The Investment Banking Industry and Morgan Stanley by Iago Seleme

Its often said that investment banks cutting staff is one of the most reliable indicators of a crisis in the capital markets. Barclays is considering cutting down its investment banking sector by a fifth and both Barclays and Deutsche Bank are revising their target returns on equity down considerably. One reason for the current decline in investment banking business is the amount of regulation being passed and enforced recently. This is one of the main challenges the industry will have to deal with in the next few years. The investment banking sector has already changed its focus from merely interpreting and understanding the practical consequences of new regulations to already implementing changes in the ways the business is conducted in a way that compliments the banks strategy. Since regulations across the world share their origin in the G20 agreement, its no surprise that they share common themes and are often similar in nature. Since investment banks are often large companies that operate in several jurisdictions, a significant competitive advantage will be gained from having a structured global response that is both efficient and cost-effective as a form of regulatory compliance. This intensifying regulatory pressure was the reason Morgan Stanley announced less than a month ago that it would exit the Indian investment banking industry and operating in India only in its other areas of business. In order to maintain its competitive advantage in investment banking, Morgan Stanley will thus have to change its business model in a way that is sustainable given the current and evolving regulatory environment. Banks that are forward-looking enough are embedding regulatory impacts in the changes of their business models as they reshape their organizations for the long term. Taking into account the high cost of regulatory compliance, it may be wise for banks to become more specialized in a few products and services, thus also being able to take advantage of the economies of scale. By exiting the investment banking sector of the Indian market, Morgan Stanley will be able to focus on the more lucrative sectors of the Indian market while focusing its investment banking efforts in more lucrative countries.

A significant regulatory change for investment banks in 2013 will be the mandatory exchange trading and central clearing of several major asset classes of over the counter derivatives, so that the changes the investment banks have been preparing for will finally become real. Banks will thus need to update their models of operation in order to focus more on their clients and to be able to compete with old and new players of this industry. As competition intensifies and prices become more transparent, the margins for core services and products will go down for the main products and services. This will mean that increase operational efficiency and differentiated offerings will be essential to stay competitive in this industry. Another regulatory challenge that investment banks will face in the coming year is related to dealing with several regulators in several jurisdictions. Although the G20 resolutions imply that new regulations will share the same theme, the regulations will still differ when it comes to specifics. Capital requirements will vary from country to country, and the US will have different regulations with regard to central clearing from the European Union. This will be as a consequence of the DoddFrank Consumer Protection Act which differs in specifics from the European Market Infrastructure Regulation. There will also be differences with regard to compensation, taxes, stress testing and specially the separation of investment and retail banking. All the changes in regulation across the world have already caused substantial work for investment banks, as theyve had to build new relationships, change reporting procedures and sometimes even their organizational structure. It will not be easy to meet these different regulatory proposals in so many different jurisdictions. It has been said that regulation alone will be the biggest cause of change in the investment banking industry, significantly affecting the capital, liquidity and return on equity of the companies. In order to be prepared for the future, investment banks will need to do strategic research to develop a comprehensive view of the regulations around the world to enable term long plans to be implemented. Assessing the impact of regulatory changes on the balance sheet will be important to prevent the company from incurring losses due to high costs of compliance with new regulation. In

cases where the costs of compliance are too great, it may be advisable for the company to leave the jurisdiction altogether, as Morgan Stanley did in India. Given the current crisis scenario and the new regulations changing capital requirements and several other aspects of the functioning of the investment banking business, stress testing will become increasingly more important as a means of assessing the companys stability and capability of dealing with financial instabilities that may lie ahead. Stress testing is an analysis conducted to check whether or not a bank has enough capital to withstand the impact of adverse circumstances. These kinds of tests are meant to find the weak spots in the banks business model, so as to possibly change the strategy to correct these weaknesses. As a consequence of the increasing regulations and the economic crisis, investment banks have been under pressure to cut costs as never before. This has already caused Morgan Stanley to cut 1,600 jobs recently, which represents 6 per cent of its staff. This has not been a decision taken only by Morgan Stanley, as Goldman Sachs cut 700 jobs, Citigroup announced plans to cut 11,000 jobs, UBS announced reduction jobs by 10,000 and Bank of American decided to cut 30,000 jobs. While not all of these cuts have been in the investment banking sector, this sector has been severely affected without a doubt. This tendency is likely to continue as about 40,000 investment banking jobs are expected to be cut in the next two years. The situation of the industry is to critical that the Roland Berger Strategy consultants have even estimated that only 5 to 10 global investment banks will survive the next 3 to 5 years. The same report has estimated that restructuring and consolidation processes will absorb 15 to 20 per cent of the industry capacity while opening up growth opportunities for the players that manage to survive. When it comes to the internal problems that investment banking companies have to deal with, one of the most well know is rogue trading. Rogue trading is when an employee makes unauthorized trades on behalf of the employer, possibly taking large amounts of risk with the hope of making a large commission. Investment banking suffers from a widespread problem of asymmetric risks,

meaning that the penalties for employee misbehaviour have not been large enough to prevent them from taking large amounts of risk with the companys money. A good example of this is the late 2011 case involving UBS in which a London trader lost the equivalent of 2.2 billion US dollars by making unauthorized trades on behalf of the company. In order to overcome this kind of problem, it will be essential for investment banks to develop a culture of responsibility and to create the proper incentives to discourage rogue trading. In an age of financial crisis and shrinking margins for investment banks, institutions cannot afford to lose such large amounts of money due to rogue trading. While the losses are big, the damages to reputation caused by such scandals can be even bigger. Although identifying the structural flaws that led to the rogue trading incidents is not as easy as one would imagine, there are a few steps that companies can take to prevent this from happening in the future. Given the significant number and scope of rogue trading incidents that happened in the past, its important the senior executives of investment banks be preventive rather than reactive in promoting responsible behaviour. Its important for executives to develop a clear view of the risks that the company is exposed to and be effective in communicating such exposure throughout the company. Often its also expedient for executives to hire independent auditors to provide checks and balances and strengthen the companys model of risk governance. The improvement of processes and controls can be achieved through an integration of the value chain, and this can also be a way of preventing misbehaviours such as rogue trading. This implies the implementation of an efficient monitoring systems to overview the activities of traders and also of a framework that establishes responsibilities and effective controls. Incentives need to be effectively aligned to encourage the right behaviour. Bonuses should not be paid immediately and should preferably not be paid in cash, as this creates the incentives for a short-sighted risk-taking culture to emerge. If such bonuses are given in the longer term, the opposite incentive emerges and a situation is created that better promotes the success of the investment bank.

In this somewhat chaotic scenario, Morgan Stanley can still be said to be one of the best all-around financial companies today. It has a well-diversified business mix which consists of franchise positions in investment banking, fixed income, asset management, equity sales and trading, retail brokerage and credit cards. Ever since it successfully merged with Dean Witter, it became a leading asset management enterprise. This broad diversification can sometimes also be considered a disadvantage, and especially when regulatory pressures increase, it maybe be in the companys interest to focus on offering only a few services in a given market such as India. Especially in a time of crisis, its an advantage for companies to minimize their fixed costs so as to achieve greater financial flexibility and be able to go through periods of diminished revenue more easily, which Morgan Stanley has found hard to do given the high fixed costs associated with its brokerage operation. While Morgan Stanley is still finding potentially profitable opportunities of investment in distressed property assets all over the world, this exposure has been a considerable weakness of the company. During the last financial crisis, Morgan Stanley recorded over 9 billion US dollars of mortgage related write-downs resulting from an unfavourable subprime mortgage-related trading strategy. As these instruments deteriorated and lacked liquidity, the company was exposed to tremendous risk of financial loss. One strategy that companies have used in the past which doesnt involve taking as much risk is growth by continuous acquisition. It involves the continuous acquisition of competitors with the objective of absorbing their customers, while reducing average operating costs, especially staff overhead and fixed costs in general. The point of this strategy is to be in motion continuously with acquisition after acquisition, showing the market that the company is able to absorb the customers while at the same time cutting costs. Instead of investing in distressed assets, as Morgan Stanley has recently done over again now in third world countries, the strategy of acquisition may be a safer way achieving higher profitability while not taking as much financial risk. Given the previously mentioned

expectation that in the next 5 years only 5 to 10 investment banking companies will remain, the strategy of growth by continuous acquisition may be a natural path for Morgan Stanley to follow. Another strategy that investment banks have used in the past is steady financial growth, which means focusing on the internal growth of the company instead of pursuing an externally focused growth strategy of acquiring companies. This strategy has the advantage of avoiding the managerial chaos and disruption caused by large mergers, while at the same time retaining more of their experienced bankers and cultivating long term client relationships. Morgan Stanley competes with insurance companies, commercial banks, hedge funds, sponsors of mutual funds and many other financial services companies. With increased merger and acquisition activity in the financial sector, the competitive space for Morgan Stanley becomes more intensive as larger companies with more capabilities become more resourceful and potentially threatening competitors. While its safe to predict that the next years in the financial sector will involve more consolidation and flight to bigness, its equally safe to predict that the financial markets are unlikely to grow significantly faster than the economy as a whole. One area in which there is a potential for growth within the investment banking industry is mergers and acquisition, which is something for which investment banking companies provide advisory services and can earn large commissions. This is due to the fact that corporations around the world have been considering international merger and acquisition strategies to protect themselves against increasing oil prices, gap in product mix, increased competition and asset concentration. Since this trend of consolidation is present not only in the wider world of corporations for which investment banks provide advisory services but also within the financial sector and within investment banking itself, this tendency may be more of a threat than an opportunity for Morgan Stanley. Although Morgan Stanley is a big company, the continuous trend of consolidation in this industry may create even bigger rivals with more diversified businesses who can challenge Morgan Stanleys position in several areas at the same time.

Finally, given the overall state of the financial industry in Europe and in the United States, an opportunity for growth can still be found in the emerging markets. Even though India is not a promising place for this industry due to the increasing regulations which have made it costly to operate an investment bank there, other regions of the world can still be a source of large profits. As investment banks around the world try to increase their profitability, only so much can be achieved through an improvement in efficiency. There are many reasons why emerging markets promise to be the source of the growth for investment banks. The banks in most emerging countries dont have a strong enough balance sheet to support the wide range of companies which need financing. Increasing competition among regions means that more capital is needed to fund expansion, whether of companies in South Africa or of China. As the emerging economies grow, they will need increasingly sophisticated financial services, and this will be a potential market for Morgan Stanley. Given all the factors mentioned above about the condition of the industry and the challenges that Morgan Stanley will probably face, it can be said that while these challenges are great theyre not insurmountable and it will not be surprising if Morgan Stanley turns out not only to be one of the one of the 5 to 10 investment banks that will survive the next 5 years but also a leading player among those few.

Sources

Investment banking revenues up, but more restructuring and consolidation expected, by Roland Berger Strategy Consultants (http://goo.gl/zS6nh) Emerging Markets: The opportunities for investment banks, by Accenture (http://goo.gl/u7aMB) Top Ten Challenges for Investment Banks 2013, by Accenture (http://goo.gl/w8hoa) Who wants to be an investment banker?, by The Economist (http://goo.gl/ktxKk) Global investment-banking revenue, by The Economist (http://goo.gl/Xc0iA) "Strategic Directions in Investment Banking - A Retrospective Analysis" by Roy C Smith (http://goo.gl/Ss5yV) UBS 'rogue' trader Kweku Adoboli jailed for seven years, by The Guardian (http://goo.gl/jJ9Oz) Morgan Stanley to cut jobs, may signal more pain ahead, by Reuters (http://goo.gl/eUmC4)