The investment banking industry has a problem. In fact it has at least three of them: a revenue problem, a cost problem, and a profitability problem. In the third of three articles to cheer you up after the summer break, I look at the collapse in profits and profitability investment banks.
You don’t have to work at an investment to know that if your revenues fall faster than the rate at which you can cut costs, then the impact on your bottom line is not going to be pretty. But if you do work at an investment bank, you will be painfully aware of the profitability crisis that the industry faces and of the consequences that will inevitably follow…
… As recently as 2009 investment banks were happily printing money on the back of the (premature) post-crisis relief rally. A sample of 14 large investment banks posted pretax profits between of just over $100bn and their average pretax return on equity was a buoyant 31%. Fast forward a few years and the combination of falling revenues and stubbornly high and inflexible costs have wiped two thirds off the profits of investment banks, according to my analysis, and slashed their profitability by three quarters.
This chart shows the collapse in pretax profits on a trailing 12 month (or four quarter) perspective:
Over the past 12 months, underlying pretax profits across the industry of $34bn have more than halved compared with the $79bn in the year before, and they are down by an eye-watering 67% compared with calendar 2009.
The reasons for this collapse become clear when you look at what has happened to revenues and costs at investment banks over the same period, as shown on this chart with the numbers rebased to 100 in 2009:
While revenues have dropped by one third since 2009 across the industry, costs have edged up by 2% over the same period. The impact on the bottom line has been stark, with profits down by two thirds. In the past year, banks have made some progress in cutting costs (they are down 8%), but this is well behind the 21% fall in revenues. As such, profits have dropped by 57%.
Not a single investment bank posted higher profits in the past 12 months than in the same period a year earlier (HSBC’s global banking and markets business was the ‘best’ performer with a drop of just 18%, while the investment banking arms of Credit Suisse, Nomura and UBS all fell into the red).
The death of profitability
When you look at return on equity, the picture is even more depressing. This chart shows the relentlessly downward trend in average pretax ROE at 12 big investment banks over the past few years (again on a trailing 12 month view):
Pretax ROE has tumbled from more than 31% in the heady days of late 2009 to just under 8% over the past year. Assume a tax rate of 30% and the industry’s average net ROE is around 5.5%, or roughly half where it needs to be in order for the banks to meet their cost of equity (roughly 11% to 12%). In summary, this means that investment banks are paying their staff large amounts of money to destroy value on behalf of their shareholders.
Note that quarterly pretax ROE (shown in the chart above by the red line) has flattered to deceive this year: after bouncing back strongly in the first three months it dropped again in the second quarter to just under 11%.
This collapse in profitability is endemic across the industry. This chart show my estimates of underlying pretax ROE at each of the big banks over the past four quarters compared with the previous four (note that a net ROE of 12% translates into pretax ROE of 17%):
Just one investment bank – JP Morgan – beat its cost of equity over the past 12 months (and even then there are concerns about its true level of profitability that I have written about here). When investment banks such as Goldman Sachs and Deutsche Bank are generating pretax ROE in the mid-single digits, you know that the industry is in trouble.
Of course, the problem is not just about falling revenues and inflexible costs: tougher regulations have forced banks to increase the amount of equity they set aside against their business, particularly on the trading side. This chart shows the impact of those changes:
European investment banks, which were required to adopt Basel 2.5 this year, have increased the equity in their investment banking units by 25% since 2009, which automatically wipes one fifth off their profitability. US banks, which still report under Basel I and which have yet to outline when they will adopt Basel 2.5, have only increased their equity by 11%, limiting the regulatory impact on their profitability.
In order to boost return on equity, investment banks have three tools at their disposal: they can increase revenues (which seems unlikely in the current environment), they can decrease costs (a process which has only really just got under way), or they can reduce the amount of equity underpinning the business (hence the rush to offload or ‘mitigate’ their risk-weighted assets).
But just to put the scale of that jigsaw puzzle into perspective: in order for the industry collectively to have hit its cost of equity in the past year, it would need to have found another $32bn in pretax profits down the back of the sofa. Achieving that through costs alone would have required cuts of another 22% on top of the 8% cuts already achieved over the past year. Alternatively, the industry would need to have magically increased its revenues by 20% out of thin air.
As banks try to clamber out of their profitability crisis, and with little sign of a recovery in market activity anytime soon, that gives you an indication of the scale of the challenge – and the savageness of the cuts – ahead.