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How Global Capital Markets Firms Can Address Profit Pressures

How Global Capital Markets Firms Can Address Profit Pressures

This article appears in the December 9, 2015 issue of Forbes

The financial world is a less risky place than it has been since the 2008 financial crisis. Profits are recovering, the big global banks are holding far more capital and they have reduced leverage by about half since the peak in 2007. But banks are still facing headwinds. Pressure from new regulation is intensifying, particularly in Europe and Asia, and that will make it difficult for capital markets and financial institutions to beat their cost of equity capital over the next five years. To try and close that gap, banks will need to reorient their mindset to restructuring and finding new and untraditional ways to cut costs.

These themes emerge loud and clear in our new report, “Restructuring for Profitability,” developed in collaboration with leading industry experts and Institutional Investor. The survey of nearly 150 highly ranked buy-side and sell-side analysts presents the collective wisdom of experts who are watching an industry in the midst of a broad transformation and reveals more optimism in the U.S. than elsewhere.

The analysts see a tough road ahead: While banks have made great progress improving their businesses, more aggressive action is needed. Those that embrace these difficult decisions will be able to deal with this challenge, but others risk years of failing to meet their cost of capital.

In 2014, the RoE for bulge bracket firms averaged 5.04%, while cost of equity capital was 10.78%. Business should pick up in the next five years enough for average return on equity capital for the largest banks to increase by 75% (U.S. analysts expect it to double), while the cost of capital will marginally decline.

Analysts expect returns to increase by 2020 to an average of 8.99%, with the cost of capital declining by 40 basis points on average as balance sheets become less risky.

Analysts expect average returns in five years will fall short of the projected 10.38% cost of equity. American analysts are more upbeat than those in Europe and Asia, but everyone is projecting some kind of lingering gap. U.S. analysts expect a gap of just 9 basis points between RoE and the cost of capital, while in Europe, that gap is forecast at 1.39%. In Asia it’s expected to be 2.77%.

U.S. analysts’ comparative optimism can be explained by the fact that in the United States, the worst of increasing regulations and restructuring is past. In Europe and Asia, many are still waiting for the other shoe to drop.

In order to meet shareholder expectations, those in the industry will need to take more radical steps to restructure their business and put in place additional cost controls. Banks have already cut front-office head count by about 22% since 2010. Now they need to look beyond obvious head-count reductions for savings. Analysts, particularly in the U.S. and Europe, favor enhancing cost controls and reengineering operations — over top-line growth and balance sheet management — to address RoE pressure and valuations. At Broadridge we have seen this trend in action — since 2008, the number of firms that have adopted our managed service platform to support trade processing has increased to 27 from five.

Some analysts believe new technologies, such as Blockchain, offer huge potential to take out costs. Others expect further reductions in pay in the industry.

But the biggest cost-saving opportunities lie in the back and middle office. A majority of all analysts (55%) believe new back-office technology has high potential for cost savings, while a further 30% see it having medium potential. In the U.S. in particular, 66% of analysts favor refocusing on the back office for cost savings.

Overall, analysts favor “mutualization” strategies — sharing operations and technology costs with other firms through outsourcing or by creating industry utilities. Mutualization has high potential for savings, says 49% of all analysts and 57% of buy-side analysts. Trade processing — costing $17 billion to $24 billion annually, including $6 billion to $9 billion on standardized trades — is one such area. Sharing standardized trade costs could save $2 billion to $4 billion annually, according to an analysis by Broadridge based on Morgan Stanley/Oliver Wyman data.

One top-rated analyst believes the industry will be driven to embrace sharing such standardized costs. “Out of necessity the industry will have to get there. If they all shared the cost of a more efficient clearing and settlement infrastructure, it would be a lot cheaper for everybody.”

From Forbes.com, December 9, 2015 © 2015 Forbes. All rights reserved.