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Squeeze is on for investment banks

September 10, 2009

Peter Thal Larsen.jpgInvestment banks are facing a big squeeze. For an industry that was generating record revenues just months after the collapse of Lehman Brothers, this may seem unlikely. But the revival looks set to be short-lived. Increased regulation and greater competition means the super-charged returns the industry generated for most of the past decade are likely to prove elusive.

Analysts at JPMorgan believe 2009 will prove to be the high point in the investment banks’ relentless upward march. They expect revenues in 2011 to be no higher than in 2006. More significantly, the industry’s return on equity will fall to 10.8 percent, far lower than what they have got used to.

What explains this reversal? Regulation plays a big part. Contrary to the received wisdom that investment bankers are being allowed to carry on much as before the crisis, regulators have whacked up capital requirements for complex, illiquid products. These were the source of much of investment banks’ profit during the boom, and most of the trouble since. Higher capital charges will make a lot of what banks’ structured credit desks used to do unviable, and reduce the profitability of what remains. Caps on leverage will also make it harder for banks to juice returns.

Similarly, the drive to ensure more derivatives are traded on an exchange or, at the very least, cleared through a central counterparty will have a big impact. Blowing away the fog that surrounds derivatives will make it harder for banks to hide their true cost from clients and clear the way for new players to enter the market.

Indeed, competition is on the rise across the board. Investment banks enjoyed near-perfect conditions in the first half of the year, as volatile markets boosted trading activity while those that had survived the crunch were able to demand wider spreads. But many of the banks that got into trouble are now rushing back into the market, helped by cheap state-subsidised funding.

Of course, banks will not sit still. Anyone who witnessed the wholesale shift from equities into fixed income following the stock market crash of 2001-2002 will recognise that the industry has an extraordinary knack for rapid self-reinvention. Most houses are already cleaning up with fat fees as companies issue equity to pay off some of the debt they took on during the credit boom. Banks also have a long track record of circumventing new regulation.

Nevertheless, it’s hard to see any new business permanently filling the hole left by the structured credit collapse. Regulators will also be much more vigilant with banks seeking to pile risky assets — of any description — onto their balance sheets. This means the majority of future business is going to have to come from more old-fashioned activities such as underwriting, advising and trading — all of which are less profitable.

What else can the industry do to improve its returns? The three obvious steps are to reduce the amount of equity they use, to employ less bankers, and to cut costs — what JPMorgan’s Kian Abouhossein euphemistically describes as a “transfer of employee returns to shareholders”. In other words, investment banks will be smaller, employ fewer bankers, and pay lower bonuses. Outside the banks themselves, it’s hard to see anybody regarding this as anything other than a welcome — and long overdue — turn of events.

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