An unprecedented array of challenges confronts the investment banking industry in the aftermath of the financial crisis. Regulatory requirements and compliance costs are steadily increasing. Client demands are changing and intensifying. Disparate legacy systems and processes need to be updated and integrated. High structural costs must be tamed. To overcome these challenges, banks must focus on transforming their businesses. We believe that building a better ecosystem is the key to success.
Progress toward a better ecosystem has been slow and tentative, however. As investment banks seek ways to deliver sustainable returns to investors, they have, for the most part, made incremental and tactical changes, complicated by pressure from regulators. Their focus has typically been concentrated on scaling back their businesses, reducing headcount and withdrawing from geographies, asset classes and customer segments. Long-term strategy has been deprioritized, hindering the emergence of new banking ecosystems.
Forces reshaping the industry
Amid this lack of long-term focus, the industry’s return on equity (ROE) has fallen. ROE for the top 16 global investment banks was 9.2% in 2016, up from the 2015 average of 7.6% but well below the peak of 19.5% reached in 2006. The sector’s performance may decline further as regulatory demands and prudential rules continue to drive up costs and risk-weighted assets. Without cost restructuring and capital optimization, banks will continue to struggle to generate double-digit returns.
Those that manage to do so will have to overcome powerful headwinds. Competition from regional and domestic rivals is intensifying. Regulators require investment banks to hold more capital and liquidity and to curb activities such as proprietary trading. And though demand for many investment banking services remains strong, particularly in the equities space, revenues of major investment banks in some businesses, including FICC, are diminishing and will likely never regain their pre-crisis peaks.
Banks’ efforts to counter these threats are hampered by legacy operations and organizational cultures, as well as legacy and proprietary IT systems that leave the banks behind the technological curve. If global players cannot evolve, they may continue to lose market share even if, as we expect, the overall capital markets sector recovers.
We have identified five levers of change that investment banks can operate to define the course of their evolution (See Figure 1). Banks must control their operations by managing risk and exerting financial controls, and protect themselves from internal and external threats. They must reshape themselves to align their organizational design and size to their future strategies. They must grow revenues and market share. And they must optimize processes and systems as they move toward a smarter ecosystem. We believe that banks must be innovative to apply these levers successfully.
A T-shaped tomorrow
Much of that innovation will take place in the realm of organization design. As the far-left illustration in Figure 2 shows, today’s banks can be viewed as rectangular in shape, with a front office supported by layers of middle-office and back-office functions. By contrast, tomorrow’s bank will be “T-shaped,” with the front office, where competitive advantage is maintained, at the top of the T. Supporting the front office will be a thin spine of functions and services. Rather than rely on their middle and back offices to handle non-differentiating data, processes and functions, this leaner iteration of the investment bank will make extensive use of industry utilities and a diverse range of partners.
By operating at the center of an ecosystem of vendors, partners and peers, the investment bank of the future will create opportunities to realize economies of scale. Depending on its chosen strategy and model of collaboration, the bank may (with regulators’ consent) shift to external delivery of support operations by other members of its ecosystem. Some banks may choose to spin off industry utilities into profit-seeking entities within the same organization and develop them into growth businesses. Others may divest some technology and operations to another player better positioned to perform specific utility services profitably. Others may lead industry consortia or participate in them by contributing financial, technological or operational investments.
Some banks will likely opt to work with other banks to set up common external platforms for meeting know your customer and anti-money laundering requirements. They might also contract with specialist third-party providers for services such as post-trade processing and tax and regulatory reporting. If these arrangements are to function safely and efficiently, banks will have to develop robust mechanisms to protect customer data and privacy and establish trust with counterparties.
They must also meet regulatory requirements. Regulatory technology solutions can play an important role for effective and efficient regulatory compliance. We also see a key role for analytics and artificial intelligence (AI) in reducing the cost and manual effort required to monitor activity across the bank. AI and advanced analytics also make it possible to analyze and prevent cyber attacks by identifying patterns of questionable or risky activity. This is a vital capability, considering the financial and reputational damage that a single data breach can cause. We believe that real-time collaboration to share information about cyber threats is critical in strengthening the industry’s data security.
Emerging ecosystem players and the challenges they face
Most of today’s industry utilities have evolved in the back-office space, which is traditionally a non-differentiating area of the capital markets value chain. Consider capital markets trade processing, a complex business featuring high-volume trading processes that are integrated with multiple products and post-trade processes. It is also a costly business, whose regulatory reporting requirements and other mandatory activities reduce the funding available to develop and implement value-added technology and processes. These activities increase fixed costs, impeding the organization’s flexibility.
Moreover, today’s trade processing businesses typically rely on entrenched, proprietary back-end systems that use outdated programming languages. The programmers fluent in these languages are either approaching retirement or have retrained in more up-to-date languages. As a result, there is a dearth of top-tier talent available to maintain and improve these systems.
To overcome these and similar constraints, various players are emerging to offer new ways of providing shared services, often in the form of industry consortia. But consortia face specific challenges, namely the difficulty of persuading competitors to collaborate, even on a limited basis. If the consortia succeed in overcoming reluctance to participate, they will then face conflicts over which technology is adopted and how to pay for integration. Their choice of technological platform may often wind up being “the best of the worst.”
Other potential players in investment banking ecosystems, in particular FinTech players, will likely encounter barriers to entry should they attempt to compete head-to-head against incumbent organizations. FinTech newcomers may instead opt to collaborate with incumbents, just as in the pharmaceutical industry, where small niche players collaborate on drug development with established producers, benefiting from their capital and marketing and distribution networks.
To collaborate successfully with new FinTech entrants, investment banks need leaders who visibly and consistently embrace the opportunity to work with — and learn from — innovative firms. Risk appetite must evolve toward working with smaller organizations, while at the same time managing the critical risks, such as cyber and data privacy, where there can be no compromise.
Opportunities through convergence
The logic behind such alliances of established and emerging players is compelling. As regulations, new technologies and cost pressures converge to all but compel change, banks and other industry players will choose to employ third-party utilities, or collaborate to develop them, both to control costs and afford themselves greater operating flexibility. The movement toward shared utilities will likely accelerate as the industry develops standards for activities that drive up cost, complexity and operational risk but do not create competitive advantages for banks.
Effective structural and technological changes could see investment banks’ legacy estates shrink, enabling greater efficiency and cost reductions of as much as 30%. Banks will have lower capital requirements and smarter revenue acquisition and will deliver a better client experience. Growth will again be a possibility.
By evolving to a T-shaped structure, investment banks can make strides toward sustainability. Better ecosystems will play a key role in ensuring their transformations are successful and durable, to the benefit of clients, investors and markets.
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