In this, the third of our capital markets blog series, we take a look at the financial impacts on capital markets institutions and implications of market volatility (both current and future). Amidst the backdrop of Brexit and an oil price war in Q1 2020, early COVID-19 impacts triggered a stock market crash in February and March this year. Given the extended nature of the COVID-19 pandemic and resulting government lockdowns, we have now seen the first recession in 11 years since the Global Financial Crisis.

Before reviewing the financial implications of key industry forces, as a reminder – in our initial blog we identified multiple scenarios that could still play out over the coming months (and years):

  • The Passing Storm – relatively successful management means that pre-pandemic norms return in many areas, although not without lasting repercussions. These disproportionately affect lower and middle income individuals and communities.
  • Good Company – the role of large corporations and of the wholesale financial services industry in supporting the public response accelerates developments towards more socially engaged ‘stakeholder capitalism’. The financial services industry adopts a heightened responsibility post crisis, both economically and socially. 
  • Lone Wolves – a prolonged pandemic period, with unpredictable bouts of volatility and an extended global recession spurs governments to adopt isolationist policies. This leads to insufficient global coordination.
  • Sunrise in the East – a more effective response and better recovery trajectory accelerates a long term increase in the relative importance and influence of East Asian nations including China. Western recovery is based on lessons learned from the earlier recovery observed in the East.

Across all potential scenarios, there are underlying industry forces which we believe will drive impacts across capital markets institutions. For each force, we have highlighted likely implications and resulting key challenges:

1. The impact on institutions will not be uniform and will depend on their geographical, sector and product mix

Leading Observations:

Over the last 10 years, we have seen a 35% drop in trading revenues, however in the first half of 2020, trading divisions of most capital markets institutions have done extremely well off the soaring volumes, particularly in the Fixed Income segment. This has led to increased revenue from the additional trading activity, offset to some extent by additional costs to manage operational processes.

Investment Banking (IB) divisions saw some growth early on as companies rushed to issue debt but then stagnated as markets demand remained low. M&A and IPO activity has been severely limited.

Gains in IBD have been offset to some extent by increased credit provisioning, particularly for SME and retail loans, exacerbated by the adoption of new accounting standards under both IFRS and US GAAP which require loan losses to be recognised sooner.

The ongoing low interest rate environment (with downwards moves requiring negative rates in many territories) continues to create a challenging environment for banks.

Whilst the initial view was that Asian-focussed banks would be impacted more than others, it has become clear that this is a truly global pandemic and the regional winners and losers are not yet decided.

Sector winners and losers are easier to identify with Hospitality being the hardest hit and Technology and Pharmaceuticals coming out as winners.

Key implications under the most significantly impacted scenarios: Passing Storm and Good Company:

  • The COVID-19 crisis has vindicated the value of a universal bank model with decreasing retail/SME banking profits (due to credit loss provisioning) being offset by increased IB profits (due to market volatility and high trading volumes).
  • Many institutions have looked to scale back their trading business in recent years due to profitability challenges. The countercyclical nature of trading profits may well change the direction of travel. Capital markets institutions will face a decision as to whether they focus on client relationships (potentially focussed on certain regions or sectors) or on providing high levels of liquidity and managing flow.
  • Conversely, institutions which are primarily focused on trading may choose to scale back their lending portfolios given the challenges in that sector.
  • Scaling up and down may well lead to an increase in the number of divestments and mergers, driving revenue for IB divisions.

Key implications under the less significantly impacted scenarios: Sunrise in the East and Lone Wolves:

  • Extent of lending activity to be reconsidered across a prolonged pandemic period.
  • Extended recession to drive level of consolidation activity with an increased focus on restructuring and M&A.

We see the following key questions facing capital markets institutions:

  • Are existing business models able to take advantage of near term opportunities (from increased volatility) as well as identify potential exits and divestitures at an early enough stage during an extended pandemic and recession?
  • Should banks revisit the universal banking model to build resilience and diversification for the medium term and future impacts?
  • Are financial institutions adequately reviewing their lending portfolio (where appropriate) ensure adequate levels of provisioning and reviewing potential impacts under a prolonged pandemic period?

2. The industry must learn to live with the increased probability of ‘long tail’ events which have the ability to create periods of high market turbulence

Leading Observations:

Market Risk regulation over the last 10 years has focussed on preventing a financial crisis and the impact this would have on financial institutions and the industry, thus it focused on limiting the trading risks taken by these institutions. Going forward we need to consider that economic turbulence may not only arise from financial sector impacts, but as a result of external forces e.g. COVID-19. In these cases, regulators may in fact want financial institutions to take more risk, to keep the rest of the economy from stalling.

COVID-19 has led to yet more delays to the timelines for the implementation of the Fundamental Review of the Trading Book (FRTB). This has led to improvements in Market Risk practice being further delayed as banks will be unwilling to go further than market practice.

Regulators, governments and financial institutions need to focus on systematic risk management and reducing its impacts on financial markets.

We are witnessing market turbulence which is much harder to predict and understand than market volatility. We are seeing a trend where they are is more uneven ‘spiking/turbulence’ 1 in the market as opposed to volatility.

Key implications under the most significantly impacted scenarios: ALL scenarios:

  • We are seeing a trend of systemic events occurring more frequently*, regulators need to understand that not all crises are financial and when systemic shocks do occur we tend to face an economic rather than financial crisis. During this period the banks need to be ‘unleashed’ rather than constrained so that they can support the real economy. Regulators therefore need to be flexible in the face of the increased probability of ‘long tail’ events and focus their efforts on operational resilience.
  • Market volatility tends to be cyclical and relatively easy to predict and hedge or bet against. However market turbulence, due to an external shock, is far more difficult for financial institutions to handle. During turbulent periods, financial institutions can lose market share if they are not prepared and do not react in time. There is additional focus on electronic markets where these can be designed to react to turbulence - using sophisticated trading strategies based on algorithms. Banks therefore need to see more innovation if they are to stay competitive.
  • Increased economic turbulence will also affect the day to day running of capital markets institutions, namely back office functions. As recent events dictate, there are significant impacts on the services provided if there are impediments to resource, technology and/or processes. Recently, it has been evident that offshored teams struggled to adapt to new ways of working during lockdown, affecting the efficiency and resiliency of pre and post-trade functions. Banks need to ensure there is robust and adequate planning in place to mitigate future ‘long tail events.’
  • Although there has been a lot of talk about the change required to make capital markets more resilient to ‘long tail’ events, the reality is that this will take a time to implement, meaning we are unlikely to see substantial change for many years to come.

* https://www.ft.com/content/54f514da-3aba-11e9-b856-5404d3811663

We see the following key questions facing capital markets institutions:

  • Have institutions adequately considered scenario planning for non-financial driven crises?
  • Are capital markets institutions equipped to manage future ‘sudden shocks’ on an increasing frequency?

3. Funding and investment horizons for infrastructure investments will be challenged, driving use of imaginative structures to fund and deliver change

Leading Observations:

Banks currently incur significant investment on change that they believe will differentiate them in the market, but ultimately this is not always the case.

Change is being delivered in a more agile way, seeing incremental results across a shorter investment horizon, but current funding mechanisms are still largely on an annual cycle.

Cost to income ratios are massively constrained for all Investment Banks and even though infrastructure investment can be capitalised, the high level of operational costs makes it impossible for most banks to transform as quickly as is required to be competitive.

FinTech platforms have demonstrated that external funding can short-cut investment cycles by providing a platform which delivers benefits quicker.

It is not yet clear how and when the next generation of technology and infrastructure investment such as quantum computing and quantum cryptography will impact the industry but it is safe to assume that there will be more technological revolutions. The large technology institutions are leading the charge on this, rather than the banks and so the banks need to be able to leverage these advances in technology quickly and efficiently.

Consortia of banks have always played a role in accelerating the advance of technology and solutions in the industry, whether it is CLS, LCH or the Symphony chat platform.

Key implications under the most significantly impacted scenarios: Passing Storm and Good Company:

  • The crisis has shown banks how quickly it is possible to act when under pressure, whether introducing home working for traders, scaling up home working for all or increasing capacity of key settlement systems. Learning the lessons from this agility will be key.
  • Alternative delivery methods must be explored, leveraging delivery ecosystems and possibilities of cloud, enabling faster delivery and more efficient management of risk. This may include leveraging agile methodologies, and exploring new procurement methodologies, for example, enabling faster identification and onboarding of resources.

 

Key implications under the less significantly impacted scenarios: Sunrise in the East and Lone Wolves:

  • Banks may be keen to not limit themselves to a single solution or platform as the landscape continues to evolve, and so common standards, platforms, APIs and tools may be leveraged in delivery solutions in order to keep this optionality.
  • 20% of the industry’s revenue base is estimated to be at risk due to FinTech encroachment – it will be important to be part of ecosystems of banks with banks and banks with FinTechs and established technology institutions to be at the forefront of the next set of advances in the industry.

We see the following key questions facing capital markets institutions:

  • Has the ability to pursue strategic initiatives in response to the COVID-19 pandemic been limited by the ability to free up sufficient change budget and / or resources?
  • Has the COVID-19 pandemic exposed limitations of existing change delivery methods and non-agile ways or working?

4. Despite positive results in the near term, profitability will remain a key constraint leading to capital buffer erosion

Leading Observations:

COVID-19 poses a major challenge to European bank solvency, liquidity and economic viability which could be more severe and have more profound long-term consequences than the 2008 Global Financial Crisis (GFC). Although supporting customers and society through the pandemic is the first priority for banks, for this to be sustained, they must themselves remain solvent and viable.

The volatility caused by COVID-19 has driven highly profitable quarters for many banks, however it is not clear these will be sustainable and that in any case they will not in aggregate outweigh the negative impact of other areas within the business.

European banks entered this pandemic before having recovered fully from the last GFC, in terms of being able sustainably to cover their capital costs – our definition of viability. The cost of equity hurdle rates were missed by an average ~5 percentage points in 2019

Although most banks have plans in place to address this, COVID-19 will increase both the urgency and the difficulty of this challenge: To rebuild their capital ratios after the pandemic, they will need to be seen as investable businesses with credible plans to restore their performance levels, against even stronger headwinds than before.

During 2019 US banks reported on average almost double the operating revenue of their EMEA counterparts, however this was offset with a 25% higher FO headcount. It is expected that 2020 banking revenue will be higher still, exceeding that of last year.

Key implications under the most significantly impacted scenario: Passing Storm:

  • As well as presenting new challenges, the pandemic could be a catalyst to fast-track business model improvements by locking in new customer behaviours and staff working practices and instituting more agile planning and governance arrangements.

Key implications under the less significantly impacted scenarios: Good Company, Sunrise in the East and Lone Wolves:

  • For many banks, organic capital regeneration on its own will not be sufficient to restore ratios. Even with a cessation of dividend payments it could take 5 years or more for retained profits to restore capital ratios back to target levels. Banks will therefore need to consider supplementing profit retention with other capital raising measures.
  • Effective securitisation markets will be critical to enable banks to reduce the assets on their balance sheets and allow alternative forms of capital to support credit requirements. Significant changes will be required in European markets to achieve this.
  • Creation of national/supra-national ‘bad banks’ is a solution that was used after the 2008 crisis to deal with non-performing assets outside the banking systems and may be required again. The US Freddie Mac/Fannie Mae approach can also be utilised.
  • There is an opportunity in Europe for Capital Markets to play a greater role in the funding of major corporates as bank credit becomes more constrained. This would bring European markets in line with their UK and US equivalents.
  • The crisis may also precipitate further bank consolidation through platforms deals, M&A or distressed acquisitions, particularly in the European market.

We see the following key questions facing capital markets institutions:

  • What drastic actions must European banks take in order to ensure they are not set back further in achieving target hurdle rates?
  • How can banks take advantage of strong performance to date in order to preserve capital buffers and guard against future headwinds?

Conclusion

We have outlined some key implications of industry forces impacting the financials and profitability of capital markets institutions.

The extent of these implications will depend on the severity of the scenario as well as the collaboration between financial institutions, large corporates and key governments.

Note however that whichever scenario is faced, the underlying industry forces impacting financial institutions will remain:

  • The impact on institutions will not be uniform and will depend on their geographical, sector and product mix.
  • The industry must learn to live with the increased probability of ‘long tail’ events which have the ability to create periods of high market turbulence.
  • Funding and investment horizons for infrastructure investments will be challenged, driving use of imaginative structures to fund and deliver change.
  • Despite positive results in the near term, profitability will remain a key constraint leading to capital buffer erosion.

If you would like to discuss any of the implications articulated above, please reach out to one of the authors who can connect you with the appropriate expert.

For further insights you may wish to read our previous blogs.