Big has been bad for shareholders in investment banks. That’s according to a report published by the consulting firm McKinsey this week. The 13 largest investment banks made an average return on equity of just 8 percent last year — below the 10 percent achieved by the next 200. Given banks’ double-digit cost of capital, the bulge bracket is still frittering away shareholders’ money. More cuts are needed.
Big banks have hardly been sitting still: They have hacked back balance sheets, chopped bonuses and — in some cases — shut down underperforming businesses. But the top line has been shrinking faster: for the biggest players, combined revenue has fallen 10 percent in the last five years, while collective costs dipped just 1 percent.
Rising legal and regulatory costs have hampered the efficiency drive. If big banks don’t swing the ax harder, the cost of employing more lawyers and compliance officers could cut their average return on investment to just 4 percent by 2019, McKinsey says. To avoid that fate, investment banking will need to reinvent the full-service model where banks aim to offer a full range of products in many places around the world. As McKinsey puts it: “The mathematics of the old world view no longer add up.”
Costs are where the biggest opportunity lies. Banks have been too sluggish to adopt utilitylike structures to handle posttrade administration. Rationalizing absurdly complex organizational structures in trading businesses is another no-brainer. On McKinsey’s reckoning, the big 13 each need to cut an additional $2.5 billion over the next five years. That’s equivalent to lopping a quarter off their 2012 operational costs.
McKinsey may be basing its calculations on a low baseline — UBS and Credit Suisse have reported underlying investment banking return on equity of more than 15 percent in recent quarters. Banks can become more efficient by tapping new clients and ditching unproductive ones. And as laggards retrench, those that remain should have more pricing power.
But in the absence of mergers — which regulators are unlikely to allow — the full-service investment banking model is unlikely to survive at more than a few institutions. And if that comes to pass, investors may finally get their money’s worth.
Dominic Elliott is a columnist at Reuters Breakingviews. For more independent commentary and analysis, visit breakingviews.com.