There is a common fear spreading through the financial markets today over the notion that our investment banking model is broken and may not be fixable.
Senior equities analyst for Sanford Bernstein Brad Hintz, who said he often feels like “the angel of death,” told the SIFMA Technology Conference in New York today that the investment banking model is not necessarily broken, but rather evolving due to changes in regulations along with the secular and cyclical nature of the business. "We're all tightening our belts," Hintz says, "and we're all seeing black swans under our beds."
This evolution is going to take its toll on two areas near and dear to the hearts of anyone making a career in financial markets. Compensation is going to be reduced and there will be fewer highly paid senior executives, particularly at the managing director level. The good news is that Hintz believes there will be no need for further mass layoffs, just selective cuts at the higher levels, such as reducing the number of fixed income managing directors by half, from an estimated 20 percent to 10 percent of a bank’s workforce.
"When I made managing director at Morgan Stanley, Barton Biggs came in to congratulate us and said you've given up everything to get where you are and your average life span as an MD is four years and 10 months," recalled Hintz. He went on to say that we still need the model of young bankers, giving up everything and struggling to reach the managing director, and compensation will be lower but still relatively high. There will however be fewer positions in some areas such as fixed income.
Just back from a marketing trip to meet with institutional clients, Hintz said some of the comments and concerns he heard included:
- Capital markets banks are uninvestable!
- Their stocks are trading like honorary European banks.
- Will any firms profit from industry changes?
- Is this a secular or cyclical problem?
- Is the model broken and should we just all retire?
“The model isn’t broken—it’s just not working as well as it used to,” said Hintz. But that doesn’t mean it isn’t working at all. Hintz noted that over the past 30 years, the U.S. Brokerage Industry has grown at an annual average of 7.6 percent. Between 1980 and 2000, it grew at 9 percent a year. The point he’s making is that while business has fallen off, it is still growing.
“Revenues aren’t great, but it’s not the end of the world,” said Hintz. “There is some good stuff such as tier one capital ratios. They’re very good as are pre-tax margins.”
He noted that M&A, equity derivatives and fixed income derivative margins were all above 35 percent and equity underwriting was over 45 percent, while fixed income market making and retail brokerage were in the 20 percent margin range and asset management was over 30 percent.
Haunting the Industry
“What’s haunting the industry now are the lessons we’ve learned from the financial crisis,” said Hintz. “All major financial institutions are linked through trading, settlement and derivatives relationships. That means a credit event at one firm is passed through to all of them. Think of it as a bunch of bungy cords tangled together so that when one person jumps they pull everyone else over with them.”
Other lessons from the crisis, according to Hintz, include:
- Wholesale funding at a bank can unwind quickly during “black swan” events.
- Hedges and risk management metrics can fail when markets become illiquid or when market sectors are perfectly correlated
- Regulatory rules do not always work as designed.
The changes going on in the financial services industry are going to impact different sectors differently.
In fixed income, revenues are going to drop. “Proprietary trading is going to be prohibited under the Volcker Rule, and this is going to throw a real wrench into market making revenues which will be reduced by around 20 percent,” said Hintz. “Fixed income derivatives will be centrally traded and settled. Leverage will be down and risk will be constrained. At the same time, carry costs are going to rise due to liquidity and funding changes. Finally, there will be lower credit ratings to the point that only one bank, J.P. Morgan, will be able to issue Commercial Paper.”
Hintz said he doesn’t think institutional equity business will get any worse than it already is. Prime brokerage is going to be hurt, and the high margin M&A and equity underwriting business is going to be hit hard.
“IPOs should be doing brilliantly right now,” said Hintz, “but when the volatility index pops, IPOs stop. Deal teams are busy but executives can’t pull the trigger. This is a cyclical problem, not secular.”
As for retail brokerage, retail revenues are correlated with non-farm pay-roll and Hintz doesn’t see any recovery until 2014.
Wall Street’s only alternative is to reduce compensation, re-engineer the business, limit capital in trading books and to push for higher commissions in equities and wider bid offer spreads in fixed income.
Hintz predicts the average compensation of an MD in sales and trading will drop by 20 percent and the percent of MDs in a trading operations will decline from 15 percent of the staff to 10 percent. SVP compensation will decline by 15 percent and all of this will reduce the compensation ratio to 40 percent.