Banking will be permanently smaller and poorer
For most of the investment bank revamps and restructuring from 2009-2014, little changed. Headcount was flat or up from 2009-2011, trending down only afterwards. For every market which was dead post-crisis, there was another which was booming. But this time it’s different; the two decade investment banking boom is over.
The catalyst for thinking long term is the annual Oliver Wyman/Morgan Stanley Blue Paper on wholesale finance. The study finds that investment banking fees, as a proportion of GDP, are at their lowest level since 1995.
For Europe, given that GDP has been mostly flatlining for years, it’s pretty clear that it’s the numerator, not the denominator, that’s shrunk the ratio.
This means that the classic association of investment banking with growth is starting to break down. It’s not enough to simply have a strong presence in a growing economy to make money; there are structural forces shrinking the total size of the capital markets pie.
There has also been a palpable change in the attitudes of bank management and shareholders, as they start to wake up to the problem. In the five stages of post-crisis investment banking grief, we’re well beyond denial, anger and bargaining, and are floating somewhere between depression and acceptance.
Although there are bright spots — financing the consolidation of the US pharmaceutical industry last year, or the recapitalisation of the European banking system over the past three years — there is simply less money in being a financial intermediary these days.
Some of the economics are being taken away by the buyside, now the repository of more securities and more direct risk-bearing capacity, than ever before. Alternative assets, direct lending, buyside intermediation, all-to-all trading, and the like have all changed the face of the market, and given a happy home to many a stray banker.
But some of the juice in the business is simply disappearing. Business models which involve extensive cross-subsidy just don’t work as well anymore. Corporate treasurers are no longer willing to tip their investment bankers as much for low priced lending, or simply for good coverage.
Banks themselves also have to unwind some cross-subsidies. Primary dealerships, for example, paid their way better when rates trading volumes were more higher, and banks could offer long-dated, highly structured bespoke macro hedges alongside their government bonds.
It’s worth remembering that the industry has been through brutal changes before. Areas of investment bank activity that now seem commoditised, such as cash equities or sovereign futures, used to be profitable in their own right.
Banks adapted and innovated, using the older, simpler, businesses to support other lucrative activities — cash equities now helps to support equity derivatives, structured products, retail broking, prime brokerage, and ECM. But pure-play institutional equity trading has become dominated by non-banks, and non-humans.
This time though, there isn’t an innovation in store that will expand the overall wallet. Instead, the only way to change the game is to cut costs, meaning people first, and increasing efficiency, in the form of better technology, afterwards.
It’s an inevitable change, but still slow-moving. For every European investment bank in apparent crisis, there’s a bullish Japanese/Chinese/Gulf Co-operation Council-based institution to talk up its hiring plans, and claim that it can grab market share in a shrinking market.
It’s also not clear that, overall, a declining investment banking wallet is a bad thing.
Some of the decline represents deals that weren’t done, or capital imperfectly allocated (though in this QE-distorted world, it’s probably best not to think too hard about whether the markets are allocating capital well). But for deals that were going to happen anyway, investment banking fees are a cost of financial intermediation; a percentage of each financing that doesn’t pass through to borrower or to saver .
The lengthy value chains in active asset management skim off more than arrangers’ fees, but the P&L of investment banking origination businesses ultimately comes out of the pockets of borrowers or savers. Let’s remember 1995, the last time fees were this low as a proportion of GDP, wasn’t a bad year.
The macroeconomic backdrop of the 1990s may have been unusually benign from a historical perspective, but growth roared on in the West, with a smaller section of the proceeds skimmed off by the financial world. A smaller banking sector need not be a disaster.