Bernstein Research draws battle lines for bulge brackets

Large international brokers are in for a war of attrition in the battle for global capital markets survival, according to leading analysts.

Large international brokers are in for a war of attrition in the battle for global capital markets survival, according to leading analysts.

In a report entitled ‘The global capital markets tontine’, Bernstein Research senior analyst Brad Hintz said his firm was betting on a long war of attrition in trading, as banks trim their services, gradually reduce capital commitments and cautiously try to raise pricing for their institutional clients.

“The massive trading franchises of the banks – currently operating at single digit return on investment (ROE) – are being viewed by management as ‘an option’, convinced that global capital market revenue is likely to grow at 6% to 8% annually and confident that a profitable ‘capital lite’ business model can be devised,” wrote Hintz, positing few capital markets players will be willing to follow UBS’s lead.

In a previous report, Bernstein Research asserted Basel III capital and other regulatory changes would profoundly alter the economics of trading, limiting the return on investment of market making businesses to around 5-6% and to achieve reasonable returns, compensation of trading units would need to be reduced to around 40% and the amount of capital employed by the trading units must decline by about 30%.

Hintz observed virtually every major firm had automated their trading activities and several banks such as UBS and the Royal Bank of Scotland had sharply cut back “subscale or underperforming” trading activities to improve operating performance and ROE. But he did not expect to see any wholesale exits from trading, because of the risk it would pose to a bank’s overall value proposition.

“Most capital markets business lines are linked through multifaceted client relationships,” the report read. “Banks that cut back on fixed income execution risk market share losses in DCM, which in turn weakens financial sponsor relationships and the high margin M&A deals they bring.”

Those capital markets banks which had the potential to take the lead in the current environment of prolonged liquidity scarcity and steep competition would have a number of distinct characteristics, argued Hintz; High margin business mix, diversified revenue sources, high trading market share, geographic strength, and the ability to adequately meet regulatory challengers.

For Hintz, Goldman Sachs and Morgan Stanley were good examples of firms with high margin business mixes as a percentage of total capital markets revenues and geographic strength and superior distribution capability.

Global leaders like JP Morgan, Citigroup, HSBC and RBC, with capital markets units representing 25% or less of total revenue had well-diversified revenue sources.

JP Morgan, Citigroup, Barclays and Deutsche Bank’s large market shares in global fixed income gave them good footing, while, Goldman Sachs and JP Morgan enjoyed the highest combined market share in fixed income and equities.

Swiss banks Credit Suisse and UBS, and for different reasons, US firms such as Bank of America, Citigroup JP Morgan, Morgan Stanley and Goldman Sachs were all well placed to deal with regulation, but Hintz believed Deutsche Bank would emerge best situated to take advantage of regulatory pressures.

“Capital markets activities are currently generating returns well below the cost of equity, and there is no obvious solution to how banks should adapt,” wrote Hintz.