SOURCE: The Boston Consulting Group

The Boston Consulting Group

April 26, 2012 12:00 ET

BCG: Investment Banks Face Tall Challenge -- Improve Profits and Polish Image

As Regulatory Climate and Sluggish Economies Pressure Revenues and ROE, Capital Markets Players Must Choose the Right Business Models and Become More Client-Centric, Says Boston Consulting Group Report

NEW YORK, NY--(Marketwire - Apr 26, 2012) - Investment banks, beleaguered by macroeconomic uncertainty, pending capital constraints, and negative publicity, will have to make hard choices on the scope of their activities -- as well as place a greater emphasis on client interests -- if they hope to return to precrisis levels of performance, according to a new report by The Boston Consulting Group (BCG). The report, titled Tough Decisions and New Directions: Global Capital Markets 2012, is being released today.

According to the report, most major firms in the industry are operating at a return on equity (ROE) of 7 to 10 percent, half the historical level and half of what investors will expect in the long term. A return to ROEs of 15 percent or higher is possible only if firms take the right steps to bolster revenues, control costs, and manage their capital and liquidity resources wisely.

"We believe that all investment banks -- whether large or small, global or local, universal or niche -- can regain their lost profitability and ROE despite the tall challenges they are facing," said Philippe Morel, a BCG senior partner and coauthor of the report. "But not every player will be able to succeed, and there will be tough decisions to make in terms of clients, markets, asset classes, and product portfolios."

The first choice confronting investment banks concerns the client segments they target and the volume they aspire to in the coming years. According to the report, roughly 70 percent of all trading volume will predominantly be executed electronically by flow providers that can achieve near-precrisis profitability by achieving scale. Twenty percent of volume will be driven by relationship experts -- banks that have redesigned their organizations to focus purely on delivery to the client -- and will comprise trades that still need manual execution. The remaining 10 percent of volume will be driven by principal traders that are willing and able to take significant and longer-term risks, and will be made up of transactions that are largely illiquid.

The report adds that two additional approaches will gain prominence in the market. Category killers, such as a hedge fund that competes directly with principal traders on high-alpha-return strategies, or a major energy company trading in commodities, will aggressively pursue parts of the value chain that are dominated by flow providers, relationship experts, and principal traders. Utility providers, focusing on such areas as clearing services, back-office functions, and risk modeling, will be active in parts of the value chain that are no longer economical or are considered less critical for many banks.

Although none of these five approaches is innovative per se, companies will no longer be able to divide their energies as many did in the past -- in essence doing a bit of this and a bit of that, the report says. Allowing for a modicum of overlap among approaches, players must decide which business model they will primarily focus on.

Bolstering Revenues. Investment banks still have a number of ways to raise revenues, such as embracing a highly client-centric strategy, capturing the potential of RDEs, and strengthening core capabilities in key areas of opportunity -- such as providing transparent hedging solutions to corporations or long-term investment solutions (to offset the low-interest-rate environment and high market volatility) to institutional investors. Limitations on proprietary trading combined with shrinking fees and margins on flow products are increasingly making client centricity the name of game, the report says. The key for investment banks is to realize that focusing in earnest on the long-term interests of the client -- not on the short-term interests of the bank -- will ultimately serve both parties best.

Controlling Costs. In order to climb back toward ROE levels in the midteens, investment banks must continue to rein in costs. This is chiefly a matter of aligning costs strategically, reworking compensation and benefits, and potentially delayering the organization. The report specifically notes that there is a clear need for greater transparency in bonus allocation and for performance to be determined on a risk-adjusted basis for the bank, factoring in qualitative performance evaluations that include criteria such as ethical standards.

Managing Resources. Regulatory pressures are forcing capital-markets players to be vigilant about capital reserves and liquidity. But even if this were not the case, efforts to deleverage and to maintain sufficient liquidity are good practice and should be embraced as part of a comprehensive program to lift performance and raise ROE. Although the worst of the liquidity crisis is largely over and solvency is now the greater concern, liquidity should still be managed like capital.

Overall, according to the report, we will see a capital markets world with a "different flavor" -- not just in developed markets but in RDEs as well. The purely intermediary role of investment banks in helping to structure financing will remain. However, because of regulatory constraints, more players will distribute assets immediately to investors that are tired of fixed-income and equity-market volatility and hungry for long-term assets to match long-term liabilities.

"Ultimately, investment banks have a history of resilience," said BCG's Philippe Morel. "They have faced financial crises before and found new ways to grow, to serve clients, to manage risk, and to move forward with confidence. There may be a shadow over the industry at the moment, but for those players that find the most efficient and effective ways to deal with adversity -- and that execute their chosen strategies sharply -- the future can still be bright."

A copy of the report can be downloaded at www.bcgperspectives.com.

To arrange an interview with one of the authors, please contact Eric Gregoire at +1 617 850 3783 or gregoire.eric@bcg.com.

About The Boston Consulting Group

The Boston Consulting Group (BCG) is a global management consulting firm and the world's leading advisor on business strategy. We partner with clients from the private, public, and not-for-profit sectors in all regions to identify their highest-value opportunities, address their most critical challenges, and transform their enterprises. Our customized approach combines deep insight into the dynamics of companies and markets with close collaboration at all levels of the client organization. This ensures that our clients achieve sustainable competitive advantage, build more capable organizations, and secure lasting results. Founded in 1963, BCG is a private company with 75 offices in 42 countries. For more information, please visit www.bcg.com.

About bcgperspectives.com

Bcgperspectives.com is a new website -- available on PC, mobile phone, and iPad -- that features the latest thinking from BCG experts as well as from CEOs, academics, and other leaders. It covers issues at the top of senior management's agenda. It also provides unprecedented access to BCG's extensive archive of thought leadership stretching back almost 50 years to the days of Bruce Henderson, the firm's founder and one of the architects of modern management consulting. All of our content -- including videos, podcasts, commentaries, and reports -- can be accessed via PC, mobile, iPad, Facebook, Twitter, and LinkedIn.