Trading activity is weak, regulators are cracking down and investment banks worldwide are confronting a stark reality for 2011: the only way to survive and make money is to diversify.
A week of anemic results in bond and stock trading from U.S. investment banks reflects a fundamental problem for the global sector: soft markets and regulatory pressure mean firms need other lines of business — besides trading for clients and for their own accounts — to sustain themselves.
"These companies are looking at markets that have lost, in some cases, two-thirds of their activity since the crisis, and it looks like it's not coming back any time soon," said Richard Bove, a veteran bank analyst now with Rochdale Securities LLC. "It will take a few years for these banks to adjust."
In the meantime, they risk disappointing shareholders and generating fresh questions about their strategies. Analysts say their shares are generally cheap, even undervalued, amid the uncertainty.
With results from the U.S. majors out of the way, attention now shifts to those large European players, the likes of Barclays PLC and Deutsche Bank AG that are expected to post 2010 figures in February. They face some of the same challenges with trading and regulation too.
Those who can point to plans for a fresh course — as Morgan Stanley has done of late with wealth and asset management — stand to benefit if those bets pay off. The sharp rise in Morgan Stanley's shares despite missing profit estimates points to that potential.
"Morgan, if they can execute, has some real opportunities here," said Roger Freeman, banking analyst at Barclays in New York. Freeman is of the view that 2009 and the early part of 2010 were "extraordinarily good periods" for fixed income and that things are now settling back to a more normal level.
'EXPOSURE TO EVERYTHING'
Trading revenue, particularly in bonds, was increasingly a profit center for investment banks in the years before the financial crisis and even in 2009. Goldman Sachs and Morgan Stanley got a quarter of their revenue or more from fixed income in the recent past.
Those revenues declined steadily throughout 2010, in part because investors were panicked over the health of European government debt and confused about Federal Reserve bond-buying programs.
But there are also structural issues as Bove suggests like changes in demand and in markets, and investors are increasingly pointing to the need for investment banks and banks in general to seek other opportunities.
"You want to own the big money-centered banks that have a little bit of exposure to everything, like a JPMorgan, a Wells to a certain extent, and Bank of America," said Keith Davis, bank analyst and principal at money manager Farr, Miller & Washington in Washington, DC:
Regulatory regimes also play a role. The U.S. government is in the midst of implementing the Dodd-Frank reforms that have reshaped financial regulation. There will be more oversight, more limits on risk and less latitude to engage in some of the behaviors that were once so lucrative.
"The Volcker rule is slowly forcing those that still have proprietary trading desks to close those businesses," said Ben Wallace, securities analyst at Grimes & Co., though he added weak markets still had more influence than tighter regulation on driving trading revenue.
The situation is much the same in Europe, where a number of new regulators are already applying pressure in the form of stress tests and raising the prospect of breaking up some of the biggest state-aided banks.
EUROPE YET TO COME
They face a difficult fixed income world like U.S. peers, but for different reasons. In Europe, the problem is one of fear — fear that national governments may not be able to pay their debts and fear that the European Central Bank may go too far in buying up debt issued by weaker euro zone countries.
"Investment banks aren't benefiting from the ECB stepping in and buying the incremental debt that is being issued by the peripheral countries, so that's a revenue source that they've lost," said Tom Angers, an investment analyst who follows European financials at Philadelphia Investment Advisors.
The U.S. weakness in fixed-income trading but more resilient performance in equities may benefit the likes of UBS, Credit Suisse and Societe Generale, which are more focused on equities, said one London-based bank analyst.
"As banks adjust to the new paradigm of regulation, equities businesses will go up the pecking order," said Huw van Steenis at Morgan Stanley in London, who issued a report earlier this week on the impact of regulation on the banks.
Regulatory change is also set to make equities even more attractive, as the business will be hit by a far more modest rise in regulatory capital needs under the Basel III bank capital rules than fixed income.
"We expect in 2011 that Barclays, UBS and other players (will) refocus their investment banking ambitions given the constraints of regulation," Van Steenis said.
The European firms are also likely to face renewed scrutiny about their bonus payouts to top executives, an issue that is still white-hot throughout the region but less of an issue than it used to be in the United States.
Regional issues aside, though, investors say all investment banks will invariably be looking at new ways to put money to work and reduce their dependence on volatile markets.
"At the end of the day, these bankers are business people and they want to get the highest return on their dollar," said Robert Lutts, president and chief investment officer, Cabot Money Management in Salem, Massachusetts. "They're going to be looking very closely at any possible business that might help them get closer to where they were."
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