Tackling the performance challenge in regional capital markets business
Small capital markets businesses have been insulated against many of the troubles affecting their larger competitors. Now things are getting tougher.
The capital markets arms of regional and national banks are often seen as smaller versions of the capital markets businesses of the top 10 global firms. However, they are actually quite different. Regional businesses have evolved along their own paths, with distinct client franchises, operating models, and sources of profitability. As a result, they require a strategic agenda that is tailored to their specific needs. Until recently, the capital markets businesses of regional banks have been insulated against many of the troubles affecting larger global banks, and in some cases have performed better than them. Regional capital markets businesses’ returns on equity (ROE) held up better than those of their larger counterparts and regionals maintained their market share.
Now, however, there are signs that life is getting tougher. Structural shifts such as increasing electronification and falling revenues, and questions about the sustainability and “fit” with their parent organizations, are leading to increased scrutiny of these businesses. This has been especially pronounced in Europe. Temporary revenue upticks from market volatility linked to COVID-19 are seen as providing only temporary relief.
Even seemingly more robust franchises are being forced to answer difficult questions. They have found that after stripping out the impact from internal flows and adjacent client bases, the businesses that remain are often far less profitable. They have also found it challenging to unlock the next phase of growth.
In response, regional players across geographies are focusing on improving productivity end to end. A subset of firms is also trying to identify three to five pockets of opportunity for capturing revenue.
Regional banks require a customized playbook to move forward on this agenda, focused on optimizing the front-office footprint, simplifying support functions and making them more efficient, and making a few targeted technology bets. To spur growth, banks should disproportionately allocate talent and balance sheet to their most valuable products and client segments, while paring back in other areas. The prize for those that succeed is significant. According to McKinsey analysis, for a representative $2-billion-revenue franchise, even a tactical set of levers focused on efficiency can lead to $150 million to $250 million of bottom-line impact over a two-year period and create capacity for more ambitious initiatives centered on technology and growth.
Regional capital markets businesses face a performance challenge
Regional capital markets businesses are too often analyzed alongside those of the top 10 global banks. However, this approach ignores differences that are critical to the way in which they manage their businesses and optimize their competitive positions.
Regionals are different on many counts, including revenues, clients, and key sources of profitability. They typically generate revenues in the range of $1 billion to $5 billion, while large players operate in the over $10 billion area. More of their business comes from corporate clients (in excess of 50 percent in many cases) versus the largely institutionally focused franchises of global players. The product mix is simpler, focused on a combination of debt capital markets, FX, rates, and sometimes equities, compared to the more expansive capital markets offerings maintained by larger players, and therefore easier to staff and support. Profitability for regionals relies materially on other areas of the bank (e.g., processing all the bank’s FX trades, cross-selling swaps on the back of corporate loans made by the corporate bank). Finally, the regional coverage model relies more heavily on corporate bank relationship manager-led interactions and is more tightly integrated with the treasury function.
Until recently, these differences were the basis for stronger performance. Regionals routinely generated ROEs of 10 percent or more, higher than that of many of the global players. They boasted more stable client franchises, were less exposed to market volatility, attracted higher margin flows, and incurred lower relative costs. As a result, they maintained market share between 2015 and 2019.
However, over the past few years, the relatively stronger position these banks enjoyed has started to deteriorate. While there is a very wide range of performance in the regional capital markets space, with wide variation in ROEs and cost-income ratios across banks, many firms have seen ROEs consistently slip below 5 percent and cost-income ratios climb north of 80 percent. This decline in performance has been particularly pronounced at a number of European firms. Recent, temporary upticks from COVID-19-related volatility are not seen as sustainable or likely to fundamentally change the longer-term challenge facing regionals.
Even firms that appear to be far more financially strong are often not so. The profitability of treasury activities and internal retail and wealth flows can mask core sales and trading activities that are far less profitable.
As a result, many regional capital markets businesses are facing fundamental questions about the scale and sustainability of the franchise, its contribution to the wider bank, and its risk profile. They also need to find an answer to the increasingly vexing question of where to find future growth.
We see eight key reasons why the strategic picture has become more challenging for regional capital markets businesses:
1. Regional firms play at a fundamentally less productive place on the productivity frontier
When it comes to front-office productivity, the data suggests that scale matters greatly. Regional and national capital markets businesses are inherently less efficient than larger players tend to be on a revenue-per-FTE basis (Exhibit 3). Many of their core clients have smaller wallets but still require substantial coverage and execution resources.
2. Client needs are changing and raising the technology bar
Corporate and small and medium-size enterprise (SME) clients have increasingly sophisticated needs associated with global operations and ever-rising digital expectations. These companies have been forced to understand their cash flows and the risks to those cash flows at an ever more granular level. This has led to a demand for smarter, faster capital markets solutions that are available across channels, provide connectivity to multiple banks at once, and can access the latest fintech offerings across a range of areas, from visualizing FX hedging needs to settling cross-border payments. For banks, building or buying the required technology is expensive. As we describe below, these needs are also attracting new entrants focused on some of the most lucrative flows (e.g., in FX forwards).
3. Electronification is eroding margins and creating pressure to invest in e-trading technology
The trading of FX, equities, and areas of rates has become increasingly electronic, leading to tighter margins. Regional banks have been required to spend more on venue connectivity, and on auto-pricing and auto-hedging engines. Increasingly, the banks that win are those with scale, and regional firms typically lack this.
4. Margins have tightened in other asset classes as well
Revenue pressure is not restricted to electronically traded products. For example, the traditionally low-risk repo business was an area where regional firms exploited the regulatory capital advantages they had over larger firms, which were more balance-sheet constrained. They are now seeing substantial price pressure as competition has intensified once more.
5. New entrants emerging across the value chain
Market making has expanded beyond the traditional dealer community to a new breed of algorithmically driven market makers, in FX and rates for example. Further, the fintech community, initially focused on the retail banking space, is now building momentum in capital markets through services aimed at the poorly served SME segment; for example, currency exchange and payments propositions that are sold on the basis of greater accessibility and cost efficiency. Client flows that regional capital markets firms could previously take for granted are thus no longer guaranteed.
6. Regulation is driving capital intensity and regtech spend
Banks continue to manage the many impacts of regulation. Significant regulatory initiatives still being delivered include FRTB, BCBS 239, and MiFID II. In some geographies, banks are also required to separate capital markets activities from the rest of the bank’s “ring-fenced” retail and commercial activities. The impact of all these efforts includes higher funding costs, reduced revenues, and increased capital requirements. These programs are also expensive and time-consuming to deliver. Some regional and national banks are spending up to 25 percent of revenues on change activities, the majority of which are regulatory in nature. Upcoming rule changes such as the shift away from IBOR benchmarks, as well as the still unknown impacts of Brexit, are likely to create further strain.
7. Relationships with the parent bank are becoming more complex
Regional capital markets businesses are often engaged in delicate ongoing negotiations over their revenue-sharing arrangements with the wider bank. A common point of debate is joint-venture arrangements concerning lucrative internal flows. These may either flatter the earnings contribution of the capital markets business, obscuring its less attractive “true” economics, or fail to compensate it for the coverage and technology resources required. Other subjects for negotiation include sharing of client lists and the operation of cross-sell arrangements, which often work less effectively than they could. Finally, some capital markets franchises are continually challenged to articulate their contribution and their fit in the context of the wider business.
In other cases, the position of the business is more secure, and the capital markets division is regarded as a utility, responsible for handing flows from retail, wealth, and treasury, as well as the classic corporate bank. However, the benefits the capital markets business brings in terms of profitability are seen as offset by technological and operating model complexity. Sometimes this is due to multiple legacy IT stacks and databases built over time. Re-platforming is one solution, but it’s neither cheap nor simple given links into other critical areas, such as treasury.
8. For firms focused on expansion, the path to future sustained revenue growth is unclear
Capital market revenue pools have been roughly flat from 2016 through 2019, but some regional players initially capitalized on the post-2008 financial crisis retreat of the top 10 global banks to increase their market share. Now that gain is being eroded by the (re)emergence of a few entrenched “flow monsters.” These global players increasingly dominate individual product verticals, operating at a lower cost per trade and amortizing technology spending across a much larger client and revenue base. The result is ever-deeper moats around their franchises, putting regional players under pressure to find client/product combinations where they retain a real edge. In addition, a number of these global firms are re-entering the mid-sized corporate space in search of growth of their own, further increasing competitive pressure on the regionals.