INTO THE BREACH.

Bob McDowall assesses the impact of the eurozone crisis on the investment banking community.

The exercise in quantitative easing by the European Central Bank in February accompanied by a contrived resolution of the Greek debt crisis have brought an era of orderly uncertainty to what was disorderly uncertainty. The crisis is not over but it has abated for the time being although the reverberations continue. The ambiguous economic and financial outlook in Europe has affected multinational companies and major imports to the region. Its economic health is important to the prosperity of other major economies including the so-called BRIC countries and the US.

Investors have many reasons for concern. The enthusiasm arising from the debt agreement could revert to pessimism. Their fears have been reflected in market volatility as many are either sitting on the sidelines or have exited the European equities market. This has impacted the equities line of business at investment banks and the recent turbulent conditions have replaced regulation and technology as the most immediate critical focus. Large, as well as mid-sized, firms have shed staff in Europe plus many firms that had had ambitions to build equities’ franchises have been forced into re-evaluating their strategies. The barriers to developing business in terms of technology investment and regulation have grown. The few that continue to pursue a strategy of scaling up have to continue to focus on efficiency, much of which is achieved through technology and headcount reduction.

Other factors inhibit the growth of equity franchise such as the absence of initial public offerings. In addition, reverse takeovers seem to be more popular in the current market climate because they are relatively low key and discreet. Contraction of bank balance sheet and lending, combined with low interest rates have made the corporate debt market a more attractive way of raising funds and securing medium term funding.

The largest firms that try to maintain their order flow and scaleability have to increase their IT expenditure principally through moving to multi-asset based platforms. These are designed to bring together multi-asset electronic trading, research and analytics onto one platform which leverage technology across the businesses and ultimately reduce the level of spending.

A tale of two models

The emerging trend is that the equities business is increasingly moving to two contrasting business models, both of which can be profitable. On one side are the largest investment banks. They continue to maintain an active business, handing substantial order flow that covers most sectors and geographies to a lesser or greater extent. On the other side are the small specialist boutique banks and brokers that place heavy emphasis on depth and degree of specialism, client service and a highly variable cost base that can be managed in response to the level of activity without service disruption. The niche model is being augmented by good quality specialists leaving the larger firms, and this is likely to continue. The focus for this group is understandably away from European equities to the geographies where there is growth, including pan-Asian, regional and national Asian markets, Latin and South America and the emerging markets of the old Soviet Republics.

Squeezed in the middle

Broking firms occupying the middle territory have a dilemma. They do not have the capital and skills to trade up and compete for the diminishing order flow. They should focus on a particular market segment, country or area of research by scaling down to their core geographic, sector or service strengths.

Other, probably more important, changes have occurred in the equities markets over the past ten years which will have an important influence on the nature of the equity franchises in the future. These have been encapsulated by Professor John Kay who is currently chairing the Review of UK Equity Markets and Long-Term Decision-Making which will be reported to the Secretary of State for Business, Innovation and Skills in July 2012.

Kay, who is a visiting professor of economics at the London School of Economics and a fellow of St John’s College, Oxford, indicates that equity markets today are primarily secondary markets. “As the source of new funds for investing in UK industry, equity markets are of almost no importance at all.” The growing focus on absolute returns over relative returns, is stressing that “pounds, not alpha” paid for pension benefits. “Taken as a whole,” he said, “People’s pensions are paid for by beta, not alpha – because alpha aggregated over all investors is essentially zero. Higher performing companies generate the additional returns. The business imperative of asset managers was not to create better performing companies but to outperform their rivals.”

The main issue is that investors and traders have very different interests and perspectives. Investors looked to gain returns from the underlying cash flow generated by the company, while the traders are interested in the returns from movements in market share prices – trading on “momentum, arbitrage or being in some sense market makers.” Technology has advanced the speed and sophistication of the latter.

Asset managers, on the other hand, have a business model built around their relative performance. Their incentive structure rewards a sale of shares over engagement. Many regard this as something that is not so much to the benefit of their clients, but an additional cost that will have to be paid for in some way or another.

These observations illuminate the more subtle changes that are influencing the structure of the franchise models in equities markets. The eurozone crisis has only served to escalate these shifts.