Thomson reuters only the strong survive by António Campello

DEC 09, 2015

Onl the trong urvive

The four largest financial institutions in the U.S. today – Citigroup, Bank of America, J.P.Morgan Chase and Wells Fargo – are the result of more than 35 mergers of large and midsized institutions over two decades, plus numerous acquisitions of smaller firms. They have weathered two major economic crashes and several smaller ones; accelerated globalization; deregulation of financial markets; a new round of reregulation; and the beginnings of an arms race in financial firms’ investment in technology.

Merger and acquiition

Change is a constant in the capital markets. But a closer look at the end of the 20th century and the opening chapters of the 21st provides some important clues as to why some firms survived and grew while others did not, what they will need to do to continue to prosper and what trends are likely to shape the competitive landscape in the years ahead. Financial services consolidation accompanied a vast increase in activity across the capital markets. Global fixedincome trading volumes captured in Greenwich Associates’ research almost quadrupled, from $14.6 billion in 2000 to $56.8 billion in 2014. The growth of new electronic channels has opened up new sources of liquidity in the foreign exchange markets, which have seen global trading increase almost eightfold, from $22.5 trillion to $174.8 trillion. Global equity commissions measured by Greenwich Associates grew from $18.4 billion in 1999 to $30.7 billion just before the 2008 market collapse, although they then subsided to $22.7 billion in 2014. Growth and expansion were propelled in part by the relaxation of trade barriers and deregulation of markets – a process that started as far back as the ‘70s and continued until the Great Recession that began in 2008. Globalization saw Europeanbased “universal” banks enter the U.S. and rapidly build up market share in the ‘90s, which intensified pressure from U.S. financial institutions to abolish what remained of the separation between commercial and investment banking and insurance under the Glass Steagall Act (1999). Even before these changes were enacted, strategic consolidation had begun, including the Travelers/Salomon Brothers/Citicorp union, Chase Manhattan’s purchase of Hambrecht & Quist, and NationsBank’s purchase of Montgomery Securities, as U.S. institutions, spurred in part by the booming market in tech stocks, sought to become more competitive with investment banks and the European universal bank model. Shortly thereafter, the Commodity Futures Moderni zation Act (2000) ensured that most overthe counter derivatives traded by “sophisticated parties” would not be regulated as futures, spurring the growth of new products like credit default swaps. Major firms’ technology investment grew as

derivatives, foreign exchange and fixed income trading volumes soared and their trading desks became major profit centers. As capital markets and investment banking grew more capitalintense, larger firms – and those that were willing to ratchet up their debt levels – gobbled up more business, not to mention smaller rivals. The collapse of the housing bubble and the resulting liquidity crisis, curiously, gave a new boost to consolidation, as only the largest firms could bail out the failing banks that threatened to capsize the financial system. Bank of America’s acquisition of Merrill Lynch, J.P.Morgan Chase’s purchase of Washington Mutual, and Wells Fargo’s takeover of Wachovia helped create everbigger institutions. The crisis did, however, create the impetus for a return to stricter financial regulation. In the U.S., the DoddFrank Act mandated the establishment of new, more stringent regulations, including the Volcker Rule that bars banks from proprietary trading in certain kinds of speculative investments, and the Basel II and III standards that increased required capital buffers for banks. The Financial Stability Board, meanwhile, identified a group of Global Systemically Important Financial Institutions, while in the U.S., the Financial Stability Oversight Council began requiring annual updated emergency resolution plans, or “living wills,” from “toobigtofail” firms. For some leading banks in the capital markets, this period has been a wrenching experience. Lehman Brothers, which was the sixth largest firm by market share in global fixed income in 2005, was absorbed by Barclays. Similarly, ABN AMRO, once a top10 presence in the foreign exchange market, was absorbed by Royal Bank of Scotland, only to reemerge as a Netherlandsfocused bank, while in the U.S. equities market, two firms that were among the top 10 in trading in 2005 – Bear Stearns and Lehman Brothers – are gone. There have also been winners. While the living wills and other regulations aimed to remove any necessity for bailouts of toobigtofail institutions, the largest banks have emerged with an even more commanding presence in fixed income and foreign exchange, even as the economy slowly recovers. Whereas the top five banks accounted for 37% of global fixed income market share in 2005 – just before the crash – today they make up 48%. Though reordered somewhat, the top five institutions in 2005 – Deutsche Bank, J.P.Morgan, Citigroup, Goldman Sachs and Barclays – still occupy those positions today.

Fixed income: intitutional market hare – gloal

The concentration is even more striking in the currency market: The top five made up 39% of the forex market in 2005, but today account for 51%. Four of the top five banks in 2005 – Citi, Deutsche Bank, UBS and J.P.Morgan – are still there in 2014.

Foreign exchange: intitutional market hare

Only in equities has the trend reversed: from commanding 49% of the U.S. equity market in 2005, the top five banks account for only 41% in 2015; in Europe and Japan, the trend is similar if not as pronounced. But here, too, three of the top five banks in 2005 – Goldman, J.P. Morgan, and Credit Suisse – still hold their position in U.S. equities today, although their market share is smaller.

quitie: U.. cah equitie trading intitutional market hare

A similar pattern holds for U.S. equity research: Market share of the top five banks has declined from 48% in 2005 to 41% in 2015, but three of the top five firms 10 years ago – Merrill Lynch (now part of Bank of America), Morgan Stanley and Goldman Sachs – are still part of that group. Notably, the other two – J.P.Morgan and Barclays – absorbed other large firms during the financial crisis. What enabled some firms to survive and maintain dominant positions in these markets while others lost their footing? Some, like Wells Fargo, avoided exposure to sectors that produced bubbles pre 2008, or, like Goldman, exited them in time to avoid serious damage. Others, such as J.P.Morgan, Barclays and Bank of America, sustained some damage but were sufficiently large and diversified that – with help from the Federal Reserve and the U.S. Treasury – they were able to play a role in the bank bailout, absorbing firms that were in danger of collapse. Those at the greatest disadvantage tended to be middlesized firms that lacked the capital to compete successfully with the largest banks and failed to develop specializations that could attract and retain substantial business. Some parts of the picture that the capital markets displayed a decade ago haven’t changed. The arms race in technology continues, and banks are forced to make enormous investments to make sure they have the infrastructure necessary to compete for a global client base. Electronic trading makes up a larger and larger portion of the institutional markets. By 2014, more than 40% of fixedincome trading volume tracked by Greenwich Associates took place online, versus less than 20% in 2010. The total volume of forex trading taking place online grew from 29% in 2005 to 75% last year. And online trading of U.S. equities grew from just 18% of total volume in 2005 to 37% in 2014.

Foreign exchange: growth of electronic trading

The investment required to keep up with these trends creates an environment that continues to favor the largest banks. But these megainstitutions are themselves faced with some critical choices. The extended period of low interest rates has made hedging less urgent for clients and the trading of many kinds of bonds less profitable. The cost of capital has risen. In the case of forex, tight margins and the investment needed to offer a highperforming electronic trading platform favor size. The rising use of decentralized blockchain databases to carry out and record transactions is likely to increase, yet how they could change the business model for banks is not well understood. As DoddFrank, Basel II and III, and other regulatory reforms kick in and liquidity requirements grow stricter, major banks are shrinking their trading books, even exiting some businesses and moving to control costs by reducing headcounts. Goldman, for example, has shrunk its trading operation, scrapped longterm plans made in 2005 to grow from 31,000 to around 50,000 employees, and reduced costs overall by 17% since 2010, according to the New York Times. Citi has sold its margin forex business and shrunk its retail banking presence, both domestically and internationally. Tighter enforcement and more aggressive investigation and prosecution by regulators has created a new category of risk: conduct risk, in which firms – or individuals – look the other way or fail to enforce internal controls against mispricing, collusion and market manipulation. This shows up in the $100 billionplus paid to date in settlements related to the financial crisis, and the billions more relating to currency market and LIBOR manipulation. Billiondollar settlements have become almost commonplace, some exceeding a previously unimaginable $10 billion. The size of these agreements impels banks both to apply stricter internal standards and to further cut costs. The path ahead may offer a larger role for specialist firms, not all of them banks and not all of them giant institutions. Some may offer better platforms for electronic trading – for example, providing greater anonymity for trading in certain types of assets. Trading and research may become increasingly uncoupled, with some firms specializing in one or the other. Other firms may specialize in offering highquality intellectual capital in the form of indepth research, data and insight on equities or other investment classes. Another group of competitors may provide services to clients in particular regions, such as Latin America or East Asia. Large money managers, institutional investors and other traditional banking customers, less constrained by regulation, increasingly see themselves, at least in part, as providers as well as takers of liquidity; some banks may carve out a role as facilitators of transactions involving these institutions.

In coming years, the financial industry itself may assume a barbell shape, with a handful of giant institutions on one end and a medley of specialist firms, nonbanks and other nontraditional providers on the other. For banks to be strong enough to survive in this more complex playing field, where risk can take many shapes, will require the agility and adaptability that the most successful ones have exhibited in recent years. They will need to satisfy regulators’ intensified riskcapital concerns. They will need to control costs, in some cases hiving off businesses that can’t generate satisfactory margins of profit, while continuing to invest in the resources and platforms required to maintain a commanding position. Given the scale of investment required, the risk of making a bad decision – of pursuing the wrong product line, of making a strategic error in technology development, of failing to capitalize on a particular customer need or preference – could prove costly or even crippling. New and unexpected risks, from conduct risk to risk generated by a new disruptive technology, will require more careful management. Despite these challenges, a handful of systemically important, toobigtofail firms will continue to exist. Given the explosive growth of global capital markets, which shows every sign of continuing, clients will continue to turn to the firms with the largest capacity as their bankers and dealers. Only the largest firms will be able to make the investment necessary to compete in a fiercely competitive electronic trading environment. A tighter regulatory environment, too, will mitigate in the largest banks’ favor, as the cost of compliance and controls gets higher. For all of these reasons, the era of consolidation isn’t over yet. Visit greenwich.com for more information

Aout the author

John Colon is the managing director for Banking and Markets at Greenwich Associates. Colon consults with the firm’s corporate finance and institutional equity practices in the U.S., Asia and Europe and is a frequent speaker at industry and investor conferences. Before joining Greenwich Associates

in 1986, Colon was an analyst in the corporate finance department of Lehman Brothers Kuhn Loeb in New York. He received his BA magna cum laude from Dartmouth, where he was elected to Phi Beta Kappa and earned his MBA at Harvard.