McKinsey Says Bond Dealer Shift Could Boost Profit 30%

The world’s largest bond dealers could boost profit as much as 30 percent at their securities units by demanding clients pay for services they’re now getting for free, McKinsey & Co. said.

Banks’ trading desks should do a better job of calculating the cost of holding bonds they don’t think will rise in value when giving clients bids for securities, New York-based McKinsey said in a report today on the investment-banking and trading industry. Other examples of the strategy shift the consultant proposed include cutting off clients who aren’t profitable for the bank.

“This industry is in search of a new model that is sustainable, serves clients and earns a cost of capital,” Roger Rudisuli, co-leader of McKinsey’s corporate and investment-banking practice in North America, said in an interview. “The shift we are advocating is part of that journey.”

McKinsey’s prescription follows a report from the company in November that said return on equity at the 13 largest investment banks could drop to 4 percent by 2019 from 8 percent in 2012 without strategy changes. Up against new leverage restrictions and stiffer regulations on capital adequacy, investment banks are struggling to lower expenses and put behind them soaring legal claims and government probes.

The formula offered by McKinsey was part of a broader plan to change how firms measure profitability, suggesting a shift from an approach focused on products to one that looks at customers. Such a change, which would include measuring expenses such as cost of capital, trade execution and sales coverage at the customer level, would improve profit at capital-markets units from 10 percent to 30 percent, McKinsey estimated.

New Constraints

In the past, banks didn’t charge to hold inventory because capital and access to the balance sheet weren’t constraints, Rudisuli said.

As firms move toward this model, larger banks will have an advantage because of their access to buyers, which means they would need to warehouse securities for a shorter period of time, Rudisuli said.

In the face of new regulations and industry changes, “the resources are much more scarce,” he said. “Now that it is, you have to make sure you allocate to the client and charge for it.”

Equities units have gotten a head start on the process, because declining commissions and rules that separated trading from research divisions have already led firms to more closely monitor clients, according to Rudisuli. Fixed-income and derivative units have more work to do.

Counting Time

To start, firms should move away from giving credit for sales based on volume, which is typically how revenue is measured at teams trading over-the-counter products, McKinsey said. Dealers should also weigh the amount of time salespeople or research analysts spend with clients and back-office costs when determining client profitability, McKinsey said.

Finally, banks should be aware of “value destroyers,” or those clients who cost more to service than they bring in, and have the courage to cut them off, McKinsey said. The bottom 40 percent of clients may generate just 10 percent of revenue while sapping almost 30 percent of resources, according to the report.

“Clients with potential for high revenues and margins should be granted priority for resources, and conversely, low-potential accounts should have their resources scaled back,” McKinsey said.

‘Ruthless Prioritization’

In last year’s report, McKinsey said the largest global investment banks should enact changes including “ruthless prioritization” of clients and combining fixed-income and equity trading to avoid a sharp decline in ROE, a measure of profitability.

McKinsey acknowledged in today’s report that management will probably run into challenges in making such changes. The consulting firm cited differences in how business units present results to management and shareholders, which continues to be focused on products, as well as push-back from salesmen accustomed to taking credit for client revenue that would be given to traders under the new approach.

While many banks are working on recovering more of their costs from clients, none have completely cracked the code, Rudisuli said.

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