(This story originally appeared on IFR, a Thomson Reuters publication)
By Gareth Gore
LONDON, April 28 (IFR) - The world’s biggest investment banks are refusing to weaken their commitment to flagging fixed income markets, choosing to sacrifice other businesses such as commodities trading and corporate lending rather than pull back from an asset class where revenues have almost halved since 2009.
Barclays is the latest bank to gamble on a rebound in its flagship fixed income franchise, deciding to exit large swathes of its commodities trading operations and thereby increase its reliance on bond trading. Rivals such as JP Morgan, Deutsche Bank, Citigroup and Morgan Stanley have made similar decisions.
The commitment to fixed income comes despite a rapid slump in client demand over the past five years, with industry-wide revenues now back to 2005 levels and bankers complaining of a lost decade due to a prolonged period of low interest rates and the impact of tough new regulations.
Rates trading has been the worst hit, with industry-wide revenues falling to US$35bn last year from the record US$83bn in 2009, according to estimates from Morgan Stanley and Oliver Wyman, while credit and securitised product revenues slumped to US$37bn from US$63bn at their peak.
Further declines are expected this year if first-quarter results are anything to go by. JP Morgan, Bank of America Merrill Lynch, Citigroup and Goldman Sachs all had their worst start to the year in fixed income since 2008. Europeans are likely to report similar declines over coming weeks.
Still, the big fixed income players have largely dismissed further restructuring, confident that demand will return. Instead, they are choosing to boost returns through efficiency gains and meet additional capital needs by retrenching from activity elsewhere in their investment banks.
They argue that, despite the decline in headline revenues, fixed income still delivers decent returns because banks have dramatically cut costs over recent years. Morgan Stanley and Oliver Wyman say banks have cut risk-weighted assets by about two-fifths since 2009, with the axe falling heavily on fixed income. Costs have been slashed by about a tenth, mainly through job losses and pay cuts.
“Today, banks generally have fewer resources allocated to fixed income than they did even four or five years ago,” said Paco Ybarra, global head of markets at Citigroup. “So while revenues have come down from the record year of 2009, we are quite comfortable with performance measures such as return-on-equity right now.”
Banks are also generally confident of an eventual rebound in fixed income. Interest rates are expected to begin to rise again in the US and UK over the next two years, injecting volatility and yield back into markets, which should be good for trading.
At the same time, banks expect new opportunities to appear between the cracks in the regulations that have killed off many traditional revenue streams.
“The fixed income industry is facing a number of cyclical and secular challenges and there is a fair amount of navel-gazing going on right now,” said Rich Herman, co-head of fixed-income and currency trading at Deutsche Bank.
“There is little you can do about the cyclical challenges, you just have to ride it out, but the real challenge is to figure out what isn’t coming back.”
The industry often reacts to regulatory changes by saying that they will be cataclysmic for the business, but experience shows that it generally isn’t all that bad. We’ve been through a number of huge regulatory changes and lived to tell the tale. It is possible the industry is being overly-pessimistic about the future of fixed income right now. It isn’t all doom and gloom.”
There are undeniable headwinds, though. Quantitative easing in the US, which has injected more than US$3trn of liquidity into fixed income markets, is nearing its end.
At the same time, banks - especially those in Europe - need either to cut their balance sheets or raise capital to meet new leverage rules. Barclays and Deutsche, both big fixed income houses, are among those worst affected by leverage restrictions.
Morgan Stanley and Oliver Wyman expect banks to withdraw a further 6% to 8% of RWAs as they adapt to those two headwinds - cuts that should improve efficiency by slicing out the fat.
They estimate about US$1trn of balance sheet is still poorly employed, with up to 40% of fixed-income, currency and commodity assets tied up in rates products that yield only single-digit returns.
That push to more efficiency could lead some smaller players either to retrench from fixed income or focus on niche products within it. Many banks are inefficient in the space, having built up their businesses quickly to benefit from the pre-crisis boom. QE-induced liquidity kept those businesses alive, but as that policy is unwound, they could be forced to reconsider.
“We have had the right incentives from the start, forcing our traders to forgo some streams of revenue if the risk-reward isn’t right for the entire business,” said one fixed-income head at a US bank. “In these past few years of cheap funding, not all banks have shown such discipline.”
“I expect to see a lot of banks hanging on to their fixed-income franchises for as long as they can, even if they don’t have the critical mass or economics to survive. But as time wears on, it is inevitable that many will be forced to cut back substantially. The let‘s-try-another-year strategy will wear thin.”
Some banks have chosen to shrink the range of products that they offer within the fixed-income space - UBS and Credit Suisse are prime examples. But that is only an option for banks whose core franchise is not fixed income - meaning the larger fixed income houses may have to simply double down.
“We’ve seen a number of other banks back out of the fixed-income space,” said Herman. “Generally, it is the banks whose primary business is elsewhere - in equities or wealth management, for instance. But fixed income is a core franchise for Deutsche Bank, so we will remain committed.”
Bankers argue that offering a full range of products to clients is important if they want to be taken seriously as fixed-income houses. The illiquidity of many of these products means that banks, with their large balance sheets, are the only liquidity providers.
“Many of the assets in fixed income are not liquid enough to lend themselves to an agency model of trading,” said Ybarra. “Fixed-income market-making requires capital.”
Banks that aren’t capital constrained, such as the larger US players, should do well and have been winning market share recently over their European counterparts, many of which have much work to do to meet leverage rules.
Even where demand remains, however, returns on some products - especially in the rates and repo businesses - will remain low under new rules. Banks that continue to offer such facilities will have to accurately calculate how much staying in those low-return areas add value to the wider business.
Not all fixed income heads are optimistic, though. “The QE-inflated bubble that led to super-sized revenues across the whole of the fixed-income spectrum is over,” said one fixed-income head at a second-tier firm.
“Volatilities are at an all-time low, rates will remain at subdued levels for some time, and the credit cycle is reaching its peak. Fixed income is going to suffer, and anyone that denies that is burying their head in the sand.” (Reporting by Gareth Gore, Editing by Matthew Davies)