The world of Goldman Sachs, Morgan Stanley and the rest of the investment banks is being remade, squeezed by new regulations and record low volatility in the markets.
So what will the new world look like?
Gary D. Cohn, the president of Goldman Sachs, described the current market well last month when he noted the “difficult environment” for investment banks. He said that “what drives activity in our business is volatility.” If markets never move, he continued, “our clients really don’t need to transact.”
The decline in volatility has sharply reduced already low investment bank trading revenue. Citigroup’s chief financial officer, John C. Gerspach, said at a recent conference that Citigroup’s trading revenue could be down 20 to 25 percent in the next year. Other banks are expecting similar declines.
Banks are being affected not only by poor economic conditions, but also by the constraints placed upon them by the Dodd-Frank Act, Basel III and other regulatory changes. These new rules have restricted the ways investment banks can make money, as through proprietary trading, and more important, they have also imposed higher capital requirements.
It is hard to understate the effect of these capital requirements on Wall Street investment banks. While the decline in trading revenue is pushing investment banks to find new business or to shrink, the capital requirements are causing overhauls at the banks.
As one banker put it to me, there is now “no room for loss leaders,” and there are “no cheap businesses.” Anything a bank does these days affects its capital allocation.
The conventional wisdom has been that these banks are making choices about how to restructure their business, but in truth their options are limited.
For example, Morgan Stanley has been shifting its focus away from investment banking. Under its chief executive, James P. Gorman, the bank has been looking for “ballast,” as he recently said in a cover article in Barron’s magazine. Morgan Stanley has found its counterweight in wealth management by purchasing all of Smith Barney. The idea is that the business will provide steady revenue through downturns.
Morgan Stanley probably picked asset management because it already had a stake in Smith Barney and lacked the capital and stability to remain a stand-alone investment bank. But as Morgan refocuses, trading is down. According to Barron’s, trading is now just 12 percent of Morgan’s revenue, compared with 30 percent in 2007.
Goldman Sachs, for its part, has played to its strengths, remaining a more traditional investment bank because it already had a big wealth management business and the capital to stay the course. Goldman has maintained its focus on trading and traditional investment banking activities, such as advising on takeovers and mergers.
In 2013 trading was 33 percent of Goldman’s revenue, almost three times what it was at Morgan Stanley and well ahead of any of its peers. And Goldman’s advisory business is likely to exceed $8 billion in net revenue this year, exceeding by more than one-third those of its nearest competitors, JPMorgan Chase and Morgan Stanley.
While Goldman tries to stay the course as a traditional investment bank, others are joining Morgan Stanley in looking to other lines of business. And again, these decisions are significantly driven by the need to judiciously deploy capital. Wells Fargo, for example, has always been known for its mortgage business, and so is focusing there.
Other banks are retrenching, lacking good options. Citigroup and Bank of America are distracted and focused on getting smaller. Citigroup has been trying to wind down its unwanted assets through a wholly owned subsidiary, CitiHoldings.
Other banks, like Barclays, which acquired the investment banking business of Lehman Brothers, are now turning away from the industry. Barclays’ investment bank is in free fall, with top executives departing. It has also announced that it will cut the bank’s working capital in half and eliminate a quarter of its jobs.
The big banks are also being pushed to contract or discard investment banking businesses by regulators. Both Barclays and JPMorgan Chase have moved to leave the commodities trading business in part because of those pesky capital requirements. A miniscandal over metal storage also helped that push. But Goldman, continuing its stay-the-course strategy, remains in commodities.
So where does it all end?
If you want to know, the best place to look is probably at Goldman, which is perhaps the last true investment bank standing.
The firm is now like an accordion. When the markets are down, Goldman slims down. Goldman has cut 10 percent of staff since 2010 and moved many employees to lower-cost locations like Salt Lake City. But when the markets heat up, Goldman’s plan is to expand. There is clearly lots of room: In 2006, its trading revenue was $25.6 billion, about 50 percent more than what it is now.
Goldman is betting that the economy will grow. For the moment, the firm is looking to change as little as possible and maintain its return on equity at its 2013 level of 11 percent.
If the strategy works, Goldman’s future is rosy, but if it doesn’t, the bank will stagnate.
As for Morgan Stanley, it will still have to see if its ballast works. Morgan continues to have world-class businesses in M.&A. advising and in other areas of investment banking, but it will now also face the pressure of being compared to other asset managers. And Morgan will struggle to meet that comparison unless it can improve its return on equity, which for 2013 was 5.1 percent, excluding accounting charges. Measure that against the world’s largest asset manager, BlackRock, which had a return on equity of about 11 percent for last year.
As banks decide what they want to be and where they will go, there will be a shakeout in investment banking.
If Goldman and others are correct that the downturn in investment banking is not permanent, those who invest now will thrive later. Either way, the transformation of Wall Street is likely to leave a few big banks as global players as the rest retreat.
One reason for this is that there are unlikely to be new entrants into the investment banking market. One effect of Dodd-Frank and other regulation is to create huge barriers to entry. Gone are the days when you could hire a few traders and be off. Now you need a whole regulatory compliance structure and capital. Companies who exit an investment banking business are thus unlikely to re-enter.
When I asked one banker who these last big players would be, he named Goldman. Also on his list were JPMorgan, because it is so big and good at what it does (despite some missteps), and Deutsche Bank, because it is the leader in Europe and Europe is still a huge market.
If such a consolidation occurs, it will concentrate economic power, the last thing regulators wanted. But the markets could also take different directions and show other business models to be more successful.
One thing is for sure, though: There are revolutionary changes afoot in the world of investment banking as they all search to do what they do best — make money.