Investment Banking – FICC Returns will Increase as Electronic Platforms Raise Barriers-to-Entry

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SEE LAST PAGE OF THIS REPORT Howard Mason

FOR IMPORTANT DISCLOSURES 203.901.1635

hmason@ssrllc.com

October 25, 2013

Investment Banking – FICC Returns will Increase as Electronic Platforms Raise Barriers-to-Entry

  • Tougher regulatory standards for risk-based capital and leverage ratios will not limit the FICC business within investment banking to single-digit returns-on-equity but rather drive it to centrally-cleared, electronically-executed trades rather than bilaterally-cleared, voice-executed trades.
    • For example, CS targets a 15% return-on-equity for its investment bank despite having half the FICC share of GS/BAC and one quarter that of JPM/C, and despite a minimum CET1 ratio of 10% compared with 8.5% for GS/BAC and 9.5% for JPM/C. Market share is a key driver of returns – see Exhibit.
    • To achieve this return, CS is restructuring its rates business to exit structured products and bilaterally-cleared swaps. The impact of this shift to cleared product is dramatic: risk-weighted assets in the rates business is targeted to decline from the current US$16 billion by 60% through 2015 and the leverage exposure from the current US$141 billion by 70% over the same time period.
  • As the FICC business shifts industry-wide from capital-intensive customized product to high-volume standard product, revenues will become less volatile. Furthermore, returns can be protected against capital-aggressive strategies by the barriers to entry/switching of electronic platforms that integrate deeply with client infrastructure and provide trusted gateways to liquidity, analytics, and reporting.
  • Well-capitalized share-leaders have poll position to build out these electronic platforms. Our favorite names are BARC and GS with at or near top-3 FICC franchises representing ~20% of firm-wide revenues; C and JPM have larger FICC franchises but these represent <15% of firm-wide revenues.

Exhibit: Market Share is a Key Driver of Returns in Sales and Trading

Overview

Tougher regulatory standards for risk-based capital and leverage ratios will not limit the FICC business within investment banking to single-digit returns-on-equity but rather drive it to centrally-cleared, electronically-executed trades rather than bilaterally-cleared, voice-executed trades.

The Swiss banks, because of early implementation of tougher-than-Basel3 capital requirements (the so-called “Swiss Finish”), provide a case study. Credit Suisse (CS), for example, faces a Basel 3 common equity tier 1 (CET1) requirement of 10% of risk-weighted assets (and expects to run an additional buffer of 50-100 bps) and yet is targeting a 15%+ return-on-equity from its investment bank (versus the 5% return on “economic capital” achieved in Q3). We believe CS is already achieving the target return in its credit business, which benefits from a strong origination franchise including in leveraged finance, and a top-3 market-share position (see Exhibit 1). The challenge is the sub-scale franchises including, in particular, the large rates business.

Exhibit 1: Relationship between Market Share and Return for Trading Businesses at Credit Suisse

To address the rates business is more challenged, Credit Suisse yesterday announced it would be exiting its bilateral swaps and structured rates-product businesses to focus on more standardized and cleared instruments. The impact of this shift to cleared product is dramatic: CS expects risk-weighted assets in the rates business to decline from the current US$16 billion by 60% through 2015 and the leverage exposure to decline from the current US$141 billion by 70% over the same time period.

Commenting on the rates-restructuring, management illuminated the broader competitive shift in the FICC businesses from structured, bilateral, capital-intensive, voice-executed transactions to standard, cleared, high-volume, electronically-enabled transactions: “it [the rates business] will be much more client-focused and leveraging of our AES capability and our electronic capabilities”. (AES is CS’s Advanced Execution Services electronic platform which generates trade ideas through analytics and seeks to reduce the market impact costs of execution through broad access to liquidity). CFO David Mathers made two additional remarks which we transcribe for reference:

  • “As everyone looks towards the new cleared environment for rates, which is where the industry is going (it [cleared] is 95% of our [rates] business in the US), we would anticipate a substantial incentive to accelerate that across the industry”
  • “The bulk of this [reduction in leverage exposure] will come from eliminating bilateral swaps trades. I think there’s very little to come from repo … because that was one of our early targets for our leverage reduction program”

Broader Implications

If CS can target a 15% return from its investment bank with minimum-required CET1 ratio of 10% and share in FICC of 7% (among those major players who have reported Q3 results – see Exhibit 2), we believe this return will be achievable for the leading US franchises which have higher share and face less onerous requirements for minimum risk-weighted capital ratios: 7% plus a SIFI buffer which varies from 1.5% for GS and BAC, to 2% for BARC, to 2.5% for C, DB, JPM and HSBC.

Among investment banks that have reported Q3 results, GS has ~15% share of revenue (we view the 10% reported for Q3 as an aberration) with JPM and C nearer 30%.

Exhibit 2: Revenue Pool and Mix among Leading Investment Banks Reporting Q3 Results

Investment Banking is total of FICC and Equities Trading plus Financing & Advisory

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