By Cary Springfield, International Banker
With a heady mix of intense competition from the fintech (financial technology) sector, an onerous regulatory burden and the coronavirus pandemic recently directing consumers more decisively towards their smartphones and laptops, the story of retail banking’s shift towards digitalisation has become a well-publicised and highly visible one. But it’s not just within the retail space that banks are experiencing such challenges. At the opposite end of the scale, the same is also true for investment banking.
The last few years have seen the investment-banking space undergo significant changes regarding shifting client expectations, industry trends promoting greater financial inclusion and democratisation, and consistently more stringent regulatory demands. For equity capital markets (ECMs), for instance, higher regulatory and reporting costs have eaten into fee income generated from IPOs (initial public offerings), leading to companies being more inclined to stay private. Indeed, there has been a drastic reduction in the number of companies going public compared to 20 years ago. What’s more, there are now many more alternative-fundraising models, which are attracting some of the biggest unicorns away from the traditional model offered by investment banks and thus further diminishing their earnings power.
Investment banking is also facing significant competition from fintech companies that can now capture a growing portion of business and clients from the traditional space. Pricing and transaction data, for example, has historically been in the hands of the sell-side, such as investment banks, and remained somewhat opaque to clients. This has helped banks command control over their pricing and has thus been a major income source through higher transaction fees and wider pricing spreads. But today, digital start-ups can aggregate such transaction data with relative ease, which means they can erode the monopoly power over pricing previously held by investment banks. As Deloitte recently acknowledged, “the trend toward greater transparency in pricing and transaction data will continue”, which reduces or even eliminates the need for a middleman in many instances.
“These businesses are sprouting and providing intermediary solutions that traditional investment banks do not offer or offer in a limited way,” Accenture observed in 2017. “Financing through crowdfunding and peer-to-peer (P2P) lending has also eliminated the need for brokers or investment banking services. As these alternative service providers have gained popularity, revenues from security finance, lending, payments and investment services of traditional investment banks have become stagnant.”
Indeed, there is already a growing trend towards the complete elimination of the investment banker when executing and completing deals. In 2016, for example, Comcast Corporation acquired DreamWorks Animation for around $3.8 billion and handled all the talks pertaining to the deal without involving an external investment-banking entity. And Spotify managed to list publicly and determine its opening price based on the volume of orders it had received, thereby eliminating the need for investment bankers to be involved in the process. “Corporates are building internal deal strategy and advisory teams as a self-service model to execute transactions directly,” according to financial-services research firm Acuity Knowledge Partners. “This enables them to be flexible and act quickly when required. Importantly, it also saves them from paying high fees, wherever they can. Corporates are hiring senior ex-bankers from leading Investment Banks as deal strategists to move quickly and close transactions fast.”
What’s more, the coronavirus pandemic has only further accelerated the need for banks to implement sweeping changes to their investment-banking business models, with fees generated from traditional units such as ECMs, mergers and acquisitions (M&As) and debt capital markets (DCMs) having plummeted during 2020. As such, there is growing urgency for investment-banking business strategies to evolve, primarily to help clients counter the economic shocks but also adapt and identify new sources of revenue during this challenging market environment of higher capital requirements, mounting bad debt and squeezed interest margins that has weighed so heavily on earnings.
Digitalisation lies very much at the heart of such a transformation. The coronavirus outbreak and the resulting social-distancing measures put in place all across the world have meant that digital tools have simply become a way of life for businesses to ensure that they can continue operating without interruption and their employees can work remotely. “For many investment banking and capital markets institutions, this challenge only builds on the fierce competition for deal flow and fee and margin compression they face while also meeting heightened client expectations,” Deloitte recently observed.
To embrace digitalisation, many thought-leaders see either transforming their core-banking systems or creating separate challenger entities as viable ways for investment banks to modernise. “While the creation of a completely new bank is appealing, since it allows CIBs [corporate and investment banks] to take advantage of the latest technology and avoid legacy issues, building a new bank is a massively complex undertaking that can take years to scale,” Boston Consulting Group (BCG) noted in March 2020. The management-consulting firm also acknowledged that such institutions are well aware that it will likely take several years to complete a traditional IT (information technology) transformation and that the results could still end up lagging customer and user expectations.
That said, investment banks do not necessarily have to undertake a comprehensive internal transformation if such a task requires significant time and cost. With banks facing growing competition from digital start-ups that tend to be more cost-efficient and flexible with lighter digital infrastructure, existing banking behemoths are unlikely to be able to outmanoeuvre them simply by implementing their own internal restructuring programmes. Instead, some may choose to create “partner ecosystems” that can plug essential service gaps in their portfolios as well as lower their overall cost structures. BCG identified three examples of such partnerships:
- outsourcing some or all of a bank’s IT and operations to ecosystem players, such as security-services firms, to channel resources toward activities that add more value,
- creating a shared-services model with other regional banks to pool IT and staffing,
- forging strategic partnerships with proprietary or principal trading firms to maintain market share in high-frequency trading activities.
Compared to historical infrastructure, moreover, Acuity Knowledge Partners sees digital platforms impacting investment banks through leveraging knowledge of historical transactions, providing interactive scenarios that are used in client discussions, offering data visualization and developing new analyses. “Overall, this is building efficiency, providing deeper insights and analysis, automating standard tasks, and enabling bankers to focus their bandwidth on winning more deals,” Acuity recently stated.
Deloitte has identified four key factors that are critical for investment banks to deliver a successful digital transformation:
- Disciplined program management: Governance tactics to boost effectiveness, including identifying a chief product owner, establishing an advisory council, starting a design authority board composed of technical subject-matter experts and creating an innovation-sensing and rapid prototyping workstream;
- Clear business definition: A human-centred planning approach that builds on a foundation of deep user insight, clearly articulates user needs and defines a future experience that addresses broader opportunities;
- Effective technology delivery: Challenges to anticipate include managing visibility and entitlement access to deals and records, determining the appropriate integration toolset for the organisation, delivering comprehensive visualisations of all available data and managing the wealth of contact and relationship data;
- Readiness for ownership: This might involve conducting periodic risk assessments to identify gaps in awareness, using an idea-collaboration platform to source features and gauge audience sentiment, and understanding business outcomes valued by executive management.
Looking forward, it would seem that investment banking will continue to have sufficient barriers to entry in place to retain its market share over the long term, examples of which include high capital requirements, costly regulatory burdens, skills of the investment bankers themselves and long-term relationships that have been forged with clients, which in several cases have lasted several generations. That said, Deloitte stresses that those who are keen on capitalising on the future amidst shifting market dynamics should consider relinquishing expensive internal infrastructures and moving toward a connected flow model through which outside providers offer services for both critical and non-critical functions. “In this new environment, the investment bank’s ability to create and harness differential insights from data becomes its new competitive advantage.”
Ultimately, some degree of reinvention of age-old business models will be required for the space to survive and, indeed, thrive over the long term. This will involve adopting technologies such as artificial intelligence (AI), machine learning (ML) and natural language processing (NLP) to develop digital platforms that can ultimately impact bankers’ workflow, client coverage and data analyses. And although restructuring internal ecosystems to integrate digital technologies is likely to be a resource-intensive process, it seems increasingly apparent that it is of paramount importance for investment banking to maintain long-term competitiveness, maximise the customer experience and best utilise data for optimal decision-making.