Investment banking outlook facing structural shifts

Competence Center Financial Services 1

Markus Böhme, Kiarash Fatehi, Pierre Reboul

Investment Banking Outlook Summer 2012 –
At a turning point?
Competence Center Financial Services

Our theses in a nutshell

> lobal investment banking revenues continue their roller coaster ride. After a soft second
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half of 2011, they strongly rebounded in the first quarter of 2012. We project a weaker
Q2 with full year revenues in the EUR 200-260 bn range, depending on how the sovereign
debt crisis in Europe unfolds.

erformance strongly differed both within and among peer groups: Global universal
P
players with a higher focus on the fixed income business on average outperformed
investment banks with a lower focus on fixed income. Many midsized and smaller players
in developed markets came under pressure. At the same time many peers in emerging
markets roared full steam ahead.

ven though these trends reflect structural changes such as revenue shifting to emerging
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markets and new regulations such as Basel 2.5/3, they are also harbingers of the squeeze
that investment banks are going to face. Unless banks make major changes to their
business models, their Return on Equity is likely to remain in single digits and many
peers underperforming today may see their economic model even more challenged
over the next 3 to 5 years.

ixing individual and industry economics will not come easy. Even with rounds of
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productivity measures, structural overcapacity still largely exists. We believe that around
75,000 jobs and one third of industry risk taking capability are still on the line. Value
chains, therefore, will undergo transformation and true exits – which we have hardly
seen so far – will be inevitable over the next 3 to 5 years.

e think that now is the time for banks to step decisively up to this challenge to reap
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early mover benefits by a bespoke mix of swiftly implementing sustainable models,
capturing growth opportunities mainly in emerging markets, and in some cases position
themselves as a solution provider for those players who need to consequently refocus
their value chains to survive.


Looking Back

August 2007 marked a watershed event in global investment banking1). Liquidity began dry-
ing up in asset backed securities markets and events eventually unfolded into the subprime
crisis that claimed banks throughout the US and Europe. Almost five years later we are look-
ing at an industry that has gone through a roller coaster ride as global revenue pools tanked
in 2008, rose out of the ashes in 2009 and subsequently hovered back to approximately
pre crisis levels before further decreasing by more than 10% from 2010 to 2011 (exhibit 1).

Exhibit 1: To hell and back – After their post crisis peak global investment banking
revenues are coming in around 2006 levels
Investment banking revenues1), 2011 Revenue trend, 2006-2012e
[EUR bn] [EUR bn]

270 265 260
Emerging 240
~ 75 ~5 Markets
18%
23% 230
WE EE 200
~ 70 ~ 10 28%
North America Japan

~5 ~45
Emerging Asia Developed
MEA 82%
Markets 77%
72%
~ 10
Latin America ~10
A/NZ

2006 2011 Bear Base Opti-
Developed Emerging 2010 case case mistic
2012
1) Adjusted IBD, Equities, and FICC revenues (before loan loss provisions) calculated scenarios
at constant 2011 exchange rates
Source: Roland Berger; company disclosure and presentations

On the heels of this roller coaster ride Basel 2.5 and other new regulatory requirements are
starting to kick in and despite myriad rescue attempts, the European sovereign debt crisis
has heightened in intensity. With dark clouds continuing to cast a shadow over financial
markets and economic activity, where does investment banking go next?

1) e define global investment banking as the collective IBD (MA, ECM, DCM, structured origination), Equities, and
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FICC (Fixed Income, Currencies and Commodities) businesses and revenue streams generated by global, regional,
and local players active in these lines of business.

4 Investment Banking Outlook Summer 2012 – At a turning point?

We believe that the answer lies in first understanding the underlying structural changes
that the industry has experienced and thinking of scenarios in how the market will develop.
We see three main shifts that are transforming the industry:

ontinued shifts of revenue pools to emerging markets, first and foremost to Asia with
C
Brazil being a second hotspot.

hile the FICC roller coaster ride and DVA/CVA effects2) have been the key drivers behind
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ups and downs, they have also somewhat masked that Equities and IBD businesses are
stagnating and contracting in developed markets.

any players will continue to see their economic models challenged. The top 16 global
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investment banks and universal players took a double hit when markets softened in
2011, just as new regulation such as Basel 2.5 kicked in boosting capital consumption
especially for European based players. In 2011 the game changed and many local players
in developed markets lost their edge as shrinking market shares and revenues propelled
cost-income-ratios into unsustainable territory. In addition regulatory headwind puts
further pressure on capital efficiency.

Exhibit 2: Despite a strong Q1 the full year 2012 revenue pool might only yield
a small uptick and substantial downside risk persists
JUNE 2012 PROJECTION

Quarterly IB revenues, Q1 2010 – Q1 20121) IB revenues by product groups, 2006-2012e
[EUR bn] [EUR bn]
88 270 265
85 260
80 FICC – roller coaster ride
240
230 Normalization vs. extra-
ordinary Q1 2009/10 levels
200
62 Weak flow and position losses
60 59 FICC
57 in Q3/4 2011
Once again subdued activity
? after Q1 2012 rebound
43
39 Equities – softening
Heavy dip in Q4 2011
Equities Softer activity with limited
Q1 pickup
IBD – softening
IBD Downhill from strong Q2 2011
Limited pipeline
Q1 Q3 Q1 Q3 Q1 2006 2010 2011 Bear Base Opti-
2010 2010 2011 2011 2012 case case mistic
Q2 Q4 Q2 Q4 Q2
2012 scenarios
2010 2010 2011 2011 2012

1) Adjusted IBD, Equities, and FICC revenues (before loan loss provisions) calculated at constant 2011 exchange rates

2) ebt Value Adjustments and Credit Value Adjustments: Mark-to-market changes in the value of own debt issued
D
and counterparty exposure as mandated by IAS but often recorded in banks' IB and especially FICC divisions.


The picture is not homogenous – for example, many German small- and midsized players
were among those hit hardest. In sharp contrast many – especially Asian and Latin American
– emerging market local players continued to grow profitably.

Exhibit 3: Not all players are born equal – At least five peer groups compete
with distinct business and economic models
Peer group IB economics (Basel 2.5)1), 2011 [%] Examples Business Ø EM rev. Ø IB/CIB
Note: Bubble size indicates peer group IB revenues2) of players model share3) share4)
Global IBs IBD, FICC, Equity ~20% ~100%
8 players Global
110
Global
100
Universals
90 Global IBD, FICC, ~30% ~60%
Global IBs Universals Equity
iency (CIR)

Developed 8 players Relatively
80
Markets Locals global
70
Advanced Emerging focus 90% ~35%
Cost effici

60 Advanced Internationals
15 players Mixed player ~35% ~45%
Internationals
50 Developed focus minimal ~30%
40 Developed FICC focus 0-5% ~10%
Emerging Markets Locals Markets Locals Limited
30 (Banks + Brokers) 50 players IBD/Equity
Country focus
20
0 1 2 3 4 5 6 7 8 9 10 Emerging Country focus 95-100% ~10%
Market Locals Mostly bifurcated:
Capital efficiency (Rev/RWA) 50 players Banks vs. brokers

1) Estimate, assuming 70% on disclosed B2.5/3 impact on CT1 ratio will come through CIB Markets' RWA uplift
2) Revenues calculated at constant 2011 exchange rates
3) Emerging market revenue share of total peer group revenue 4) Investment Banking revenue share of total CIB peer group revenues

What Lies Ahead

So far in 2012, these trends are continuing to affect the industry. First quarter results
strongly rebounded from the second half of 2011, which was characterized by higher risk,
drying up of client flows and position markdowns as the sovereign debt crisis unfolded
(exhibit 2).

However, not all ships were lifted equally by the tide. Once again emerging markets players
roared full steam ahead. Small and midsized locals in developed countries, meanwhile,
saw a mixed picture with many of them registering only a moderate recovery or even further
revenue contraction against the global trend. Among global players the field was split but
on average universal players, who enjoyed broader sources of flow such as FX and rates
businesses driven by transaction banking, seemed to fare better (exhibit 3 and 4).


Exhibit 4: Recent performance diverges both between as well as
within each peer group

Contracting Moderate recovery Rebounding Continued growth

Q1 Q1 Q1 Q1
2010 2011 2012e 2010 2011 2012e 2010 2011 2012e 2010 2011 2012e

Global
Universals Global Universals
Globals

rebound stronger
Global IBs than IBs

Developed market
players increasingly
Developed

Locals
Markets

under pressure
Advanced
EM franchises as
growth driver?
Advanced
Emerging
Markets

Continued growth?
Locals


However as banks close the books on the second quarter and will begin reporting results
in a few weeks, we expect to see a sharp drop off from the first quarter. Although this sort of
Q1 to Q2 drop has been more the rule than the exception over the last few years (exhibit 2),
the questions that persist are just how bad will the drop off be and where do we go from here?

Even assuming that the sovereign crisis slowly abates, we would expect the full year outlook to
be just around 2011 levels – a year that was rough, but not nearly as negative as 2008. Nobody
can and wants to project the impact of a euro meltdown. In this case all bets would be off. But
even if the sovereign debt crisis is still as intense by the end of the year as today, the downside
for investment banks for the rest of the year will be substantial. In this case the revenue pool
may shrink by another 15% to about EUR 200bn. Even under rosier scenarios, with a fairly
quick recovery and a much more favorable trading environment and deal pipeline, revenues
seem unlikely to revert to 2010 levels (exhibit 2).

As a result of this challenging environment one European and North American player after
another has already lowered their RoE targets: 12 to15% became the new standard down
from the earlier 25% targets. We believe however, that the industry's economic model is more
challenged than those lowered targets suggest. Even when factoring in the stream of restruc-
turings and lay offs already announced, the industry will only return to single digit post tax RoEs
on average. Our base case scenario envisions a 9% RoE and in our bear case, a mere 5% RoE
(exhibit 5).


Exhibit 5: Unless markets revert to a bull trajectory it is bye-bye to double digit RoEs
for 2012 except for high growth pockets in emerging markets

Industry RoE1) – 2012 Base case scenario [%] Peer groups RoE range [%]
0% 20%
Ø 2010 RoE: 15%
11
9 Global IBs

Ø 2011 RoE: 7% 5
Global Universals

Bear Base Optimistic
Developed
Scenario Case Scenario
Markets Players

Cost-income Emerging Markets
ratio [%] 80 70 65
Players

1) After-tax, assuming an effective tax rate of 30% for all peer groups

Once again emerging markets focused players are poised to deliver higher returns – provided
there will not be a sharp reversal of fortunes, and confidence falters tanking emerging markets
growth.

However, for an average developed market focused player or even global players driven by their
European and US businesses, these single digit RoE's lead to an unsustainable trajectory. On
the other side IB players face even more headwind since they are less focused on FICC and
hence benefitted less from the Q1 revenue uptick. In addition they lack regular FICC flows from
transaction banking.

Over the next 3 to 5 years, European players will face further headwind as the full effect of
proposed regulations such as Basel 3 kick in, squeezing capital and economics. We do not
know when exactly this will happen and how long local regulators will allow for transition.
Despite that uncertainty we are sure that post tax industry RoEs might remain in single digits
therefore falling some 7% to 8% short of targets unless more drastic action is taken (exhibit 6).


Exhibit 6: What would it take to continue to sustainably earn positive
economic profits in the IB industry?
Mid-term perspective RoE [%] How could the profit gap be closed?
Capital reduction of ~30% of industry RWAs in
order to overcompensate Basel III uplift
Larger, consolidated books
7-8 Risk management activity transferred to
institutional investors ('shadowbanking 2.0'?)
4
12-15 Capacity
Cost reduction of industry cost base by around
9-11 one-third reduction
5-7 ~15% headcount reduction and exit
d it
Reduced compensation benefits of around 10%
pressure
15-20% decrease of non-compensation budget
Target Baseline Basel 3 Mid-term Profita-
RoE 2012 effect baseline bility gap
~10% Repricing
Limited roll over increased capital requirements
Baseline 2012 given by base
case and optimistic scenario Capacity and demand gap starts to close

Source: Roland Berger

Restoring growth
Such gloomy scenarios make it impossible for most European and US players to retain their
capital allocations. To close this RoE gap the industry would truly need to reduce capacity
to sustainable levels. Evidence suggests that this reduction has yet to occur:

ew players have truly exited full lines of business. For example RBS and UniCredit have
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exited from parts of Cash Equities and Credit Agricole, Santander and BBVA have left
commodities, but none of them was a major player in these business lines anyway.

ostly, headcount reductions have increased individual players' productivity but did not re-
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duce capacity in the overall industry. Furthermore, announced reductions take longer to work
their way through the system – of about 25,000 job cuts announced by the top 16 players
in mid 2011 only 15,000 were realized by year end because attrition came down sharply.

ome (especially large) players successfully mitigated large parts of the Basel 2.5 driven
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RWA (Risk Weighted Assets) uplift through RWA reduction programs. These programs how-
ever, largely pertained to legacy asset sell offs and transfer of certain securitization tranches
and other assets whose capital consumption would have skyrocketed under Basel 2.5 to
hedge funds and other institutional investors – a space often coined as 'shadow banking'.
The industry's client focused trading and risk management capacity itself has hardly been
reduced.


We feel that real capacity reduction is the only way to restore economics in the mid-term. A
shake out with real product line exits, capacity reducing and efficiency boosting mergers and
joint ventures as well as a fundamental reduction in vertical integration in particular for local
players will be required to achieve 12 to 15% RoE assuming a flat to moderate revenue pool
trajectory (exhibit 6).

One scenario to close the collective RoE gap would mean:

educing industry RWAs by about 30% or close to 2 trillion euros – this would mean we
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are heading towards 'shadow banking 2.0' as hedge funds would have to pick up half of
this amount – with the other half requiring a real consolidation into fewer, more capital
efficient books.

epricing (and hence increasing the revenue pool at flatter volumes) by about 10%, which
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would not seem realistic without reduction of overcapacity.

educing the industry cost base by around one third – even with sizable cuts on the non
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compensation related cost, further structural compensation adjustments, including the effects
of guarantees and the effect of large albeit deferred bonuses, as well as sizable headcount
reductions would be required. We would estimate that about 15% of the 500,000 jobs
in the industry would have to be cut. Unprecedented rounds of layoffs – well beyond the
10,000 already announced but not executed – would become inevitable.

How can the industry and individual banks mend their economics – especially when the weight
of their portfolio is not geared towards emerging growth markets? We predict four key develop-
ments (exhibit 7):

Exhibit 7: Eventually, industry players will need to take radical action –
Four major areas for profitable change

Next wave of headcount reduction and Universals withdrawing capital
productivity based compensation Lower risk taking capacity for some players
Complexity reduction A real wave of (product line) exits
Process re-engineering and automation

Stepped-up efficiency
Reduced over-capacity
programs
Refocused + industrialized
Battle for (emerging)
( g g)
value chains
growth markets
Challenged local players truly refocus on
unique client value proposition and scale Global leaders 'localizing'
back trading platforms Local leaders professionalizing
Large platforms leveraged into true bank
for bank offerings
Industry utilities emerging

Source: Roland Berger


refocusing and industrialization of value chains is necessary. Winners will evade the
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looming shake out by refocusing on their true edge and value proposition. For smaller players
this might mean concentrating on sales, basic structuring and counterparty risk absorption
with strict focus on their privileged corporate banking and other quasi-captive franchises.
Likewise industry utilities and true bank for bank leaders will emerge to fill this void while
other large players might choose to focus on certain products, client segments and regional
niches, in which critical mass can be reached independent of a full scale offering.

oving fast will be essential and earning the right to grow and consolidate will mean
M
stepping -up efficiency programs.

ooner or later the industry will tackle its over-capacity as mid-sized players that neither
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managed to focus nor to catch up with volume leaders will need to exit some product lines.

ome capacity will continue to shift into emerging markets and more and more bankers
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will head from London and New York to Sao Paulo, Singapore, and Hong Kong as well as
places like Jakarta. However, there will be more aspirants than opportunities as the battle
for emerging growth markets heats up: Global firms build their presence on the ground
(especially beyond hubs such as Hong Kong and Singapore). Regional champions such
as Standard Chartered in Asia or Itau in Latin America invest into their IB capabilities and
local players get serious on various forms of IB, CIB or merchant banking growth.

Moving decisively and robustly executing this transformation while maintaining day to day
focus on capturing business and managing risk in volatile and adverse market conditions will
be paramount. Perhaps another five years down the road we will look back on 2012 as the
year that decided the fate of banks that survived and those banks that did not.


Contact

Markus Böhme
Partner
50 Collyer Quay, #10-02 OUE Bayfront
Singapore, 049321 Singapore

Phone: +65 65 97-4577
E-mail: markus.boehme@rolandberger.com

Kiarash Fatehi
Partner
OpernTurm, Bockenheimer Landstraße 2-8
60306 Frankfurt, Germany

Phone: +49 69 29924-60
E-mail: kiarash.fatehi@rolandberger.com

Pierre Reboul
Partner
11, rue de Prony
75017 Paris, France

Phone: +33 1 53670-325
E-mail: pierre.reboul@rolandberger.com

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Roland Berger Strategy Consultants
07/2012, all rights reserved
www.rolandberger.com

Investment banking outlook facing structural shifts

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