In Lesson 2-2, there was a general discussion about investment banking. Entry level investment banking positions have long been prized by finance majors and MBAs from prestigious universities. Prior to the 2008 financial crisis, the investment banking industry was literally on top of the world with eye-popping salaries and high profit margins. Investment bankers were referred to as the ‘masters of the universe’ and the ‘titans of Wall Street.’
Since the crisis, investment banks’ return on capital have collapsed. Return on equity ratios for the world’s biggest investment banks have been halved, to about 10% in Europe and 13% in America. The near-term outlook is even worse, with returns likely to fall to single digits as new “Too Big To Fail” regulations take effect. As a result, the investment banking industry faces a leaner, humbler future. The Economist ran a story recently about the decline of the investment banking industry – much of the following derived is from this article.
Regulatory and structural forces are at work to throttle back the investment banking industry. The most immediate of these is a bevy of new regulations that will fundamentally change the business of investment banking. Higher capital ratios and tightened credit standards, that have already been agreed to, but are not yet fully in place, are forcing banks to shrink their balance sheets and will make their businesses far less profitable.
Regulations that are still largely on the drawing board will make investment banks easier to break up, less able to use cheap retail deposits to fund their trading business and to take risks and, as a consequence, operate less profitably.
Another threat facing the investment banks is the march of progress. Just as competition has made cars, air flights and computers cheaper and better over time, investment banking is also under pressure to offer more and charge less. Thanks to new technologies such as algorithmic trading systems, many of the jobs formerly done by bankers are now carried out by computers that do not leave and join rival firms or demand large bonuses. Moreover, many of these systems are being bought by banks’ clients, allowing them to trade directly with one another or to demand better foreign-exchange rates or cheaper interest-rate swaps.
Commissions and spreads, the revenues that banks can make from trading, have already been relentlessly compressed in the less complex areas of their business, such as trading common stock or exchanging currencies. The squeeze on margins is now spreading to more complex businesses, such as bond trading and derivatives.
While the industry’s revenues are likely to bounce back from the low levels observed immediately after the financial crisis, it is not likely that the profitability levels will return to their robust pre-crisis levels of 25+% given the array of new regulations. It appears that the ‘masters of the universe’ have been tamed for the time being.
- The End of Investment Banks (dailyfinance.com)