Executive Summary
With a sea change in the political environments in the US and Europe, the financial services industry is entering a period where the burden of regulation and compliance will lessen in the next 18 to 24 months, freeing up capital and favourably affecting revenue and profitability in investment banking and, with a few exceptions, the capital markets more broadly. We expect the industry to return to a level of modest growth in 2017 and accelerate in 2018.
The coming wave of deregulation will be driven most directly by the Trump Administration in the US, which has stated that reducing regulatory burdens overall is a priority and is more immediately focused on dismantling the Dodd-Frank Act, notably by eliminating The Volcker Rule. In Europe, Britain’s exit from the European Union will indirectly lead to an easing of regulations, as countries in continental Europe strive to attract financial institutions from London, forcing the UK to adopt a less burdensome regulatory environment.
While EU financial players are accelerating their efforts to comply with MiFID II, with some markets facing greater obstacles than others to hit the looming 2018 deadline, there is some discussion as to whether implementation of MiFID II in the UK should be specifically reconsidered.
Unlike deregulation, the effects of monetary policy are the source of some debate. While the argument that increasing interest rates will translate into higher net-interest revenues for banks has been touted by some market observers, we are sceptical that such a relationship actually exists. Rather, increasing interest rates will have a deleterious effect on the fixed-income securities held by banks, which will heavily outweigh any benefit in the form of interest margins.
As deregulation progresses and more capital becomes available to be deployed elsewhere, financial institutions will take a harder look at financial technologies in which to invest. Within the FinTech arena, there will be three major areas of focus in the next two years: Blockchain, artificial
intelligence and technology focused on regulatory compliance, commonly referred to as RegTech. While Blockchain has captured the imagination of many market participants, we believe the expectations for it are too high and that it is poorly suited for many areas within capital markets where implementations are being pursued.
Figure 1. Industry Revenue Forecasts
Source: Opimas Analysis
Attempts to replace large portions of the equities or fixed-income markets with Blockchain, for example, will be met with failure. We expect banks to refocus their Blockchain efforts on niche markets, with low volumes and low levels of automation. More importantly, the rise of artificial intelligence will see application in a wide range of areas, and we believe that its promise in the capital markets is far greater than for Blockchain. Finally, RegTech will continue to grow, even with shrinking regulatory requirements, as banks seek to automate compliance and risk management, which are heavily reliant on manual processes that require armies of compliance and risk professionals.
Deregulation
A Change in Political Winds
For almost a decade, the banking industry has been under intense regulatory scrutiny on both sides of the Atlantic. Waves of new rules and virtually continuous litigation have forced banks to expend an enormous amount of effort on compliance-related activities. This focus has compelled financial institutions to significantly expand staff dedicated to risk management and compliance, required IT departments to allocate the bulk of their new systems development to conforming to new regulations, and stifled new product innovation for fear of provoking new litigation. Increased capital requirements have forced some firms to scale back lines of business or exit them entirely, and restrictions regarding OTC derivatives and proprietary trading have had deleterious effects on revenues and profitability.
It appears that the financial industry has now reached the zenith of regulation, and the pendulum is ready to swing in the other direction with a greater emphasis on deregulation. Two major factors will push this forward:
- First, and rather obviously, the recent election in the United States has put politicians in favour of deregulation in control of both the executive and legislative branches. President Donald Trump has made his misgivings regarding the Dodd-Frank Act widely known. This, coupled with lower corporate and capital gains taxes, stands to significantly benefit financial institutions.
- Secondly, and rather more inadvertently, the United Kingdom’s decision to leave the European Union will put pressure on both sides to reduce regulatory constraints. While the precise form this will take is more difficult to predict, several countries in the EU are eager to attract financial institutions away from London. This is likely to take the form of tax incentives, less onerous labour regulations, and generally lighter regulation. The UK, in order to retain its dominance as a financial hub, will come under pressure to respond and this competition between the UK and EU will prove beneficial for banks.
Trump Deregulation by the Numbers
If President Trump’s deregulation agenda is fully realized over the near term, we estimate more than US$27 billion in capital could be redirected by financial institutions. In Figure 2, we examine the likely financial impact of the deregulation based on what President Trump has been proposing, mainly by dismantling Dodd-Frank, but more specifically:
- Suspension or elimination of The Volcker Rule would eventually allow financial institutions to gain US$6 billion from trading activities. This figure does not include labour, legal / litigation fees and technology costs, though there will be significant savings in each of these areas. The Volcker Rule is the easiest regulation to jettison, because regulators could simply immediately stop enforcing it. To date, there has been little evidence that The Volcker Rule has made the financial system safer, so it should be the easiest part of Dodd-Frank to eliminate. Indeed, there is significant evidence that repealing The Volcker Rule would have a beneficial impact on the market by increasing liquidity in various asset classes by allowing dealers to hold inventory.
- Reductions in capital and liquidity requirements. While these regulations will be the most difficult to scale back since they are globally implemented and compelled banks to build myriad models and retain armies of risk and compliance teams, the reduction in capital and liquidity requirements could be massive, freeing up nearly US$20 billion in unproductive capital that banks are hoarding and could redirect to other areas. Further, shrinking this compliance burden will significantly reduce banks’ operating expenses, which will translate to a lower cost-to-income ratio and higher return on equity.This roll back will not happen overnight, but it could also prompt the Basel Committee to re-write capital standards globally to avoid regulatory arbitrage triggered by US deregulation.
- Elimination of the Consumer Financial Protection Bureau. The elimination of or serious reduction in CFPB regulations will mean a potential savings of nearly US$1.4 billion for banks, although the savings will mainly accrue to US retail banking activity.
- Revisitation of Too Big to Fail. The knock-on effect of deregulation of the Financial Stability Oversight Council’s rules and mandates tied to Too Big to Fail, Living Wills, derivatives and enhanced prudential standards could return an additional US$840 million to institutions.
The interconnectivity of the global financial ecosystem will compel regulatory agencies in other countries to follow Trump’s lead with US deregulation, or risk losing financial firms to the US. We expect regulators in the EU and UK to rapidly respond in kind, or create other incentives to prevent financial institutions from shifting trading books and other business to the US.
Figure 2. Revenues and Cost Savings Anticipated under Trump Deregulation
Source: Opimas Analysis
Brexit
While considerable uncertainty surrounds the precise form the United Kingdom’s exit from the European Union will take, much of the discussion to date has centred on three distinct topics: passporting, clearing and remote access. The implications of each specifically are:
- Passporting. UK-based banks obviously wish to retain passporting privileges so they can continue to sell their products and services from the UK into the EU. However, it is looking increasingly likely that there will be a hard Brexit, which would put passporting rights at risk. In practice, we do not believe that the end of passporting will be overly burdensome for large financial institutions. Virtually all large banks have subsidiaries within continental Europe and will be able to shift effected business to those subsidiaries.
- Clearing. The European Central Bank (ECB) has unsuccessfully made efforts in the past to require the clearing of euro-denominated instruments to occur within the Eurozone. The UK’s departure from the EU will bring this to the fore again. However, an implementation of a Eurozone clearing requirement seems exceedingly unlikely to occur; instruments in almost 30 currencies are cleared in London on a regular basis. Even if such a rule were implemented by Brussels, the clearing of trades only represents a small portion of the overall value chain.
- Remote access. Under EU rules, brokers can readily access exchanges or other trading platforms in other EU member countries. There has been some concern that the EU would place restrictions on such remote access. For example, a London-based broker may in the future face additional restrictions when accessing Deutsche Börse’s platform. However, restricting remote access rights runs the risk of substantially harming EU-based exchanges more than anything, and banks would be able to simply channel transactions through continental subsidiaries.
Overall, the potential benefits for financial institutions under Brexit outweigh the downside. We expect to see a handful of cities in Europe, notably Paris and Frankfurt, compete to lure banks away from London. This will take the form of tax incentives, labour law exemptions and special economic zones. The British government will have to respond by making its business climate more favourable to financial institutions. We believe that a reasonable starting point would be for UK regulators to reconsider the looming implementation of MiFID II, as well as reviewing myriad other EU regulations currently in force in the UK, including EMIR, MAD, AIFMD, among others.
Interest Rates
Central banks around the world have pursued extremely low interest rates since dramatically lowering rates in 2008. The Bank of Japan was the only major central bank that did not slash interest rates that year, but for the simple reason that its interest rates have essentially been at zero for as long as almost anyone can remember.
Interest Margin
The Federal Reserve has started to very cautiously raise rates, and this move has been cheered in several quarters of the US banking industry, in the belief that higher interest rates will lead to greater profitability. We believe that this optimism is misplaced. While higher interest rates would certainly allow banks to increase their gross-interest income, it is far from clear that their net-interest income would increase. Figure 3 clearly shows that changing interest rates do not directly translate into movements in net interest margin. Steep declines in interest rates between 1984 and 1994 were accompanied by a modest increase in net interest margins, while increases in interest rates from 2004 to 2007 saw net interest margin. The sharp cut in interest rates during 2008 was followed by a jump in interest margins. Overall, it is difficult to discern any correlation between the nominal interest rate and banks’ net interest income. Individual institutions may have organised their balance sheets in such a way that they can benefit from rising rates. However, it would be a mistake to generalise this to the rest of the industry. Higher interest rates will not necessarily translate into higher interest margins for banks.
Figure 3. Interest Rates and Interest Margin
Source: Federal Reserve Bank, FDIC, Opimas Analysis
Asset Valuation
While increasing interest rates will not have a beneficial impact for the net interest margins that financial institutions can achieve in their lending activity, higher interest rates will have a negative impact on fixed-income securities, particularly government bonds that banks hold in their portfolios.
Rates and Equities IPOs
As years of very low interest rates have filtered from central bank lending and government bonds to corporate bonds, the market for initial public offerings (IPOs) has suffered tremendously, as can be seen in Figure 4. This drop in IPO activity is particularly surprising in the light of the fact that many equities markets are currently at, or near, record highs. In late January, U.S. equities closed at all-time highs, with the Dow Jones Industrial Average breaking 20,000 for the first time. Despite record levels in equities markets, the cost of borrowing has fallen to such an extent that debt financing represents a far more attractive alternative than issuing shares.
Interest rates are unlikely to rise sufficiently in the coming year to completely revive the notoriously volatile IPO markets, but we do expect to see the decline witnessed in 2016 to come to a halt, and to not show further erosion in 2017.
Figure 4. IPO Issuance Activity by Major Regions 2011-2016
Source: Opimas Analysis
Industry Revenue Forecasts
Revenues for the global capital markets, investment banking and securities servicing industry are finally looking up. After anaemic growth in 2015 and a decline of over five percent in 2016, we expect 2017 and 2018 to show a marked improvement, with growth returning to five percent by 2018 as the effects of deregulation in the US and Europe take hold. To further examine the possibilities on the horizon, we have developed optimistic and pessimistic scenarios that are shown in Figure 6. In the event that efforts aimed at deregulation are stymied and monetary policy takes an unfavourable turn, we expect to see virtually no growth over the course of the next two years.
Sales and Trading
Equities trading saw a particularly bad year in 2016, with aggregate industry revenues declining 13%. We expect this decline to come to a halt in 2017 and to see modest growth in 2018. Fixed income, on the other hand, fared better in 2016, seeing a very substantial increase in activity, with trading volumes jumping by 30% in Q4. While we do not expect this increase in activity to continue throughout 2017, we are cautiously optimistic. Similarly, foreign exchange trading also saw a very substantial increase in activity at the end of 2016, with greater volatility driving significant trading volume.
Investment Banking
Equity capital markets (ECM) took a hammering in 2016. Overall revenues in the industry were down 35% in 2016, but we do not anticipate further erosion in this line of business in 2017. With continued low interest rates, we expect debt capital markets (DCM) to fare somewhat better than equities, and mark single-digit growth in 2017. The advisory side of investment banking had one of the highest growth rates of any line of business in 2016 with zero percent growth. While M&A activity is notoriously hard to predict, we expect to see modest growth here in 2017.
Figure 5. Global Revenue Forecast
Source: Opimas Analysis
Securities Services
While sales and trading stands to benefit from lighter regulations, the securities servicing side of the house could see this translate into wasted investments. Over the past few years, custodians have made very substantial investments in collateral optimisation solutions, which were predicated on regulations that were very proscriptive in terms of collateral. Should these rules be weakened or even eliminated completely, these investments will have been for nought.
Figure 6. Revenues Under Different Scenarios
Source: Opimas Analysis
Figure 7. Outline of Differing Scenarios
|
|
Baseline Scenario |
Optimistic Scenario |
Pessimistic Scenario |
|---|---|---|---|
|
Monetary Policy |
Interest rates remain low, with only 0.5% increase through 2017, and 1% through 2018 |
Interest rates remain low, with only 0.5% increase through 2017, and 0.5% through 2018 |
Monetary tightening interest rate increase by 1% or more in 2017, additional 1% in 2018 |
|
Capital and Liquidity Requirements |
Reduction in capital requirements by 2018 from 12% to 10% |
Significant reduction in capital requirements by 2018 to pre-crisis levels from 12% to 8% |
Current regime remains in place |
|
Other Regulations |
In US, elements of Dodd-Frank repealed by early 2018, in particular:
In UK, an exit from the EU leads to a review and weakening of regulations such as EMIR and MiFID II |
In US, Dodd-Frank largely repealed by early 2018 In UK, bank levies and special taxes on banks are eliminated. EU regulations currently in place are substantially weakened. In EU, countries start to attempt to attract financial services from London by offering less onerous labour laws, favourable tax treatment, and lighter regulations |
In US, Dodd-Frank essentially remains in place In EU and UK, regulation essentially remains unchanged. |
|
Litigation |
Somewhat less strident enforcement of regulations, with fewer multi-billion dollar settlements |
Less strident enforcement of regulations |
Litigation continues at current level |
|
Market |
Equities markets maintain current high levels and continue to grow in single digits Bond issuances continues to grow at current rates |
Equities markets grow in double digits Bond issuance accelerates |
Equities markets mark modest declines in single digits Bond issuance flattens Significant decline in commodities |
|
Macro-Economic Variables |
Global economy grows at 3% in 2017 and 3.2% in 2018 Little change in trade policies and/or immigration, modest de-regulation, |
Global economy grows at 4.2% in 2017 and 5% in 2018 Little change in trade policies and/or immigration, deregulation more broadly e.g. oil/gas exploration |
Global economy grows at 1% in 2017 and 2% in 2018 Increased tariffs hamper trade, bottlenecks in hiring foreign workers |
Source: Opimas Analysis
FinTech
While financial technology-driven start-ups have been able to penetrate a number of markets, achieving scale is very difficult, and there have been very few, if any, Ubers or Airbnbs in the capital markets. Disruptive technologies are generally focused on the retail banking market, with innovations in areas such payments and peer-to-peer lending that have been able to upend or dislodge incumbent players. Within the capital markets, the more esoteric nature of the products and services provided, as well as a regulatory framework that favours large, existing financial institutions, has kept technology-driven start-ups at bay. To have a reasonable chance of success, new technologies in capital markets must be introduced and often collaboratively seeded by existing, established players.
There are exceptions, however. Start-up IEX Group’s introduction of a “speed bump,” a coil of fibre optic cable that slows down high-frequency traders’ access to its market by 350 microseconds, has forced rival exchange NYSE to introduce its own speed bump, while Nasdaq sought to thwart IEX’s inroads by undertaking a speed upgrade. However, such in-market disruptions are few and far between.
In recent years, the financial industry has been more defined by a period of disruptive regulations, rather than disruptive technologies. With greater liberalisation, financial institutions will once again be able to focus large portions of their IT budgets on innovation. We have identified three technology areas that will receive the greatest amount of attention, investment and implementation in the next two years: Blockchain, artificial intelligence and RegTech.
Blockchain
Blockchain, the system underpinning Bitcoin, is undoubtedly the technology that has captured the greatest attention over the past two years. While the possibilities that Blockchain presents have been widely praised, we are far less confident that Blockchain will be able to have a major impact in established, high-dollar-value, high-volume markets. It is exceedingly difficult to believe that Blockchain will be able to replace the entire post-trade infrastructure in equities markets, as has been promised by the technology’s most ardent supporters.
Figure 8. Spending on Blockchain in Financial Services
Source: Opimas Analysis
In reality, the advantages offered by Blockchain over more traditional technologies in such an environment are difficult to discern, and limitations in terms of Blockchain’s ability to handle high-volume transactions and the absence of a clear governance structure make it a costly, risky bet for most applications. Even more, demonstrable progress has been slow:
- Over 70 institutions have joined the R3 CEV consortium—13 backing Digital Asset Holdings—but in late 2016 the exit of Goldman Sachs, Banco Santander and Morgan Stanley dealt a blow to the consortium
- Only 14 of the top 30 banks have actually started work on a Blockchain proof of concept
- Only one third of the global stock exchanges have launched a proof of concept initiative related to Blockchain
- In fact, investment in Blockchain-related initiatives accounts for a mere 1% of the overall FinTech space
Over the course of 2017, we expect to see financial institutions abandon the overly ambitious plans laid out for Blockchain, and to re-focus their Blockchain initiatives on more targeted areas that suffer from a lack of automation and where volumes are not so great that a Blockchain implementation will be overwhelmed. These application areas will be small niches, and the projects aiming to revamp massive portions of the trading infrastructure will fall by the wayside. This reframing of Blockchain initiatives will account for a narrowed set of applications, but will lead to a projected rise in investment by 2018, though it will not match 2016 levels.
Artificial Intelligence
Figure 9. Applications of Artifical Intelligence
Source: Opimas Analysis
While the prospects for Blockchain are rather limited in capital markets, we remain optimistic regarding the application of artificial intelligence (AI). As IT departments are freed from years keeping up with regulations, they will turn their attention to creating greater efficiencies internally and competitive advantages externally. AI will play an important role in achieving this and in Figure 9 we show where the impact of AI will be the greatest, the most closely watched of which will be the investment management and trading spaces. AI will be the cornerstone on which financial institutions rebuild their business models, albeit with some trial and error:
- Alpha generation. While hedge funds already rely on AI for investment decisions, they are still years away from reaping the full benefits of AI as it will require experimentation and failure before wide adoption
- Improved decision making. Machine learning offers predictive and even prescriptive capabilities, which is why we estimate that it will do wonders in the risk management area
- Cost reduction. The biggest benefit of AI is in the back office where it could significantly reduce operating costs. Eventually, proper roll out of AI technology in the custody space alone could generate more than US$5 billion in cost savings through a 20% reduction of internal staff
RegTech
Rather counter-intuitively, we expect spending on RegTech to continue to grow, exceeding US$7 billion within two years as shown in Figure 10, despite the lightening of regulatory burdens that we anticipate in 2017 and 2018.
Figure 10. RegTech Spending
Banks have had to contend with waves of new regulations that were then subject to rapid change and reinterpretations. As a result, it has been difficult for banks to automate many of these processes, and they have had to rely on heavily manual processes. Banks have been forced to hire hundreds or even thousands of compliance and risk professionals to fulfil their regulatory obligations pertaining to data management, activity monitoring, transaction reporting and such.
In the next two years, we expect to see a greater emphasis on automating as many of these functions as possible. This will lead to a reduction in staff by 2018. A reduction in the overall level of regulation, coupled with the automation of many of the compliance tasks that remain, will lead to significant savings in ongoing operational costs tied to compliance.