Investment banks need to rethink profit strategies

Boston Consulting Group (BCG) forecasts that return-on-equity in the investment banking industry could fall to as low as 5% and says overall compensation structures need to be rethought as part of a cost reduction.

In a report issued on Wednesday, BCG highlights the now well-documented constraints within which investment banks are operating: a weakening business outlook; strict regulations; high capital costs; and reduced leverage. The Massachusetts-based consulting firm goes on to question whether investment banks can emerge from the crisis as viable universal banks, suggesting most have not yet fully examined this issue as they have been focused on short-term survival.

Had the crisis been less acute, investment banks would have restructured themselves, shed unproductive assets and innovated to create new opportunities, suggests BCG, but the severity of the current downturn is weakening the resilience of investment banks, while increased governmental activism and regulatory scrutiny are hampering innovation.

BCG also makes the now well-recognised point that balance sheet leverage was underlying growth in the most recent up-cycle, with proprietary risk-taking replacing risk-free intermediation as the core revenue driver. But it goes on to suggest that this dynamic masked the commoditisation of the core intermediation business and banks are now being forced to confront their sub-scale and unprofitable presence in many businesses.

BCG has developed scenarios of how revenue in the investment banking industry could evolve. In a bull market scenario, revenues will grow at a compound annual growth rate of 4.5% between 2007 and 2010 and result in a profit margin for the industry of 16% in 2010, down from BCG¹s estimate for 2007 of 22%. In a deleveraged scenario, revenues shrink over the same period at a CAGR of 10% and profit margins fall to 5% by 2010.

The assumptions underlying these projections are debatable, but the firm's conclusion that no matter how revenues play out, investment banking profitability will worsen significantly due to a shift towards commoditised businesses which yield lower returns on assets is now generally acknowledged.

BCG suggests that the crisis offers investment banks an opportunity to reinvent themselves and shift towards managing risk-adjusted profitability. It adds that even at the height of the recent credit cycle, credit-light business models generated the highest profitability. BCG therefore concludes that merely combining corporate and investment banking without focusing on non-credit, fee-based revenue streams is a failing strategy.

"We expect investment banks to return to a smaller and simpler business model," says BCG. "Such a model will have to accommodate smaller profit pools, (and) greater client demand for simpler financial solutions and the specialised capabilities of individual investment banks."

The consultancy also questions whether the universal bank model, which has been forced on investment banks, is the answer, calling it a tactical rather than a strategic solution.

An analysis by BCG of total shareholder return (TSR) at banks finds that between November 2006 and November 2007, before the onset of the crisis, the 126 largest financial institutions globally delivered an average TSR of 0%. This is based on a TSR of 5% at universal and commercial banks and -8% at investment banks. From December 2007 to December 2008 the average TSR of the same set of 126 institutions fell to -51%, with investment banks at -68% and universal banks at -55%. BCG therefore concludes that the problems were not driven by the configuration of banks but by their inability to manage risk.

BCG does, however, agree that the move towards universal banking is an opportunity for corporate and investment banks to be combined, and suggests that the reason such combines have not hitherto worked is that capital was a commodity pre-crisis. The current scarcity of capital, on the other hand, will drive the success of the combined model. BCG comments that, thus far, few universal banks have been able to leverage the diversity of their franchises to drive revenue synergies, saying most banks have failed to optimise client revenue potential and the cost to serve.

The increasing share of revenue being driven by mature, low-return-on-assets businesses leads BCG to conclude that banks will need to be highly focused on operating efficiency and address both compensation and non-compensation costs. The firm estimates that investment banks need to cut over $100 million in costs for every $100 billion in assets.

The consultancy firm suggests headcount reductions have to be accompanied by a recalibration of overall compensation structures to more manageable levels, and emphasises that savings achieved from a reduction in salaries, benefits and bonuses have less attendant operational risks than trying to reduce non-compensation expenses.