities and structured fixed-income trading products in Asia ex- Japan. In Asia it axed up to 60 traders in credit structuring, real money and rates sales amid broader efforts to cut 10,000 jobs worldwide, or 10% of its total 64,000 workforce.
The move stunned competitors and clients.
“Many clients are unhappy about what has happened,” said a former UBS employee. “Nobody at the rank-and-file level, nor many fixed income buy-side clients in Asia, can understand why they are doing this. Right now, morale at the organisation is at rock bottom.”
However, UBS stock soared to its highest level since July 2011 after the plan was announced.
Larger banks with big balance sheets are best placed to bear the increasing capital cost of derivatives. They account for roughly 60% of the FICC revenue pool and typically make most money in flow products, which are less affected by Basel III. With large balance sheets and FICC businesses they can soak up extra capital charges more easily, and could even benefit from pure-play investment banks scaling down in FICC.
“We believe an onshore presence around the region is key to having a deep and diversified fixed income business. It means we’re not too reliant on any single currency, asset class or geography,” says Gordon French, head of Asia Pacific global markets at HSBC. “There’s no question that scale matters in flow fixed income markets.”
RBS’s McCormick agrees. “To run those businesses you do have to be global. You might be doing well in a couple of pockets but if you’re not firing on all cylinders, it becomes very tough,” he says. “If you get into the situation we did where you have to subsidise that from other areas that are strong, you get into a vicious circle where you’re actually denuding investment of those [strong] businesses … to make weak ones better.”
However, even these integrated banks will see FICC profit margins fall and are trimming where possible. In November, Citi cut more than 20 employees in its Asia FICC division, including the head of FICC sales in Hong Kong and Macau and foreign-exchange traders.
Axing secondary equities
For other institutions, the sword is falling upon equities.
The new regulations impact equities divisions far less, only increasing the risk weighting of equity risk assets by an additional 20%. But the sector is heavily commoditised; even in good times cash equities makes virtually no money, with market leaders relying on accompanying prime-broking services. And over the past two years, trading volumes have fallen.
“We’ve seen pressure in brokerage, clearing and execution fees, and market data,” says Nick Gardiner, a partner at the BCG. “These are typically 10%-15% of the total cost base. Experience suggests that it’s possible to squeeze 15% out of that by rationalising the set of brokers that you’re using and which market data sources.”
Deutsche Bank cut 10% of its Asian equities sales and trading staff, or about 50 people, in September amid weak trading revenue. Back in January, Samsung Securities shelved nascent plans to be a regional equities player, firing people of among staff of 100. And RBS was unable to gain the scale to compete and sold its Asia equities and M&A business to CIMB on April 2.
Industry sources suggest that Barclays may also trim or cut its equities and M&A departments. The bank only began to build the businesses in 2008, and it has been costly. A November 14 Morgan Stanley report estimated that the UK bank could raise its RoE from 9.5% to 14% if its exited Asia equities and investment banking and focused on FICC. It estimated that Barclays’ Asian equities and investment banking business will have a cost-to-net-income ratio of 110% in two years, higher than in Europe and the US, while estimated net income of €600 million (US$970 million) in 2014 would be lower compared to other regions. A spokeswoman for Barclays declined to comment on whether the bank was considering cuts to the two departments.
Cutting back longstanding businesses is painful, even if necessary. Gardiner expects it to take a minimum of three to five years for banks to restructure FICC and equities divisions.
Cutting investment bankers
Most global banks are even slimming down core investment operations after 2012 revenues failed to improve over a lowly 2011.
Initial public offering (IPO) volume, the core fee earner of investment banks in Asia, tumbled to US$36.1 billion in Asia ex-Japan between January and December 13, the lowest since 2008, according to Dealogic.
China IPO volumes nosedived to a quarter of their 2010 peak. That hurt; ECM heads say that in recent years China IPOs accounted for around 60% of revenues. J.P. Morgan’s Fang Fang, chief executive of its China operations, told Bloomberg that IPOs may account for less than half its China investment banking revenue in 2012.
Largely as a consequence, investment banking fees in Asia excluding Japan fell 28% in 2012 compared to the same period in 2010, Dealogic notes.
“We’re not going back to the glory days of 2009 or 2010,” says Thérèse Esperdy, co-head of J.P. Morgan’s Asia Pacific corporate and investment bank. “But will deal flow reemerge once people see signs of stability and a sustained effort of reform post the [China] leadership transition? Yes. Investors will rebalance, recalibrate and re-engage.”
In straitened times, investment banks will have to cut resources and staff to prevent RoE ratios from sliding. BCG says the cost-to-income ratio of ECM and M&A globally is around 80%, compared to 60% for commercial, corporate and transaction banking departments.
That has led investment banks to try cutting senior staff such as managing directors to 10% of personnel from 20% today, says BCG’s Gardiner. Goldman Sachs has promoted the lowest number of senior officials to partner status since 1999 and persuaded existing partners to leave to save costs, according to The Wall Street Journal. About 13% of its partners are in Asia.
Banks further down the fee rankings will require the deepest cuts. As of late December the top three fee earners from M&A, ECM and DCM activity across Asia ex-Japan were UBS, J.P. Morgan and Deutsche Bank, respectively. They accounted for 12.2% of the Asian fee pool, according to Dealogic.
The next tier includes, in descending order, Credit Suisse, HSBC, Goldman Sachs, Citi, Morgan Stanley and Bank of America-Merrill Lynch.
Some lower-ranked banks may have to cut up to 30% of core investment banking operations as they decide which strategies, services and geographies to focus on.
“They absolutely must cut people if they’re going to raise the return on equity above 10%. If they don’t, shareholders will wonder why they’re in the business,” says an industry insider. “UBS made a really bold move [cutting in FICC] and its stock price shot up.”
Overall, investment banks must cut 40,000 jobs globally, according to a November report by Roland Berger. Assuming Asia comprises around 15% of this, or the equivalent of its contribution to most bank revenue levels, 6,000 jobs will need to go.
Banking groups that count corporate and commercial banking alongside investment banking have embarked on more radical structural shifts.
Deutsche Bank further integrated its global transaction, commercial and investment banking operations in Asia in June, and is planning to more closely integrate its asset and wealth-management businesses. This will be a “potent” move to take advantage of the fact that many Asian companies are headed by families and will be especially beneficial in markets like Southeast Asia, according to Singh. J.P. Morgan merged its investment bank, corporate bank, treasury and securities services in July.
The banks describe such moves as “synergies” that help complementary divisions work together. That’s true, but it also allows them to eradicate coverage overlaps. A bank may have an investment banker, a corporate banker and a commercial banker covering a corporate or the family that owns it; combining divisions lets it cut some relationship bankers and support staff, leaving the remainder to discuss a broader range of financing options.
Advocates of this approach include Deutsche Bank, Citi, HSBC, J.P. Morgan and increasingly Bank of America-Merrill Lynch. They argue that because they provide corporate clients with a list of low-margin flow services, including cheap loan funding, clients should give them investment banking mandates too.
HSBC claims the strategy is paying off. “We don’t have to worry about the next IPO or the M&A deal,” says Robin Phillips, head of the bank’s global banking and markets for Asia-Pacific. “We can mine our commercial-banking client base [and] our private-banking client base, and there’s a clear demonstration that is working.”
The UK bank is targeting shared revenue of US$2 billion between its commercial banking and global businesses in all regions, with a large portion of that coming from cooperation between commerical banking and global banking and markets.
Citi is also using its corporate bank network to help win mandates for investment banking deals, such as Temasek Financial’s US$1 billion selldown of SingTel shares in September. It appears to be working; the US bank was the only institution to rank in the top three for arranging equity capital markets, G3 debt capital markets and M&A deals in 2012.
Larger, full-service banks can also typically provide capital to corporations 200 basis points cheaper than pure investment banks such as Morgan Stanley, claims an investment banking head at one integrated bank. They can then barter cheap funding into inclusion on investment banking mandates.
“There are obvious advantages from a balance-sheet perspective vis-à-vis the standalone, traditional investment banks,” agrees Esperdy. “Over time, and that’s not necessarily a 12-month horizon, people will need to rethink their model.”
A combination of desperation among investment banks for business and the increased assertiveness of integrated banks has increased competition for ECM and M&A transactions, inflating the number of bookrunners on deals.
An extreme example occurred on November 30, when the People’s Insurance Co (Group) of China conducted a HKD8.1 billion (US$1.04 billion) IPO that had 17 banks mandated in various arranger capacities.
Pure-play investment bankers think it’s bad for business, arguing that gangs of deal participants tend to squabble, while each member has less incentive to support the issuer.
“If someone’s going to pay you a red-cab fare, why would you give them a Rolls-Royce every time?” says one investment banking head.
But the banks have still been willing to take lesser roles. Partly this is down to poor market volumes, but IPOs and block trades are also increasingly commoditised. As a result, fees will keep falling, leaving banks that rely on them at a distinct disadvantage.
“It will be much more challenging for the pure, standalone players and they will have to reconsider their business models to … play in this new era,” says Joydeep Sengupta, a partner at McKinsey & Company.
Pure-play investment banks argue that they retain a key competitive advantage: superior advice.
Dan Dees, co-head of investment banking in Asia Pacific ex-Japan at Goldman Sachs, says pure investment banks have been written off before yet continue to thrive. And it’s true that they topped Asia’s ECM and M&A league tables in 2012.
Dees believes more clients ultimately value intellectual capital over balance-sheet support.
“[Offering cheap financing and deal support] moves them up the league tables no question, and they leverage off of their balance sheets as they have in the US and Europe. But I still think clients want to reward innovation and expertise, which is how we hope to find our way to the top again next year.”
Matt Hanning, UBS head of investment banking for Asia Pacific, agrees. “We’re not looking to deploy the balance sheet the way a commercial bank would,” he says. “You can legitimately consider whether you need to have as talented an individual plugging the last mark of the client relationship if you’re owning the client relationship through a balance-sheet relationship.”
Being seen as the industry best is an advantage. But the line of error for pure-play banks has become thin. They are increasingly reliant on a narrower set of businesses, as the new bank capital regulations makes fixed income trading costlier and incoming US rules look set to cut them off from proprietary trading too.
Being more dependent on remaining business channels is bad news when ECM and equities trading are becoming less specialised in tough times.
Meanwhile, integrated banks can continue relying on stable returns from flow businesses that contribute to RoE. That helps offset slower times in investment banking, which could prove a key advantage if capital markets continue to drift and equity trading volumes remain low in 2013.
If that happens, investment banks will face renewed pressure to cut costs and deploy valuable capital in only the most profitable areas. They will have to consider which countries to cover less and which product teams to slim down.
This could mean the world’s investment banking specialists revert to a model closer to merchant banking; using a mixture of their own capital and money from wealthy private clients (see box) to support core clients with select, high-margin deals.
Over the long term, five or six large-scale banks are likely to underpin the bulk of the region’s FICC markets and they will increasingly account for ECM and M&A volumes too, courtesy of their corporate relationships. Plus there will be local champions, favoured in one or two nations.
Investment banks, meanwhile, will reduce their FICC trading and account for a smaller proportion of Asia’s investment banking volumes. But three or four specialist investment banks will continue to get senior roles on IPOs, block trades and advisory work for favoured clients, courtesy of established personal and political connections, and the fact they employ top talent. There will always be demand for elite advice.
The biggest losers will be international firms that lack either a cutting-edge reputation or market heft. Their only choice to boost RoE will be to focus on the most profitable divisions. Expect to see more players exit certain industries and countries as cost-conscious London, Tokyo or New York headquarters slash struggling operations.
It may take another year or two, but Asia’s investment banking space is set to get less crowded.