McKinsey Says Investment Banks Should Merge FICC, Stocks

The world’s largest investment banks should enact changes including “ruthless prioritization” of clients and combining fixed-income and equity trading to avoid a sharp decline in profitability, according to McKinsey & Co.

The companies should cut the number of products they offer and push many clients to electronic platforms, New York-based McKinsey said in an annual review of the investment banking and trading industry released today. The firms must also understand which clients are most profitable and restrict use of balance sheet to those customers, according to the report.

McKinsey offered ideas to help improve profitability as it said the return on equity was 8 percent last year at the 13 largest investment banks and may drop to 4 percent by 2019 without remedies. Companies have largely dealt with obstacles as they arise instead of implementing a more comprehensive strategy, the consulting firm said in its report.

“The extent of the challenges facing the current business model suggest there is a serious question over its viability,” the consultants wrote. “The mathematics of the old world view no longer add up.”

The 13 largest firms trailed performance of the broader investment-banking industry, which produced a 10 percent return on equity last year, according to the report. The largest firms could see ROE drop by half amid new leverage restrictions, additional rules on trading and derivatives, and revenue growth that will probably be just 1 percent annually over the next few years, according to the report. ROE is a measure of how well a company uses reinvested earnings to generate additional profit.

‘Execution Factory’

McKinsey said the average large investment bank needs to cut costs by an additional 25 percent, and reduce risk-weighted assets by $60 billion while increasing revenue by $1 billion to reach a 12 percent return on equity. The way banks currently operate, as many as 20 percent of clients are unprofitable, Kevin Buehler, a director at the consulting firm, said in an interview yesterday.

“Banks can no longer afford to provide all products to all clients in all geographies with a full-service approach,” Buehler said.

Investment banks have exposed themselves to inefficiencies and duplication by organizing by asset class, separating traders who buy and sell stocks from those who deal in commodities or currencies, according to the report.

Instead, firms should organize into an “execution factory” that handles most flow trading of standardized products, largely through electronic platforms, according to the report. That includes interest-rate swaps, which will more closely resemble equities as they are traded on swap-execution facilities, Buehler said.

Reduce Headcount

“The asset class by asset class mindset is quite deeply embedded in most organizations,” Buehler said. “You still need sales professionals who understand what their clients’ needs are in that asset class, but the bundling across asset classes may be quite different.”

Banks should also have a separate division that designs and structures unique hedges and other products for clients, and another group that allocates all funding and customer financing, McKinsey said.

The portion of global investment-banking and trading revenue that comes from Asia, excluding Japan, will surpass that of North America by 2017, McKinsey said. In that year, Europe, Middle East and Africa will contribute 33 percent, down from 39 percent in 2012, while Latin America will climb to 4 percent from 3 percent last year.

Firms must also continue to reduce headcount and try to determine the true profit a trader generates beyond an average employee in his or her spot in order to most efficiently distribute compensation, according to the report.

“Most banks are doing a much better job than in the past in aligning compensation with absolute performance levels,” according to the report. “The next stage is to better identify value created by incremental profits generated, rather than the ‘value of the seat’ of the underlying franchise, with pay-out ratios recalibrated accordingly.”

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