Thomson reuters the future of investment banking by António Campello

DEC 09, 2015

The future of invetment anking trengthening the function

Investment banking as an industry is still suffering from low ROEs and productivity, and a less than stellar reputation. Banks continue to wrestle with internal hurdles to serving clients holistically and technology that too often lags other industries. The EY publication, “Transforming Investment Banks,” details the numerous current challenges that banks face: Tougher regulatory requirements for capital, leverage, liquidity and collateral have substantially lowered bank ROEs. Commoditization, increasing price transparency and the movement of products to exchange clearing have squeezed pricing, and complex, higher margin products have fallen out of favor with customers. Vastly increased compliance, risk management and business controls have created a structurally higher cost base. Older, customized and siloed technology has become increasingly inflexible and expensive to maintain. While most banks have made numerous tactical changes and improvements, these are insufficient, and wholesale transformation will be required for success in the future. Productbased management: the legacy Many of the major causes of investment banks’ troubles are rooted in longstanding “vertical” business models that emphasized a productbased organization, dedicated inhouse supporting functions and a producerbased culture. Historically, banks have built their organization, technology, data and risk management around each separate product. This productbased focus has made it difficult to implement enterprisewide functions, serve clients holistically across the bank, leverage shared technology, optimize resources or maintain single sources of critical data. The historical need for

flexibility and the concentration of margins in the newest products have justified keeping product dedicated functions like technology, operations and reference data inhouse, incurring significant development and maintenance expense. Finally, compensation has been product revenuebased and concentrated on frontoffice product staff, and this has been blamed for sometimes motivating behaviors inimical to client and shareholder interests. The changes successful investment banks will need to make as part of this strategic transformation depend on “horizontal,” crossbusiness capabilities and functional management roles, such as those in the COO, CTO, CRO and CFO organizations. To regain and deliver sustainable, doubledigit ROEs, banks will have to enhance their efficiency, controls, client focus and digital capabilities. Banks will have to optimize their business operating models as well as financial resources such as balance sheet. They will need to transform their cultures to enhance controls, risk management and accountability. Banks will need to become more clientcentric, by measuring, managing and serving their clients in a more integrated fashion. Finally, successful banks will need to shift from tactical enhancement and remediation of legacy technology to utilizing technology to create competitive differentiation. To accomplish these changes, banks will need to shift their primary management axis away from product and producer, to increase the emphasis on key functional roles throughout the management hierarchy. Implications of enterpriselevel regulations The regulatory environment that has emerged over the past few years stresses crossbusiness controls and capabilities at the enterprise, jurisdiction and legal entity levels – more than product specific regulation. Recovery and Resolution Planning (RRP) requirements include demonstrating firm wide management information and capabilities related to areas including collateral, payments, clearing and settlement activities, funding and liquidity, and shared services. The U.S. Intermediate Holding Company (IHC) and other geographic “perimeter” requirements set standards, such as sustainability and resolvability, for all the products and supporting functions within a given jurisdiction. Other Federal Reserve Bank (FRB) requirements are based on material legal entities, the key pieces of the corporate structure, rather than the productbased businesses, which may reside in multiple entities. Addressing broad regulatory requirements such as these will require the attention of COOs and other managers, who can understand the interrelated functions and shared services on which each business relies. Also it will draw on CFOs, who design and manage the transfer pricing, booking models and other financial mechanisms that link products to corporate entities. Successful banks will respond to these kinds of regulatory requirements with broad structural reform programs that cut across businesses, products and functions at many levels of the corporate hierarchy. Beyond just complying with regulation, this structural reform will create new, firmwide processes, controls and reporting systems, which will increasingly guide the operation of the bank and shift responsibilities away from individual product managers. Powerful, centralized functions to control risk and cost Slim product margins, expense pressures and expanded controls are forcing banks to centralize various functions, lessening the independence of product managers in areas such as risk management, funding, technology, data and client service. Centralizing collateral management is a prominent example, requiring coordination across frontoffice trading, technology, operations, funding and other areas. Regulations and market changes have increased the importance of collateral to secure counterparty exposures and simultaneously make it scarcer by restricting the eligible types. Margin and funding pressures have made optimizing the sources and uses of collateral critical to bank profitability. Successful banks are centralizing the control and management of collateral, taking these responsibilities away from the individual businesses. This includes tracking available collateral across the enterprise, managing collateral transaction workflows, tracking the associated agreements and

schedules, and evaluating collateral sufficiency under stress scenarios. Central izing collateral management is a technology and data challenge; optimizing it requires strong financial and analytical capabilities; and reliably transferring the collateral to counterparties depends on operational precision and straightthrough processing (STP). Successful investment banks will also centralize the ownership, policies and management around key data, in many cases creating a Chief Data Officer (CDO) role and organization. By driving standardization of data, rules for data quality, its lineage and its usage across the businesses, banks can lower technology costs and manage datarelated controls at an enterprise level. This can reduce duplication and the need for data cleaning and remediation, as well as enable easier crossproduct reporting. For example, in BCBS 239, the Basel Committee has set specific compliance requirements related to risk data aggregation and reporting, primarily for global systemically important banks (G SIBs). Data standardization can also improve financial metrics, such as the optimization of risk weighted asset (RWA) through more accurate calculation of Credit Valuation Adjustments (CVA) or more complete valuation modeling of positions. Centralizing data management affects clientfacing areas such as onboarding and KYC, as well as technology standards and budgets. Becoming more clientcentric Lower profitability and constrained resources are forcing banks to intensify their measurement, manage ment and prioritization of client relationships across all of their products, services and geographies. Banks can no longer afford to serve every incremental client, and must optimize the “gives” and “gets” of their key relationships. Evaluating multiproduct client relation ships in terms of profitability, return on balance sheet and other financial metrics requires aggregating and analyzing data from disparate sources and technology systems. For example, assessing a client’s overall contribution may require understanding how their transactions affect variable costs in operations, or how their pledged collateral affects liquidity or leverage calculations. Managing and prioritizing among clients will require banks to coordinate sales and client service units across product groups, and to motivate behaviors that optimize at the firm level. Successful investment banks will invest in clientcentric service models that combine content, transactions and services across products to present a comprehensive experience or “storefront” to the client. This may include crossproduct sales and service organizations, segmented by client type instead of by product. For certain client segments, banks will also invest in cross asset class and crosstrade lifecycle portals that combine tailored content and analytics, transactional capabilities and posttrade reporting. Significant bank clients are likely to be multichannel, perhaps trading across both electronic and hightouch (trader) channels, and banks must flex to accommodate these clients’ organizations and priorities. Managing down the costs of complexity Investment banks are saddled with various complex legal entity structures, transaction booking models and technology architectures. Often, these were created for tax reasons to meet the specialized business needs of products or jurisdictions, or were the result of mergers and acquisitions. However, in the current environment, requirements imposed on bank balance sheets, controls, resolvability or reporting can multiply the costs of maintaining this complexity. For example, booking models that “backtoback” transactions through multiple accounts or entities may have optimized accounting or regulatory requirements, but now can double or triple the balance sheet used. Simplifying legal entity structures or booking models will require intricate coordination among legal, finance, compliance, risk, operations and technology. Historically separate technology applications for products or regions may now create a complex web of systems feeding crossfirm risk systems or client reporting. Removing

this complexity can involve expensive, nonreusable investment programs, but continuing it creates ongoing competitive disadvantages in terms of costs and impaired flexibility. Successful investment banks will simplify to match the evolving needs of their client and product strategies. Successful banks will also manage down complexity and reduce fixed costs by outsourcing more functions to vendors, industry utilities or memberowned consortia. Investment banks have launched various utilities to support functions including posttrade processing, reference data and client onboarding. Choosing which functions to outsource may be based on strategic considerations, costs and separability. To the extent a function does not provide competitive differentiation or admits economies of scale, it may be a candidate for a utility serving multiple banks. Banks must also consider the costs of transitioning to the utility, the expected unit cost savings and the fixed costs that will not disappear when the function is outsourced. Some risks may be mutualized as functions move to utilities while outsourcing other activities may leave the bank still holding the related exposure or liability. Shifting technology from a cost to a differentiator A vicious cycle of technology spending has long plagued investment banking. Older technology systems, devel oped and maintained inhouse and often specialized by product or region, have become increasingly expensive to maintain or enhance. For many banks, at each budget cycle, the shortterm optimization often is to augment rather than replace these legacy systems. The cumulative effect has been that while technology is consistently a significant percentage of investment bank expenses, little of this spend has been strategic, and investment banks often lag other industry sectors in terms of use of leadingedge, digital technologies. Consequently, investment banks have traditionally focused on the importance of staff as a competitive differentiator and rarely created strategic differentiation through technology. Successful investment banks will break this cycle of spending by making transformative investments, outsourcing certain functions to vendors or utilities, or acquiring relevant technology innovators. They will use technology as a differentiator, for example, to create new trading models, significantly better cost structures or analyticsbased understanding of client needs. These changes will shift the role of the CTO away from primarily supporting human workflows and increasingly toward identification, design and supervision of strategic product and service capabilities. Beyond just managing cost effective development and support of applications, CTOs may need to source and manage strategic investments, coordinate technology partnerships and “ecosystems,” and run technologyenabled profit centers. Prioritization Each aspect of this investment bank transformation will be a significant and firmwide initiative, and they are interdependent. Centralizing certain functions will enable the structural reform necessary to meet RRP regulation, and reducing the legacy costs of complexity will help fund the investments to make technology a differentiator. Just sequencing and coordinating the critical components of this transformation will be a challenge, which must be individually guided by the specific strengths, finances and situation of each investment bank. Managing an investment bank into the future will not be easy. However, sustainable profitability and ROE will accrue to management teams who can prioritize and complete this transformation from a collection of productbased businesses, to an integrated, clientcentric organization based on controls, technology, optimization and centralized functions. Visit ey.com/banking for more information

Aout the author

Jonathan Firester is an executive director in the Capital Markets practice at EY. Firester’s previous positions include manager of the equities portfolio at a $500+ million quantitative hedge fund, COO of Prime Brokerage at a toptier investment bank and head of Equities Division Strategy at a large investment bank, with over 20 years of industry experience.

Roy Choudhury is a Principal in EY’s Financial Services Advisory practice and has more than 15 years of experience across banking and capital markets. He leads the Capital Markets – Operations practice in the U.S. He also coleads the Treasury & Liquidity practice and is responsible for a range of

services. He has extensive experience in leading global transformation opportunities of budget exceeding $100m across New York, London, Singapore and Hong Kong.