Nov. 15 (Bloomberg) -- Wall Street firms must slash pay and headcount and shed almost a third of their trading-business assets to earn even half the returns they once made, according to Sanford C. Bernstein analysts.
So-called risk-weighted assets at U.S. banks have to shrink 33 percent and European lenders must slice 28 percent, Bernstein analysts led by Brad Hintz and Chirantan Barua wrote in a note to clients today. The firms also must cut their compensation ratio to 40 percent of revenue from 50 percent by firing high-paid managing directors and replacing some traders with computers, they wrote.
“This implies that the industry is likely to shrink, and more firms will ultimately need to follow UBS to the exit,” the analysts wrote, referring to the decision last month by UBS AG to scale back its trading businesses. “Over the next few years we expect rampant consolidation.”
Firms produced returns on equity, a measure of profitability, of almost 20 percent from their capital-markets units in 2006 and almost 30 percent in 2009, according to Sanford Bernstein. The current trading environment, along with new derivatives rules that will reduce margins and capital requirements that limit leverage, would cut ROEs to about 4 percent, according to the note.
“We believe the advantages of scale, technological efficiency, and trading discipline will become increasingly important, particularly to firms attempting to be among the last standing,” the analysts wrote.
Even scaled-back firms will struggle to beat their cost of equity capital, which is about 10 percent, they wrote. Last month, UBS announced it was largely exiting its fixed-income trading business, and Royal Bank of Scotland Plc earlier this year eliminated most of its equity-trading unit.
Many banks are already embarking on plans to reduce costs and risk-weighted assets. Morgan Stanley laid out a plan in September to cut 35 percent of RWAs in its fixed-income trading unit. Goldman Sachs Group Inc. plans to cut its total RWAs by 3.8 percent by the end of next year and said in July it plans to trim $500 million in annual expenses, mostly from compensation.
Banks whose trading businesses survive the fallout may receive some benefit from being able to charge higher prices as competitors exit, the Bernstein analysts wrote. Even with the profitability challenges, the analysts expect capital-market revenue to increase 6 percent to 7 percent a year over the next five years.
“With this growth trajectory and the strategic importance of capital-markets activities within broader client relationships, these businesses cannot be abandoned lightly,” Hintz and Barua wrote.
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