Investment Banking Outlook Mixed according to Standard and Poors

Standard and Poor’s, one of the leading global credit rating agencies, released some comments about the investment banking industry in general this month. Overall, the agency sees a mixed outlook for the industry, with some opportunity for growth, albeit with a great deal of uncertainty and risk. Cost cutting is expecting to continue for several more years, while the implementation of Basel III may lead to differences in terms of competitiveness between jurisdictions. That said, modestly increasing revenues and more responsible risk practices may see investment banking credit profiles improved in the medium term.

Cost Cutting and De-leveraging Expected to Continue for Several Years

In the view of S&P, cost cutting and de-leveraging is expected to continue amongst the investment banking industry for “several years.” Interestingly, the rating agency doesn’t view these cuts as being driven purely by regulatory changes but rather will continue even once the regulatory landscape has stabilized. While painful for employees in the short run, these cuts will eventually leave the industry better off, with higher margins for the giants. This will act to counterbalance diminishing returns on equity caused by ongoing deleveraging.

Capital Markets Revenues Projected to be Stable

While cost cuts seem to be a longer term trend, revenues appear to be set to make a modest recovery. S&P predicts that revenues will be approximately 5 percent higher in 2012 than in 2011. This will be followed this coming year by revenues generally in line with 2012 results, though there may be more risk to the downside than to any positive growth. The rating agency also expects that institutions focused on U.S. operations will outperform their European-focused peers.

Responsible Investment Banks May Improve Their Credit Profile Over Time

The de-leveraging and better risk practices taking hold across the industry will likely improve the stand-alone credit profile of investment banks over the next several years. While much of this change has been driven by tighter banking regulations, the industry does deserve some credit in how it is moving to better assess risk. Institutions with better credit profiles will be able to obtain lower cost capital to fund proprietary operations, which could result in higher margins in the medium to longer term.

Regulatory Differences Will Lead to Competitive Distortions

Standard and Poor’s remains concerned about differences in regulatory regimes across different jurisdictions, leading to competitive issues between institutions. In Australia, Japan and Switzerland, for example, all will see the implementation of Basel III occur on schedule. This puts their institutions in a more difficult position in delivering returns equal to their peers in the U.S. and Europe who will not be facing the same regulatory framework. The implementation of the Volcker rule as well as European ring fencing measures may also weigh on the industry, but the extent and timing remains uncertain at this time.

Overall, the rating agency paints a picture of great uncertainty for investment banking, but also some opportunity to begin turning the ship around. Stability in terms of capital market revenues will be welcome relief to most that rely on the industry, especially following several years of volatility. Further consolidation will be painful in the short run, but will set the industry up for a stronger future. Importantly, governments and regulators will hold a key stake in the future direction of the industry – one that is core to any sustained economic recovery in the developed world.

Unsurprisingly, it looks to be an interesting time ahead for the investment banking industry.

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