• Trading and Issuance Revenues Under Pressure: Q4 2015 revenue problems, including those from fixed income trading and equity issuances, have carried into 2016. Overall, the confidence levels of investment bank executives were muted. This is placing downward pressure on earnings estimates.
• Challenges in Balance Sheet Shrinkage of Non-Core Low Return Assets Weighing on Global Bank ROEs: International banks, in particular are still in the process of selling down illiquid non-core assets, but the recent market downturn is making this difficult to execute. Investors are losing patience with investment banks with legacy / “old strategy” issues that are creating current losses. In response, banks emphasize they remain focused on maximizing net realizable value of assets targeted for disposal.
• Litigation Overhang and Compensation / Headcount Under Review: Banks are still dealing with litigation related to the financial crisis, while changes in regulatory requirements and revenue challenges are leading to changes in headcount and compensation structures.

Non-Core Units and Trading Losses

To facilitate balance sheet shrinkage in the aftermath of the financial crisis, multiple banks restructured / created “non-core” units to house problem assets, put them in run-off mode, and separate them from the core banking operations. We met with the head of one international bank’s non-core unit, who told us that he compiled a team of traders less than four years ago to decrease his firm’s problem holdings, and has since sold off over €100 bln of risk-weighted assets. He did note that it will be harder, although still possible, to sell the rest of these assets (over €20 bln) within the guided timeline if market conditions worsen, as increased illiquidity will shrink the pool of available buyers (and widen out bid/ask spreads).

Companies are taking trading and mark-to-market losses on some of these assets and others, as the recent market downturn has hit these holdings, which as mentioned can be quite illiquid and difficult to exit. One of the banks on the tour recognized significant losses in the 4^th quarter on these positions (which were not in a “non-core” unit), in addition to massive restructuring costs, performance for which they received large pushback from investors during our meeting. Although the bank executive stressed that the losses were related to part of the “old strategy”, that did not reassure investors who were lamenting the fact that this institution’s past issues keep coming back and punishing current shareholders, exemplifying the structural problems with previous investment bank models (e.g., warehousing complex illiquid assets, long-dated derivative contracts, etc.).

One bank executive told us that he is not “wed” to his firm’s investment bank (implying he would exit the business if necessary), and does not expect investors to wait for his bank to fix its issues in that division.

Outstanding Litigation Overhang / Headcount Realignment

Exiting legacy positions are not the only costs weighing on the investment banks, as there are still some unresolved legal issues with U.S. regulators and supervisors. One bank on the tour is still dealing with litigation from the U.S. Department of Justice over RMBS issues and representatives from that firm told us that they are anticipating a material fine sometime within the next few years – with some investors on the trip expecting the amount to be in the billions of dollars.

As regulatory changes and depressed revenue has put pressure on global investment banks, executives are increasingly focused on expenses to bring profits in line. One bank executive told us that he recently pulled guaranteed compensation packages from employment agreements for prospective new hires within his investment bank, in an attempt to rein in costs and change the division’s culture.

Another bank executive told us that headcount in his firm’s commodities trading division has declined by ~75% in recent years. A representative from a competitor firm told us that his bank cut headcount in its fixed income, commodities, and currency trading business (“FICC”) by 10% over the past three years – as revenue declined by ~US$2.6 bln – although he did say that they are still committed to the business division.

Volatile Markets Creating Revenue Headwind

Revenues for most investment banks on the trip were down in the 4^th quarter (year-over-year). Fixed income trading for one participating bank was down over 50% in Q4, which contributed to an overall decline in global markets revenue of ~30%. Although the same bank’s M&A advisory revenues were up year-over-year, debt and equity issuance fees have declined materially, which brought down total investment banking revenue. These results were largely comparable to other investment banks on the trip (e.g., FICC revenues down materially, lower equity underwriting revenues, higher advisory fees, etc.).

Trip participants noted that Q4 revenue issues have carried into 2016. Market volatility has had a negative impact on equity underwriting in 1^st quarter of the year, as evidenced by the fact that U.S. equity capital markets volumes are down 57% year-over-year^[1]. One bank executive stated that although this business is under pressure, it can turn on and off very quickly, and he is confident in a rebound. He did concede, though, that the high-yield market has been tough, but did not provide a catalyst for a turnaround. Near the end of the meeting he noted that we won’t look back on this time and view it as “the era of global opportunity”.

Notes

[1] Source: KBW.