Four key factors explain why investment banking is in great shape, and we see three long-term structural growth drivers with the potential to drive revenue growth higher for top investment banks
In this report, we explore the future of key themes impacting the investment banking industry and take a long-term view on what the future of the industry could look like – who the winners and losers could be.
The Investment Banking (IB) industry, in our view, is in a much better shape today compared to where it has ever been and the key factors behind this are:
i) transformation to a more sustainable, lower capital intensive execution business;
ii) focus on captive revenue streams;
iii) higher barriers of entry for Tier II/III players leading to consolidation in market shares for Tier I investment banks, but also a head start to fight off the threat of fintech new entrants unlike in retail banking;
and iv) increasing share of “captive” business.
We have a revenue growth assumption of 5% per annum versus normalised 2019 levels and see this as conservative, especially for Tier-I players who are the winners with undiscounted revenue opportunities from structural changes and from following best-in-class “Tencent-type” cross-selling opportunities.
Overall, we believe the growth outlook, reduced risk profile and cost discipline offering material positive operating leverage for the industry should enable Tier-I investment bank businesses to command a higher price to earnings (P/E) multiple than what the market currently assigns and we now reflect this in our standard operating procedure, with P/E multiples of 12-12.5x 2023E earnings for Tier-I IB businesses of Goldman Sachs and Morgan Stanley (GS and MS), which are our top Global IB picks, as well as an increased 9x P/E multiple for Barclays, which is our European IB pick.
Our new Global IB pecking order is: Goldman Sachs, Morgan Stanley, Barclays, UBS, Societe General (SG), BNP Paribas, Deutsche Bank (DB) and Credit Suisse Group (CSG).
GS, MS as well as Barclays generate through the cycle double-digit return on earnings (on JPMe allocated capital) in their CIB businesses.
Long-term growth drivers
We see a number of long-term structural growth drivers for the industry with the potential to drive revenue growth higher, including: i) QE and its subsequent unwind driving volatility, ii) China equity and bond markets opening up, iii) ESG growth potential, iv) European securitisation market structural growth and v) Private markets through mid-corporate penetration.
Retail fintech players are building ecosystems with client acquisitions through free or, in the long-term, revenue generating relationships such as voice calling (WeChat)/payments (Square) and expanding their product offerings. Global investment banking, being a highly fixed cost business, requires having a high level of trading market share and being the liquidity provider of choice to generate cashflow that can be reinvested into their business.
The IB business is becoming more technology heavy and hence needs to operate with a steady base of captive clients such as: i) corporates through transaction banking; ii) institutional through research and custody; and iii) retail, in particular wealth management, driving recurring equity revenue streams.
The most important cross-selling business in this respect is transaction banking for large corporates to keep the client business captive and allow ongoing product sales such as corporate bond issuance, foreign exchange rates, as well as hedging activities in these and other asset classes. In our view, transaction banking as a corporate ‘captive’ business is allowing IBs to be able to predict a more stable cashflow stream.
The other area where we see further cross-selling opportunities is securities services, as for any scale player, there is likely to be material overlap in the key clients serviced in the markets business and in securities services.
We believe there will also be a further ramp-up of services provided to Asset Managers as the asset management (AM) industry focuses more on managing their core activities of asset allocation and asset flows, thereby leading to stronger tie-up with IBs on the middle/back-office functions. This should lead to longer lasting relationships with IBs, as while “traditional” securities services and product offerings are commoditised, expanded offerings should lead to more sticky clients.
In other words, custody pricing is already under pressure and will be like the “checking” account, as we witnessed in retail banking. Hence, the key is to generate captive flow business for cross-selling products such as research, trading and potentially in-house benefits from improved risk analytics.
We believe IBs with material transaction banking, custody businesses will be at an advantage to maintain and even scale up their business further – in particular US money centre banks. Overall, we see: i) further consolidation in favour of Tier-I winners, and ii) ROE improvement for transaction services driven franchises. In our view, Tier-II IBs, with insufficient returns will continue to lose marginal market share due to lower resources to invest in people, trading technology and risk operations.
Increased electronification provides opportunities for scale players to develop electronic capabilities offering material, largely untapped “Tencent type” revenue potential – Platform businesses to cross-sell own/other products, white label offering for smaller banks, data opportunity and use of AI for front-to-back execution. This also provides an opportunity for third-party providers having platforms with All-to-All trading functionality to directly connect clients – but we see this unlikely to disrupt Tier I IBs.
We also believe an integrated IB model which is global, diversified and offers a full suite of products will be able to attract and retain even alternative clients.
An example of this more integrated model is prime brokerage ‒ a very low ROE business on a standalone basis considering its high leverage exposure and hence unattractive under leverage ratio regulatory constraints of 3-3.75% in Europe and 5% for US banks. However, top prime-brokerage houses now generate 2x+ in multiplier effect revenues such as liquidity (for example, dividend swaps), risk-recycling (for example, correlation, Vol risk in structured products), block trades, and convertibles.
In addition, we do not see the current state as the end state and believe Tier-I prime brokers should be further able to increase this multiplier in the future by improving net positioning (i.e. clients shorts and longs) due to better back-office and risk technology through Artificial Intelligence (AI), thus materially reducing hedging and pricing. We think hedge funds are a very important client base in the trading life-cycle within IBs. The largest prime brokers globally are MS, GS, and JPMorgan Chase.
We believe technology is not only key to differentiation between players, but also key for clients as they demand strong execution.
Overall we expect IBs, in particular those in the US, to be the ‘winners’ as their revenue scale means they have the ability to invest the highest absolute amount of tech dollars compared to any sub-scale European player where shareholder pressure to improve RoE weighs on these decisions.
IBs are highly agile and well ahead of retail banking in terms of adjustment to technology as reflected by their sophisticated trading operations. In our view, the Global IB of the future will be built around an ecosystem comprising:
- a captive client business model which is global;
- an alternative client business, mainly hedge funds offering risk recycling opportunity;
- a well-diversified, large-scale, and liquid sales & trading franchise that operates in all products and globally to minimise revenue correlation risk; and
- a global, best-in-class ‘Tencent-type’ ecosystem business model that has material untapped business opportunities to create.
This is a summary of a full report, which can be accessed here.