Investment Banking

THE INVESTMENT BANKING INDUSTRY:

Investment Banks (IB’s) are financial intermediary institutions that play a critical role in the capital market, by supporting the entities on rising capital both in the form of equity or debt. Another key area of action of IB´s has been providing assistance in Merger & Acquisition (M&As) processes. Other activities are also conducted by these institutions including brokerage, derivatives and equity securities trading, market making and financial advisory. All the trading and underwriting related activities are part of the called Sell Side being the advisory and assistance services included in the Buy Side of the business. These activities are divided according to their nature in Front Office, Middle Office and Back Office.

Front Office covers the revenue generating activities, namely “Investment Banking” (securities underwriting and M&As), Sales & Trading and Research. Because they also obtain revenues from trading financial instruments with their own money, they must ensure the total independence of their different divisions (advisory and trading) to avoid conflict of interests. Such dependence is kept by the commonly called “Chinese Wall”, being an ethical barrier preventing any possible conflict of interest due to information leakage that could be used to obtain benefits in proprietary trading or for other customers.

Middle Office involves activities such as risk management, financial control and compliance, treasury and strategy. These control related activities on the transactions conducted by Front Office, and are crucial to keep the business within the reasonable level of risk (market related risk), protecting the company stability.

Lastly, the Back Office comprises of the operational side and all technology Related responsibilities. While Front Office negotiates and makes deals, back office is responsible to ensure the transactions are executed successfully .

The industry evolution

Having its origin in the 19th century, the industry has undergone through several ups and downs with successes and crises followed by regulatory actions aimed at protecting the investor interest and the health of the sector. Some relevant acts worth mentioning, dated in the first half of the 20th century are the Security Act of 1933 (disclosure of all relevant information in security issues), Glass-Steagall Act of 1933 (Separating Commercial and Investment banking) and the Security & Exchange Act of 1934 (Setting Financing & Governance Procedures).

Later in the 1970’s, important changes began in US market following the going public of most firms, the collapse of Bretton Woods system, the volatility of the market created after the rising of OPEC, the Employee Retirement Income Security Act of 1974 (Prudent Man Rule) and the Repeal Of Fixed Commissions in 1975.

Changes continued in the 80´s in US and in the international capital market with the adoption of the Shelf Registration Rule (1982) and the numerous M&As. More recently in the 90’s, the IB industry enjoyed a golden era signed by the issuance of $15 trillion in securities, $10 trillions in M&As, the emergence of the Euro and the globalization of the industry. The wave of privatizations in US, the rising of the pension funds and sector deregulation were factors that fuelled the growth of the business.

The growth of the international market brought volatility as the industry was susceptible to the risks caused by crises such as the Mexican Devaluation (1994), The Asian Economic Crisis (1997) and the Russian Default in 1998 that contributed to the fall of LTCM. Looking at the evolution and trend of the IB´s industry, many analysts have categorized the sector as one signed by a short memory, at that is evidenced by the quick recovery and survival after the 1998 crisis with the significant rising of Euro-denominated securities and Internet IPOs. Investors were also interested in emerging markets and the wave of M&As continued while banks were in a race to be part of the Global Bulge Bracket. Exhibit 1 contents the global IB revenue and fees trend for the past 10 years, and how are they divided by provenance, showing clearly the impact of the latest financial crisis in 2008.

The present and the future scenario:

The impact of all these events went beyond just the regional economy, but impacted the global economy. Repercussions were felt not just in the industry, but affects individuals and families. Political pressures have pushed regulators to strengthen measures to mitigate the risk of future financial crises. The increasing regulations (Basel III, Volcker Rule) are changing the cost structure of the industry, forcing them to rethink their business model. With total global revenues in 2013 of $76 billion, the cost of regulatory compliance is estimated about$15 billion. Industry ROE has moved from 20%-25% before 2008 to 10%-13% after that year. The increase in controls has pushed the IT cost of the business to approximately 7.3% versus an average of 3,7% in other industries. Also, the need to completely eliminate proprietary trading by July 2015 (Volcker Rule) in US and within two years in Europe is also going to curb one of the main revenue streams for IBs.

The challenge that IBs are facing calls for a paradigm shift and many analysts are convinced that low profits is a new reality that is here to stay. Institutions have been taking all the possible cost reduction initiatives (Exhibit 2) including traditional headcount reduction. But not being enough, alternatives not commonly seen as a possibility for sensitive transactions in this industry, as outsourcing back office and research activities, are now discussed. Other changes in paradigms that IB’s are now forced to consider include moving from a global diversification to a narrower scope of business lines.

Experts view that in the future, IBs have to define the segments in which they have the highest competitive advantages and focus their activities there. Given the commoditization and low profit activities, volume and level of scale seem to be the way forward and it opens possibilities only for a few players including those that can become a global highly automated Business Flow providers. The economic case is compelling. Despite the argument of losing control of core activities, banks may consider the opportunity of important cost savings by outsourcing their flow to an utility who is able to concentrate a big volume and take advantage of the economies of scale, but this is an alternative to be carefully analyzed.

Bankers and portfolio managers, have to become more customer centric , a cultural change that could take years, considering an industry built by revenue seekers. It implies having customer satisfaction as part of the KPIs (not only the volume of sales), as well as a clear top-down risk management culture.

Citing a McKinsey’s partner: “In order to get to that right culture it is really about clarifying the priorities of the bank, moving away from self-centredness and the notion of ‘I’m here to make money for myself’ and saying: actually we are here to serve society and real economic purpose, doing the right thing, not selling your clients things they don’t understand or frankly don’t need”. Clearly, the banker career changed including bonuses significant reduction and less attractive remuneration.

The future of the Investment Banking industry seems signed by a business model change in which massive growth in the same terms observed in the previous decades is no longer seen. Concentration in areas of clear competitive advantage, cost reduction, risk control, low profit, outsourcing of business flow, commoditization and customer oriented culture are key elements to be considered in the new Investment Banking business model.

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