A Nietzschean Take On Investment Banking
What doesn’t kill you makes you stronger.
That’s the subtext of a recent FT article charting the unlikely resurgence of investment banking a decade after the financial crisis. The headline statistic is that industry profits are back to pre-crisis levels and many of the top investment banks have emerged with stronger franchises.
The winners in the global banking race have undoubtedly been the US banks. And more often than not, success in financial services is a function of broader economic success. The US economy emerged from the crisis relatively unscathed, and US capital markets remain the world’s largest and least competitive. Of course, that might change. Asian economies are enjoying strong growth, and Chinese bond market is huge and only going one way. The macro landscape has now shifted in favour of banks, with the bottoming out of the rates cycle. The fiscal backdrop in America is more favourable too, with the Trump administration ushering in tax cuts that are boosting the real economy and encouraging corporate activity.
The resurgence of investment banking is a timely reminder that the core business of big banks – helping institutions raise capital – is paramount. While trading revenues have become more volatile in the electronic era, margins have compressed and QE has reduced asset price volatility, core investment banking revenues have been fairly steady. DCM in particular has been a cash cow for banks over the past decade, serving as a reminder that the core business of investment banks – helping institutions raise capital – is important and will always remain so.
But the renaissance of investment banking is down to more than luck and timing. We’re witnessing natural selection at play, a form of Schumpeterian creative destruction.
The effects of the crisis continue to play out in unexpected ways. Regulatory costs have increased, but the economics of banking have become more attractive as the industry has adapted to challenging conditions. The wave of consolidation that occurred after the crisis has left the survivors with economies of scale and global reach, whilst cost-cutting initiatives (borne out of necessity) have streamlined operations.
Perhaps the biggest takeout from the FT article is that profitability does not equal return on equity. Due to the increased regulatory burden, big banks have almost doubled shareholder equity since the end of 2007, resulting in lower returns. How can they turn this around before being forced to divest large swathes of their operations?
The answer lies in technology. Since 2007, banks have become much more receptive to tech and willing to invest in infrastructure, either by building it themselves or partnering with innovative companies. This is partly a defensive move, to ensure they maintain market presence in the face of encroachments from fintechs and big tech. It’s also offensive, and all banks without exception now acknowledge the strategic importance of technology in driving growth and increasing returns on capital.
The FT focuses on the top players in terms of total revenues, but it’s interesting to reappraise this list on terms of return on equity. When you do this, you find that the return on equity for smaller, more focused banks is higher than the big players. This suggests that the future of banking lies not in full-service models but in franchises that are focused, specialised and differentiated, powered by innovative technology.
The financial crisis has played an important part in the evolution of our industry, and now technology is helping to shape the next chapter. As Nietzsche observed, “The future influences the present just as much as the past.”