Regulation reshaping the investment banking industry

October 2013 | COVER STORY | BANKING & FINANCE

Financier Worldwide Magazine

The past few years have been an uncertain time for investment banks around the world. After years of prosperity and exceptional returns, the industry was sent reeling by the global financial crisis, and has suffered since. Further, with a raft of incoming regulation due, the business of investment banking may soon fundamentally change. In order to compete, investment banks must redouble their response to the regulatory challenge, begin to restructure large sections of their business and, in many cases, reinvent their client proposition.

Current conditions

In the near-five decades between 1960 and 2008, the global investment banking industry rode an unprecedented wave of expansion in terms of both size and revenue. By almost any measure, the sector generated outstanding returns for shareholders, making its employees incredibly wealthy in the process. Since the financial crisis, however, much has changed and the industry must now contend with exceptional regulatory, supervisory and strategic challenges, all during a period of poor economic growth. “The sector has been hit heavily by market conditions and regulatory changes,” says Barney Reynolds, head of Financial Institutions at Shearman & Sterling LLP. “The regulatory changes have been particularly significant in introducing new restrictions, requirements and regulatory capital charges which have increased the costs of many types of transactions.”

As a result, returns have collapsed. According to the Boston Consulting Group, returns on equity (ROEs) for the world’s biggest investment banks have halved, to about 10 percent in Europe and 13 percent in America. They are expected to fall further as the full force of regulatory change is felt. Revenue also remains depressed. Immediately following the crash, revenue slumped by half, then recovered to unmatched levels the following year. Since this time it has remained weak, with 2012 generating just two-thirds of 2009’s record $341bn.

In addition to the more immediate impacts of the financial crisis, the sizeable losses incurred and the subsequent failures and taxpayer bailouts shook confidence in the sector to the core. This explains, at least in part, the wave of regulation seen since 2008. As much as regulatory change has been an attempt to reign in the excesses of the investment banking industry, governments have also largely submitted to public opinion on the subject.

Regulation has been aimed squarely at increasing transparency, reducing risk arising from opaque markets, increasing capital requirements, dampening leverage and overall risk-taking, and restricting the usage of customer assets. Starting with the capital requirements, Basel III requires all banks by 2019 to have equity buffers about three times larger than the minimum under the old rules. The largest banks – those deemed systemically important –must have even larger capital cushions. The very biggest, most interconnected or complex banks must hold up to an extra 2.5 percent of equity capital on top of the 7 percent that will be mandatory for others.

Although the rules limiting the businesses in which banks can become involved are generally less developed than those covering capital requirements, they also have far-reaching consequences. The US Volcker Rule, for instance, proposes to stop banks trading for their own profit. Many banks are currently ignoring or attempting to evade this proposal, but it will still outlaw a range of profitable activities that banks have relied on in recent years. The Volcker Rule affects a number of European banks, too, as it will impact their US operations. And while such a rule is unlikely to be applied outside the US any time soon, other jurisdictions are watching closely. Regulators in the UK, for instance, have said they may impose something similar if the Volcker Rule proves successful.

The way in which such regulation has been rolled out means investment banks face the unenviable challenge of responding to multiple regulations that are either a work in progress, as in the case of the Volker Rule and other bank structure reforms; span multiple years, such as Basel III; or have been driven by local regulators. In a number of cases, new regulation falls under all three of these umbrellas. The regulatory environment, then, is one of increasing complexity, and banks have been understandably troubled by the uncoordinated nature of its implementation and potential impact on future earnings. They are also concerned about how rules such as the Dodd-Frank Act and Europe’s proposed cap on bank bonuses will be implemented.

The effects of this regulation have been wide-ranging, affecting the types of business that banks carry out, the organisation and location of legal entities, and where, and how much, capital they hold. Investment banks have been left grappling with increasing compliance costs, a reduction in the scope and profitability of their business activities, and additional capital costs. All of this is hitting home at the same time, making for what many see as a ‘perfect storm’ for the industry. The sheer volume of regulation is becoming too much for many banks to absorb, particularly those at the smaller end of the scale, and, more worryingly, may be too much even for regulators to keep track of.

There are further dangers of regulating too fiercely, and governments should be wary of pushing too hard. Rules on securitisation have made it harder for banks to shed risk and keep issuing new loans. By unlocking the capital markets and helping firms to manage risks, investment banks provide important channels of credit to economies struggling with slow growth. Despite what public opinion would suggest, the investment banking sector plays a vital role in reducing the cost of capital and in allocating that capital to its best use. Despite the risks, however, global leaders may be tempted to pile on additional regulation if we see more controversy along the lines of the Libor rigging scandal.

Meeting the challenge

In this environment, forging successful business strategies can be a daunting challenge. In what ways, then, are investment banks responding to the new regulatory landscape, and how are they juggling the sustainability of their business models with compliance requirements?

In the wider industry, banks have been cutting their losses by shrinking investment banking units and focusing on more profitable businesses. Swiss bank UBS announced 10,000 job cuts throughout its investment banking operations in 2012, and British bank Barclays said this year that it would lay off almost 4000 employees as part of a major reorganisation.

As major banks withdraw from the market, others may reap the benefits, says Mr Reynolds. “The price of capital and capital-raising are likely to be susceptible to increase, along with the price of advisory, custody, client asset and other services, particularly after further industry consolidation as some of the current players drop out of the market. So, many opportunities abound in the short to medium term.” But the more forward-looking banks are not relying on job cuts or disengagement alone. Rather, they are incorporating regulatory changes into their business models, and redefining their organisations for the longer term.

According to Accenture’s ‘Top Ten Challenges for Investment Banks’ report, high compliance costs have led a trend of consolidation and outsourcing of high capital-consuming business practices, exemplified by the scarcity of banks registering to be Swap Dealers or Major Swap Participants. The report also notes that global banks are setting up overseas funds transfer services for other providers, including fund management processes.

Investment banks have several options when responding to forthcoming regulation. These range from basic compliance to comprehensive outcomes that use the regulatory response as a lever for implementing change programs. In the case of the latter, frameworks for change must be closely tied to the bank’s overall strategy, and the best approach to today’s regulatory demands may be to organise them into common themes for implementation.

Mitigating foul play

Investment banking has always faced the problems of rogue trading, market abuse and excessive risk taking, and, on the whole, the financial services industry has supported the re-regulation of the sector in this respect. However, despite tighter regulatory controls, trading scandals have remained prominent in the news headlines. Most recently, JP Morgan revealed losses of $5.8bn on the back of a series of credit default swap transactions, and Barclays was fined a record £290m for attempting to manipulate the Libor inter-bank lending rate. Recent years have also seen UBS lose $2bn on unauthorised trading activities and ETFs, and Societe Generale take a €4.9bn hit due to the actions of a junior trader. While regulators can do their utmost to combat such offences, the buck stops with financial institutions themselves. What steps, then, can they take to mitigate such risks?

Identifying the failures that lead to rogue trading and market abuse is complicated, though there are a few key areas that banks can address, including aggressive corporate culture, a focus on profits to the detriment of risk management, and inadequate processes, controls and IT systems. Effective governance is a prerequisite to getting a handle on such areas, according to Accenture’s report, and it is essential to appoint dedicated senior executives, such as a Chief Risk Officer, to communicate the company’s risks and exposures throughout the organisation. No matter how well potential risks are communicated, however, without adequate processes and controls, misdemeanours are still likely to arise. Banks must therefore place a greater emphasis on regularly reviewing trading operations and implementing monitoring systems and mechanisms to identify suspicious trading patterns.

In addition, in order to combat short-term risk taking, banks must reconsider their approach to incentives and payouts. The industry has already come a long way in this respect. Remuneration in the sector remains excellent compared with other industries – it must be, to attract high-quality candidates. But where investment banks were once legendary for the size of their bonuses, payouts are now a shadow of their former selves. And Accenture’s report suggests that banks can go a step further, by tying bonuses to designated funds composed of assets generated within the bank. In this way, the team that executes the deals has a stake in their value and success.

But perhaps the most important step that investment banks can take toward preventing rogue trading and other undesirable practices, is to foster an organisation-wide culture of compliance. No level of technology, monitoring or governance can fully protect a bank from the risk of foul play, but a strong culture of risk management can certainly help. Nurturing a responsible corporate culture is certainly a more effective means of battling such offences than mere regulatory compliance. “Sophisticated legal and compliance oversight is key, but cultural change runs deeper than that and includes those on the business side,” says Mr Reynolds. “Significant efforts are being made to control culture. I don’t think these involve going through the motions. There again, I don’t believe they will be fail-safe, since no culture can protect against all types of individual behaviour. I just think that systems will become more and more sophisticated so that the actions of rogue traders are picked up swiftly and dealt with,” he adds.

The future

Going forward, what can we expect from the investment banking sector? Are further challenges on the horizon, and if so, how will banks adapt in the long term? Perhaps a good sign, at present, is that some investment banks are beginning to hire once again.

Recruiters say they are at their busiest since 2010, and banks are adding new staff to revenue-generating positions including M&A advice to equities trading. According to the Financial Times, Nomura, Citigroup and Bank of America have started hiring dealmakers and traders in Europe – a sign that recruitment is picking up following a two-year cull that saw thousands lose their jobs. In addition, several banks have scrapped the traditional summer hiring freeze to ensure they get the best talent.

However, these are slim slivers of light, and the industry should not become too excited. Mr Reynolds, for one, expects more regulation in the coming years. “I see more regulation of some business lines such as prime brokerage – which can be conducted in an investment bank as well as a bank, repos, stock lending, and more regulation of areas such as rehypothecation, client asset protection, treating customers fairly and market conduct. These reforms are all in gestation at the international or local levels and will be implemented over the next few years leading to enhanced costs to be passed on or swallowed.” Banks must therefore expect further regulatory change. They must also be prepared to incorporate new rules into their long-term business models, displaying agility and flexibility in the face of adversity. Being prepared for and adapting to change will be critical to long term success.

In the meantime, it must be recognised that public opinion of the sector is likely to remain focused on the issues of business lending and bonuses, while the many positive actions undertaken by banks and bankers may take a long time to shift perceptions. While the technical challenges of implementing new regulations, and incorporating them into business structures, are complex and will take time to implement, this may prove a less daunting and time-consuming challenge than winning back the confidence of the general public.

Matt Atkins