Investment banks face bleak future

INVESTMENT banks face a fight for survival as returns and revenues shrink, according to two reports released today.

A study by McKinsey & Co claims that investment banks are heading for a “day of reckoning” that will see many firms fall by the wayside.

And figures compiled by data provider Dealogic show that European revenues from primary advisory business have slumped to a 14-year low.

Data for primary business deals announced in August 2011 – such as advice on mergers and acquisitions, floats and debt sales – show revenues fell to just $546m (£334.8m) in Europe.

The last time they were lower was in August 1997, when they hit $474m, whereas last August banks netted $935m.

The dire numbers coincide with McKinsey’s assessment that, without drastic action, investment banks’ returns on equity will drop to just seven per cent from a current average of 20 per cent.

That is below McKinsey’s nine to 11 per cent estimate of the cost of equity, making most banks non-viable as businesses if they fail to take action.

New capital requirements from Basel III will be responsible for three quarters of the hit to returns, McKinsey claims. Worse still, it did not model the additional effect from unilateral measures such as the UK’s bank levy or proposals by the Independent Commission on Banking (ICB).

With mitigating actions, such as shutting down chunks of their business, altering pay schemes and hiking prices, McKinsey says banks should be able to push returns up to 11-12 per cent and, with succesful overhauls of business models, to 12-14 per cent.

But the study warns that the decline in trading volumes that has seen banks lay off thousands of workers “will be exacerbated by regulation, especially in structured credit and rates”.

The knock-on effect will see the cost of financial services and credit rise for businesses, as banks pass on some of the costs of regulation.

McKinsey adds that banks’ fixed income, commodity and currency (FICC) divisions and structured credit will be worst hit.

Some products like collateralised debt obligations (CDOs) “may even cease to exist” while others will see a “six-fold increase in capital requirements”, potentially making them unprofitable.

The charge for counterparty risk could rise by a factor of 2.5, McKinsey suggests, for trading unusual over-the-counter (OTC) derivatives that cannot be cleared by central clearing houses.