Bulls v bears: what does the future hold for banks?
One of the biggest debates in the investment banking industry is about the sustainability of the bumper profits banks have made in the first quarter. Some analysts say the first five months of the year are a good guide to what we will see over the rest of the year, while others caution the outlook is bleak. Financial News/Wealth Bulletin lets two leading banks’ analysts make the case for each view. Here are extracts from their latest research reports
The Bull Case
Huw van Steenis, Morgan Stanley
Q2 and beyond is likely to be stronger than the market anticipates – due to higher margins being more sustainable than the market fears, steep curves, decent activity levels, plausible healing trade in markets and decent cost control, which together will drive earnings upgrades as the quarter continues.
Our industry discussions and the datapoints we track suggest fixed income, currencies and commodities in Q2 are only about 10% down on the Q1 run rate, while some parts of the business that weren’t firing have opened up (ECM, equities, credit).
Take the following data points:
- ECM is running over 3.5 times the Q1 run rate. Credit Suisse, Goldman Sachs, Bank of America Merrill Lynch, Barclays and BNP Paribas have all seen their ECM run rate revenues up fivefold on Q1. While the quarter has a month to run, these daily run rates provide material upside.
- Debt issuance is running 7% up on Q1 for the top 11 wholesale banks we track, with an improving trend.
- M&A has been the weaker spot, down 30% Q2 on Q1, although May jumped about 25% on April as risk appetites improved.
- European cash equity trading run volume rate is up 30% in Q2 run rate on Q1, while equity derivatives are showing a steady performance in Q2, per exchange data. With FICC, exchange trading is rarely a good guide, but our interviews with banks suggest Q2 running close to Q1 (and ahead for some).
Our hunch is capital, funding and risk management constraints will mean margins drift down rather than gap down. We realise we are in a minority in thinking this, but this is what all our discussions suggest. Our thesis is that margins come down as capital and funding constraints are reduced, which in any case would be when top lines are in good shape.
This – plus the fact that winners seem to be seizing market share from weakened competitors – means the ‘flow monsters’ are benefiting disproportionately. In FICC, JP Morgan, Goldman, Barclays, Deutsche and so on are gaining share ahead of the pack, based on our discussions. To be clear, this is a point for the leading franchises. Many banks are having to retrench in wholesale – notably the German banks, which are retrenching significantly, and we think this capacity won’t return fast.
The Bear Case
Daniel Davies, Credit Suisse
Nearly all of the competitive problems of the investment banking industry are still here:
- Structural cross-subsidies between flow trading businesses and capital markets, as a result of:
- Substantial genuine synergies between trading market share and ability to win fee-based mergers and acquisitions or capital markets business, leading to:
- A highly geared “tournament like” reward structure, where the top two or three players make supernormal profits compared to the rest, as a result of which:
- Players outside the top two or three have a structural tendency to want to increase their market share
Price competition in investment banking has, in our opinion, only rarely been driven by entrants in the past. Typically, the lion’s share of competition has come from incumbents.
If the sector generates economic rents, then sufficient capital will be generated to “invest” in market share and destructive competition.
We would also note that, at present, several of the best-capitalised players may be earning premium spreads because of an awareness on the part of clients of the need to manage their own counterparty risk.
This seems unlikely to persist, in our opinion.
In our view, the trend toward centralisation and transparency of trading in a number of key rates lines is almost certainly bad news for the investment banks in the long term (and correspondingly, good news for end-users).
The more centralised a market is, the easier it is for customers to compare quotes and the greater the temptation for incumbent players to try to boost their market share by quoting inside a competitor’s spread.
Since the increase in spreads which has been seen over the last two quarters is actually quite small in absolute terms (on a vanilla swaps transaction, the bid/ask spread could “double” by increasing from five basis points to 10bps; the cost of a forex trade could “triple” from 2bps to 6bps), the apparent pricing power of the remaining incumbents after the crisis could be competed away very quickly.
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