Ambition should be applauded, but only so long as it stays on the right side of achievable.
James Gorman must be getting tired of being asked about his fixed income business. At this week’s shareholder meeting, the chairman and chief executive of Morgan Stanley was again being grilled over whether there is a profitable future for a mid-sized player in fixed income.
In particular, the question for Gorman and for Colm Kelleher, the fixed income veteran who runs the institutional securities division at Morgan Stanley, is how a bank without the scale of a JP Morgan or a Deutsche Bank (which generate two or three times the revenues as their smaller rival) can compete in fixed income without taking as radical approach to restructuring as, say, a UBS.
For the timebeing, Gorman is confident that there is a profitable future for the division, just so long as it can keep bringing down the risk-weighted assets in its fixed income business to levels that are no longer punitive in terms of capital. He said this week that he saw no reason for more job cuts, that the business was roughly the right size, and that its RWA diet was not only on track but ahead of target.
It has already reduced its RWAs by 35% from $390bn since it first announced its crash diet in the third quarter of 2011, and this year has cut them to $253bn , slightly deeper than scheduled. It plans to reduce them by another fifth to $200bn by 2016.
What does that mean in practice? On the back of some fairly simplistic assumptions, this translate into a reasonable target, but one which will require everything to come together and work smoothly in a manner that has not traditionally been associated with fixed income at Morgan Stanley.
Take the following assumptions:
- In 2016, the fixed income division at Morgan Stanley will have $200bn of RWAs under Basel III.
- Assume a 9% equity ratio (as Morgan Stanley does), and it will fund these RWAs with $18n of equity.
- Assume that in order to be sustainably profitable, the division needs to generate a net return on equity of 12%, and it will have to generate net profits of just under $2.2bn.
- Assume a tax rate of 30%, and it will have to generate pretax profits of $3.1bn.
- Assume a pretax margin in the fixed income division of 40%, and you end up with a revenue target of just over $7.7bn in Morgan Stanley’s FICC division in 2016:
This $7.7bn is only 37% ahead of the $5.6bn the FICC division made in 2012 and it has nearly four years to get there. That translates into a compound growth rate of just 8%, which suddenly makes the target look like child’s play.
But there is a but. Several of them in fact. The target of $7.7bn may be little more than a third above the divisional revenues from last year, but it is an altogether more challenging 70% higher than the bank’s FICC revenues over the past four quarters of $4.6bn (that annual growth rate has just gone up to 14%).
This is because in the first quarter of this year, Morgan Stanley’s FICC business posted an unpleasant surprise for the third time in the past four quarters, with revenues falling by 42%, compared with an industry average of 13%. A big reason for last year’s disappointing performance was the downgrade by Moody’s in the second quarter, and the bank has said that it does not see the $1.5bn it made in FICC in the first quarter as a ‘ceiling’ of any kind. But neither point changes that the target is tougher than it at first looked.
At the same time, Morgan Stanley will have to generate revenues not far short of its banner year in 2009 to hit the $7.7bn target, but with a lot less ‘stuff’ to play with and a lot fewer staff to play with it. It target of $200bn in RWAs is around one third less than the $310bn in RWAs off which it made $5.6bn last year, and around half what it used to deploy.
And, with little prospect of any growth in industry-wide revenues to give Morgan Stanley a leg up towards it targets, any growth will have to come by stealing market share off others. This means the bank will have to beat bigger players like JP Morgan, Goldman Sachs and Deutsche Bank in taking market share from other firms who are retrenching in fixed income.
Oh, and there will be no room for any mistakes or accidents over the next four years.
Of course, it’s not impossible. But it might be a lot harder in practice than it looks on paper.