Five years on from the financial crisis, investment banks are still struggling to find a consistently profitable model.
Under-promise and over-deliver is great motto for business, and for life in general. But it seems to have got lost in translation in the latest results from the big Wall St investment banks.
Instead, they failed miserably to live up to already low expectations and have set a low bar for their European rivals, who start reporting their third quarter results in earnest this week (a table with the full details of the Wall St banks’ third quarter and year-to-date performance is at the bottom of this article).
It hardly came as a surprise that fixed income had a terrible quarter. A few weeks ago I wrote about the FICC engine room flooding:
Whichever way you look at it, the third quarter is turning into a bit of a car crash for fixed-income trading and it wasn’t a vintage few months for equities or investment banking either…
I warned that overall FICC revenues would be down by ‘more than a quarter’ with a ‘double digit decline’ for the year so far.
Here’s what the scorecard looks like so far for the third quarter in FICC compared with last year:
You know things are bad when the best performing investment bank is down by 8% on the quarter, or when Goldman Sachs performs worse than Morgan Stanley. From the results so far, overall revenues in FICC have dropped by a nice round 25% compared with the third quarter last year -but that is likely to get worse when Barclays and Deutsche Bank report this week.
Given that FICC accounts for more than half of the big investment banks’ revenues and a larger proportion of their profits, no amount of juggling bonuses or cutting costs could prevent this sudden collapse from having a dramatic impact on the banks’ bottom line (although the banks deserve some credit for cutting their costs by 7%).
This chart, which shows the estimated return on equity at investment banks in the third quarter, gives an indication of the carnage. You have to pay a lot of money, apparently, to get performance like this:
You’ll remember from your first day at business school that you are destroying value if you fail to make a return on equity higher than your cost of equity. Yet five years on from the financial crisis, this doesn’t seem to have troubled Wall St. Just one investment bank – the corporate and investment bank division at JP Morgan – generated an ROE above its cost of capital. Everyone else is in single digits.
Sure, you can argue at the margin about the comparability of the numbers at different banks, but a few adjustments is not going to turn a low single-digit ROE into a world-beating high-teens, or vice-versa.
The freeze in trading volumes and client activity over the summer will have a bigger impact than just disrupting the banks’ third quarter results. Instead, it will blow a bloody great hole in their numbers for 2013.
Here’s what has happened to the banks FICC numbers when you compare the first nine months of this year with the same period in 2012:
While JP Morgan is sitting out in front like the class swot, it looks the rest of the street are going to come in somewhere around 15% to 20% down for the year in FICC. This is a problem. As things stand, the decline in FICC revenues is likely to blow a $6bn hole in top line of the biggest banks according to my calculations.
Conveniently, if revenues from equities and investment banking can maintain the sort of growth they have shown this year, they will generate about $6bn to plug that gap. Revenues are therefore likely to be flat this year and, with costs down, profits should be slightly up.
That’s fine. Just so long as the decline in revenues from FICC flattens out, while equities and investment banking keep their side of the bargain too. But if fixed income is entering a structural bear market for the next few years, and equity markets are exposed to the life support machine being switched off, then the model will need rethinking. Again.