With JP Morgan kicking off the second quarter earnings season for investment banks today, here is the third article in a series looking at the challenges facing investment banks.
Whichever way you look at it, Wall Street has a problem. Over the past few days, I have written about its revenue problem (revenues have fallen by one third over the past two years across the street), its cost problem (cost-cutting has failed to keep up), and its profitability problem (average pretax return on equity across the industry has more than halved over the past year to less than 10%).
Despite a recovery of sorts in the first quarter of this year, the painful combination of falling revenues and stubborn costs is punishing the banks’ bottom line: on a trailing 12 month view (that is, the past four quarters), pretax profits slumped by 50% in the year to the end of March at a sample of 15 large investment banks, and they have collapsed by two thirds over the past two years:
While every investment bank posted a decline in pretax profits in the past year when compared with the 12 months to March 2011, not all banks have struggled to the same extent.
JP Morgan tops the rankings for pretax profits with $8.8bn in the past 12 months, a decline of just 8% (although rivals argue that JP Morgan does not fully allocate central costs to its investment bank division). HSBC’s global banking & markets division (which includes several more stable businesses than most ‘pure’ investment banks) notched up $7.2bn.
A clear chasing pack has emerged in the past year with four banks: Goldman Sachs, Citi, BAML, and Barclays – separated by just a few hundred million dollars of pretax profits at around the $5bn mark. A clear second tier is also evident, with BNP Paribas, Morgan Stanley and SG coming in just below $2bn.
Deutsche Bank is somewhere in between on $2.8bn after a worse than average 56% fall in pretax profits in the past year, while the newly-created RBS Markets division made pretax profits of $1.1bn (down 72%). Credit Suisse (-$1.1bn), Nomura (-$0.5bn) and UBS (-$1.2bn)will all have to keep up the momentum of the past quarter to reverse their rolling 12 month pretax losses.
With revenues continuing to fall and banks struggling to bring down costs fast enough, the outlook for the rest of the year is not pretty.
On my estimates, investment banks would need to cut costs by as much as 26% relative to 2011 in order to get their profitability up to where it needs to be (at least in line with their cost of capital)
This assumes that the in the second quarter revenues are in line with analysts expectations (a 30% fall in FICC revenues compared with the first quarter, and a 20% fall in equities and investment banking revenues), and that banks are able to cut their costs by 10% compared with the first quarter (an optimistic assumption).
The chart below shows three scenarios and their likely consequences for investment banks: the first is that revenues in the second half of 2012 are the same as in the second half of last year. The second assumes optimistically that revenues jump by 10% over the rest of the year, and the third assumes that fall by 10% on what was a pretty dire second half in 2011.
Whichever way you look at it, the implications for investment banks and their staff are grim: in order to meet their cost of capital, banks would have to cut costs by between 17% and 26% compared with last year. That translates into many more thousands of job cuts, and many fewer millions in bonuses…