Higher aggregate costs and new competition have cut investment bank ROE in half over past 10 years

Higher aggregate costs and new competition have cut investment bank ROE in half over past 10 years

Higher aggregate costs and new competition have cut investment bank ROE in half over past 10 years

The FINANCIAL -- Major investment banks’ return on equity has fallen from close to 20% in 2006 to less than 8% in 2014, meaning firms will have to make significant changes to return to low double-digit profitability and offset the impacts of higher costs, control failures and intensifying competition, according to EY’s Transforming investment banks 2015, a report on how investment banks can shape their legacy and rebuild their business models.

Aggregate costs for major investment banks increased from US$148b in 2005 to US$185b in 2014, a 25% increase resulting from a more stringent regulatory environment, litigation, and fines and trading losses due to control failures. If costs had remained at 2005 levels, 2014 return on equity (ROE) would have averaged 4.5 percentage points more, at 12.3% instead of 7.8%, according to EY data on investment bank performance.

Many banks now are targeting a 10% ROE, barely above their cost of equity. Achieving 12% to 15% ROE is possible, but banks cannot do it on cost reduction or revenue growth alone. They must focus on optimizing assets and operations, transforming culture, becoming client-centric, and investing in technology to hit an ROE above 12%.

Steven Lewis, Director, Global Lead Analyst, EY Banking & Capital Markets, says:

“Investment banks have found themselves in protect-and-survive mode for the past several years, making incremental changes to fix issues around profitability, productivity, culture, controls and trust. These piecemeal reforms have done little to rebuild the industry, and only a comprehensive, transformative approach will help investment banks thrive again.”

A cost and productivity crisis is harming the industry

Many institutions have taken initial steps to simplify their business, rebalancing their focus across portfolios and exiting non-core or poorly performing business lines. Further legal entity rationalization, of both special purpose vehicles and booking entities, can save banks millions each year. EY estimates that each legal entity costs a bank up to US$600,000 annually, meaning rationalization can yield significant savings and reduce risk and complexity when investment banks are operating hundreds or thousands of entities.

Existing asset optimization initiatives will gather pace, but they are insufficient to improve performance substantially. EY has found that even when institutions have delivered risk-weighted asset (RWA) optimization programs, further savings of 15% to 20% of RWAs can still be made by improving data, models, and regulatory and business processes.

Roy Choudhury, EY Americas Capital Markets Operations Leader, says:

“To deal with a challenging ROE environment, investment banks will need to reassess their customer, product and service profitability, factoring in a range of market and regulatory constraints. Cost-optimization in Capital Markets – Operations likely will be an area of heightened focus for banks, and firms are in the early stages of assessing utility-type solutions to improve cost efficiency in securities operations. Taken together, these changes will help enhance efficiency, productivity and profitability.”

Three quarters of banks are not yet using compensation to drive cultural change

Weak controls and employee behavior that is unaligned with delivering client and shareholder value have proven costly. Banks should identify what drives behavior, focusing on employee incentives. While 74% of banks globally are focusing on enhancing communications about behavior, only 26% are thinking about adapting compensation to reflect softer cultural issues.

EY analysis shows there is little correlation between staff cost per employee and revenue per employee between fiscal years 2012 and 2014. The report says banks should consider redefining employee behavioral expectations and the employee proposition to attract and retain talent motivated by new cultural attributes rather than pay alone.

Boutiques and other new competitors are taking market share

Since the financial crisis, clients have diversified their sell-side relationships and spread business across multiple firms to secure the best price and manage risk, giving rise to an increased role for boutique banks. Boutiques advised on 22% of global M&A deals in 2014, compared to 16% in 2007.

The report says banks must identify their core clients and their needs, improve systems to monitor client satisfaction, and enhance the client experience by creating a “single shop front” — breaking down silos and creating a single customer experience within the institution.

75% of banks’ IT spend goes to systems maintenance

The past 15 years have seen significant market restructuring, takeovers, business exits and volume increases, but technology has remained underinvested. IT departments continue to be under pressure to do more for less every year and spend 75% of their budgets on systems maintenance. They will have to invest to upgrade and integrate legacy systems and determine whether certain technology functions, processes and underlying services are best provided internally or externally.

Through salary model optimization, operating model efficiency and supply chain enhancements, banks can free up a further 5% to 10% of their staff costs to reinvest in technology. Banks also should increase investment in improving data to give them a better understanding of the efficiency of processes and behaviors of clients.

Micha Missakian, EY Europe, Middle East, India and Africa Financial Services Assurance Market Leader, says:

"Enhancing data quality will not only improve risk management and regulatory compliance, but it also will be a key component of a bank's success in the future. Those that invest in data quality will reduce cost, will better serve their clients and will eventually be better positioned to switch from a remediation agenda to a profitable growth agenda.”