This article originally appeared
in the June 2009 issue of
The journal of
Special Report: Dealing with the Downturn
Can a new business model
save investment banking?
By Robert P. Gach and James R. Sproule
Transparency, liquidity and increased oversight will be prominent
features of the new capital markets landscape. The key to growth
in this industry: customer-focused financial-product innovation that
helps clients identify and manage risk.
The axiom is as simple as it is sobering: The current global economic
downturn began with the sudden widening of credit spreads in August
2007, which precipitated a crisis that soon engulfed financial markets
around the world. Until strength and stability return to those markets,
there can be no sustained recovery.
The damage to the banking system has been staggering. As of the beginning
of March 2009, banks worldwide had announced losses of $840 billion. Total
damages could run as high as $1.4 trillion.
Capital markets and investment banking play a key role in the global
financial system and the overall economy. They are an important source
of the financing critical to the health of the economy, as well as the
ultimate arbiters of where value is being created. This article focuses
on that sector by exploring the five areas where the future shape of the
capital markets will be determined.
Revenues are being hit by the flight from complexity and a slowing
economy. But new products will emerge that deliver transparency and
reduce risk or offer the possibility of significant outperformance.
No amount of cost cutting or margin research has calculated that sales and
enhancement can compensate for trading accounted for 75 percent of
steeply falling revenues in this sector. investment banking revenues during
Yet robust revenues are essential to the recent boom years. At the same
everything from innovation to the time, traditional corporate advisory
extraordinary returns that financial work fell to 20 percent of revenues
services have been able to generate (although advisory revenues rose to
over past decades. 40 percent of total revenues in 2008,
in light of losses in the credit markets).
At least in the longer term, Accenture
remains optimistic. We believe Before the credit crunch, the finan-
that the demand for traditional cial markets may well have reached
financial products such as equities a high point in terms of both margin
and bonds will continue its historic and volume. But for management, this
trend of running up to 3 percent may not prove to be as controversial
ahead of the supply. This demand a notion as might be imagined.
is driven by both global demograph-
ics and the clear need to save for As investment banks are absorbed
retirement. Savings in 2008 alone into larger, traditionally more
totaled $5.8 trillion globally, and conservative retail banking opera-
the trend will continue to support tions, their ultimate parent orga-
revenue growth as well as the nizations may be less willing to
creation of a host of new financial take on risk or pay out commensu-
products and services. rate reward. In fact, some banks’
managements may prefer lower
Given their size, maintaining sales but possibly more stable earnings.
and trading revenues is crucial For an industry accustomed to
for investment banks’ overall rapid change and high profits, this
Number 2 performance. Indeed, Accenture would be a radical shift indeed.
Scope for recovery to an eventual rebound. Where
Does this mean that a chastened a financial product’s underlying
industry will abandon the complex, principle or added value is less
high-margin products—entire new apparent—as is the case in a num-
classes of securitized and monetized ber of complex and illiquid over-
assets—that fueled the money-spin- the-counter instruments, such as
ning trading operations before the credit default swaps—demand and,
credit crisis? hence, revenues have fallen and
will not soon recover.
In analyzing what caused the
house of complex financial products Successful, profitable financial
to collapse, two factors stand out: products will be those that address
The potential for illiquidity should liquidity concerns, have transpar-
have been more carefully consid- ent ultimate liability and still offer
ered; and calculating liabilities an attractive risk-to-return ratio.
for products was nearly impossible These are most likely to be based
when those products had to move on cross-product complexity, the
through multiple iterations to linking together of highly liquid
ultimately determine a valuation. financial instruments.
Some banks’ manage- But Accenture believes that The high degree of liquidity would
labeling all complex products as mean that each piece could be
ments may prefer “excessively risky” is too sweeping priced separately. At the same time,
lower but possibly a judgment. Although there have
been clear failures across a wide
these products would tie the pieces
together in such a way that they
more stable earnings. range of new financial instruments, would offer investors attractive
there is scope for recovery; it all returns for risks undertaken. What
depends on the product in question. margins these products will com-
mand remains to be seen. But if
For products like collateralized complexity is to be profitable again,
debt obligations, the principle of it must be more transparent, more
diversification remains sound and liquid and utilize a wide range of
relevant, and this alone points financial products.
2. Risk and liquidity
Risk parameters have expanded to include liquidity. Efforts to increase
liquidity and transparency will mean more on-exchange trading as well
as new capital structures. At the same time, changes in accounting rules
could promote the development of new structures that are capable of
accepting illiquidity risks.
Although liquidity has always slid into recession has led to a
been vital to financial markets, collapse in liquidity.
the lack of it was seldom seen as
a financial risk by investors and This collapse has already had
bankers—until the credit crisis. a significant impact on bank
A combination of banks losing balance sheets and will have a
faith in counterparties that were similar impact on future bank
assumed to be financially sound revenues and profits. Exact per-
and a more general uncertainty centages naturally vary, but with
Number 2 about future losses as the economy some investment banks generating
The Great Collapse
Investment banking revenues rose significantly from the first quarter of 2005 through the second quarter of 2007,
driven in particular by higher debt trading revenues. These revenues stalled in the third quarter of 2007 and then
plummeted in the fourth quarter of 2007 as trading losses were accumulated and declared in year-end accounts.
Investment banking revenues, 2005–2008, $ millions
Debt capital markets
Equity capital markets
1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q
2005 2006 2007 2008
Source: Accenture research
up to 50 percent of trading revenue markets firms may simply become
from proprietary positions, it is less willing to accept risk than they
clear that illiquidity can quickly were in the past.
impair assets necessarily held on
a balance sheet as a natural part Transferring risk
of business operations. Where risks are known, informed
judgments can be made about the
As a result, some more conserva- wisdom of particular investments.
tive retail bank managements and The greatest danger comes, of
shareholders, even regulators, may course, where risks are unknown.
seek to scale back investment bank- Therefore, assuming that risks
ing operations that take significant can be identified and assessed, an
proprietary positions. Clearly, there equally likely approach for other
is a need for better reporting and firms will be to transfer risk to new
pricing transparency, as well as kinds of entities or to standalone
for risk assessment and liquidity divisions within more traditional
Number 2 support. Ultimately, some capital existing institutions.
It is notable that funds simply write These moves will be further enhanced
down the value of their investments by the exchanges themselves, which
rather than recapitalize their balance will encourage liquidity providers to
sheets. In a world where illiquidity enter the market.
risks are evaluated and these evalu-
ations become an integral part of Once something approaching
the calculations aimed at delivering normalcy returns to the markets,
outperformance, it may well be that so too will the desire for outper-
fund-like structures become the formance. When this happens,
most appropriate home for potentially banks are likely to move away from
illiquid financial products. structures where illiquidity and
attendant capital requirements are
Concerns over liquidity are also an issue, and create new corporate
going to have an impact on the once structures better able to cope with
high-margin business of complex, significant market fluctuations.
custom-made derivatives. Banks are
going to be increasingly unwilling In accommodating new illiquidity
to create illiquid over-the-counter risks, banks and funds will be able to
financial products in light of investor take advantage of new opportunities
reluctance to buy such products. This and a new route to outperformance.
does not necessarily mean complex But the need for better transpar-
derivatives will disappear, but their ency and reporting will be absolute.
use will increasingly shift to financial The premium on illiquid products is
institutions that can better accom- certainly likely to rise, giving higher
modate illiquidity risk. potential returns to investors who are
less constrained by immediate capital
For financial markets, the need for de- requirements. Hedge funds could be
monstrable transparency and liquidity one of the principal investors to take
is likely to lead to greater standardiza- on this risk as they look to maintain
tion and, thus, on-exchange trading. returns in a world of lower leverage.
3. Capital requirements
The rising cost of capital is likely to hit financial institutions’ returns,
and lending dependent on a deposit base is not going to be sufficient to
fund long-term growth.
While arguments will certainly con- to market” products held on their
tinue about the origins of the credit trading books, resulting in valua-
crisis, there is no doubt about its tions significantly lower than those
chief impact on the banking sector: implied by discounted future cash
Substantial write-downs of assets flow models. This undervaluation
have left banks around the world in has amplified pressures on banks’
need of significant recapitalization. capital reserves and has led to
calls to recognize only realized
Part of the debate over bank solvency losses and gains.
has focused on the application of
fair-value accounting to complex Proposed reforms include shifting
financial instruments, something a portion of trading-book assets to
that becomes particularly compli- the banks’ own accounts, essentially
cated in illiquid markets. Prevailing reverting to cost accounting and using
Number 2 rules have forced banks to “mark the acquisition price and discounted
A wealth of ideas
Banks and hedge funds drove the development and trading of innovative financial products
over the past decade with the total value traded rising to $1.4 trillion in 2008.
Growth of financial products, $ billions
Foreign exchange (OTC)
Credit default swaps (OTC)
Equity derivatives (OTC)
June 04 Jan 05 June 05 Jan 06 June 06 Jan 07 June 07 Jan 08
Source: BIS; Accenture research
future cash flows to determine an in- cost of debt means leverage levels
strument’s value. Although this would will fall, and banks will find it
ease solvency pressure, it would also difficult to maintain their historic
mean less transparency for investors. return on assets. A reduction in
leverage from 95 percent of capital
There is no clear and simple solution to 66 percent, for example, could
to this problem. But whatever the reduce average ROE from approxi-
final outcome, capital adequacy mately 15 percent to 10 percent.
will in all likelihood be the driving
force in determining how firms and Although there may be little risk
funds accommodate risks. of regulators stipulating leverage
levels, more cautious integrated-
Revisiting leverage bank shareholders will undoubtedly
Banks traditionally have had three demand a curtailing of the appetite
principal sources of capital. for the sort of high-risk business
models traditionally favored by
In the past, equity played a relatively investment banks. Where govern-
minor role on banks’ overall balance ments have become shareholders,
sheets—although this may well be the appetite for risk is likely to be
changing with the injection of sub- even lower.
stantial government capital.
Retail deposits have once again
While banks will undoubtedly become a key source of funding,
Number 2 continue to use leverage, the higher especially as a number of commercial
banks absorb formerly independent For the moment, banks rightly
investment banking operations remain focused on working through
and as former investment banks their current losses and assessing
refashion themselves as bank hold- the length and depth of the global
ing companies. recession. In the medium term, how-
ever, banks will be unable to raise
Once established, a retail de- sufficient capital to accommodate
posit base is a relatively low-cost future economic expansion unless
source of financing and tends to they utilize the capital markets.
be reasonably static. However,
accumulating deposits is a slow Banks, therefore, face two challenges.
and expensive process, and the They need to reassure potential
most obvious way to attract more investors that in the future, they
deposits—paying higher rates of will not face the same risks that
interest—increases banks’ cost led to the present crisis. And they
of funding. In the medium term, must find ways, without resorting to
growing an industry on a stable excessive leverage, to give investors
(even stagnant) depositor base is an attractive return for the risks
going to prove difficult. they are undertaking.
There will continue to be a premium on financial-product innovation. But
innovation will shift increasingly to the buy side. High fees will be dependent
on demonstrable performance.
During the past decade, there higher costs of doing their own
has been a notable shift in power research, a reduction in the number
in the financial markets to the of brokers they could work with
buy side, the end-consumer of and significant competition from
most financial products. With this low-cost index funds.
shift, sell-side investment banks
no longer provide free research, The capital markets will nonetheless
control access to corporate clients, continue to see rapid innovation.
determine what financial products But precisely where innovation will
will be made available or, in many occur—and what sort of risks and
cases, even provide liquidity. This rewards will be involved—shall be
gradual change in the balance of subject to a good deal of change in
power across financial markets has the future.
been accompanied by an equally
important shift in the source of What is certain is that product
innovation. innovation will be more focused
on customer needs, such as liquid-
Much of the recent innovation in ity and transparency, than it
financial markets has been driven has in the recent past. This cus-
by hedge funds. This does not tomer-focused innovation will
mean, however, that fund manag- ultimately include process inno-
ers are not feeling a good deal of vation and other ways to help
pressure. Not only have their port- clients better understand and as-
folios been decimated; even before sess risk, including risk associated
the crisis, they were grappling with products that have already
Number 2 with a number of challenges—the been developed.
Adding value highly evolved version of precisely
The search for returns will force the same thing.
high-cost active fund managers,
particularly at hedge funds, to Innovation may well require flexible
look where few others have gone capital structures. For products with
before. This will drive managers an inherently high risk, it may well
to increase their funds’ presence be that corporate entities that can
in areas such as less liquid, small accommodate illiquidity are more
company stocks and to continue appropriate. These entities could be
their expansion into private eq- captives of larger integrated banks
uity. Fees will become more closely or completely independent.
tied to performance, which will
reinforce the need for innova- As long as uncertainty grips the
tion. Firms that can build on this markets, large amounts of money will
innovation—by adding value or remain in cash or cash-equivalent
allowing value to be effectively instruments. Once this money reenters
added by others—are going to be the market, there will be more than
the industry’s high performers of enough of it chasing top fund manag-
the future. ers for them to maintain generous
As for the growing sentiment that
hedge funds are something of an The rewards are potentially
endangered species, this is certainly substantial. But more than ever
a possibility. But if they do disappear, before, they will fall to those who
they will be replaced by actively can deliver innovative instruments
managed, leveraged funds with broad that offer a reasonable balance of
mandates—in other words, a more risk and reward.
Effective regulation will need to take a global, coordinated, flexible and
holistic view of risk across all instruments and segments of the market.
The crisis in the financial markets ing concerns over moral hazard and
has exposed two conflicting truths: a culture of excessive risk taking;
Any regulatory scheme that does an increasingly interrelated and
not seek to harmonize rules on an complex global financial system;
international scale is likely to be and the lack of consistency across
ineffective. But only a national markets.
government is going to have suf-
ficient money and political clout Clearly, reaching broadly based
to effectively underwrite a system agreement on what such a system
in trouble. will look like and how it will func-
tion is going to be a slow and dif-
What is needed today is a coordinat- ficult process.
ed and structured global regulatory
framework that actively identifies Emphasis on oversight
and manages shocks throughout the Regulatory regimes will continue
financial system. Moreover, any to foster competition and support
such global approach must strive a technologically enabled market
to resolve a number of difficult and, infrastructure. But there will be
Number 2 at times, conflicting issues—includ- a new emphasis on repairing gaps
The global liquidity index, which is based on nine different measures of liquidity that are then
aggregated by the Bank of England, shows the total collapse of liquidity in the global financial
system beginning with a severe contraction starting in August 2007.
Global liquidity index
Standard deviation from the mean
92 92 93 93 94 94 95 95 96 96 97 97 98 98 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08
Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June Jan June
Source: Bank of England
in oversight. There has long been We believe regulators need to
an appreciation that international address five issues.
regulation is both necessary and
should have some sort of risk • Accounting rules. Fair-value,
assessment at its heart. What is historic-value and mark-to-
now also being appreciated is that model systems all have advan-
regulation cannot separate financ- tages. Looking at where each
ing into various constituent parts. system might be best employed
and by whom has to be a press-
The Basel II accords basically ing priority as banks rebuild
addressed commercial bank capital their businesses. Strict guid-
adequacy with little consideration ance as to when each set of rules
for what was going on in the wider should be employed may be
debt capital market. While the necessary, but a greater degree
system is an improvement on of flexibility certainly looks to
what preceded it, Basel II has put be desirable.
rating agencies at the core of its
risk assessments. Risk weighting • Capital adequacy. Rules for
is undoubtedly to be welcomed, many complex financial instru-
but there are serious questions ments need to be reviewed.
about the ratings themselves as Transparency must be central to
well as about whether the agencies any solution, which obviously
were appropriately responsive to places a premium on the under-
Number 2 the credit crisis as it developed. standing of such instruments.
• Emerging markets. Countries such • Regulatory scope. Principles-based
as India and China are already regulation will continue. However,
major players in the global capital regulators are going to take a
markets. If these countries are to much broader, more dynamic and
be financed rapidly, with minimum interactive view of their role.
risk to investors and at minimum
cost to local companies, new capital • Transparency and liquidity.
adequacy regimes will need to be Both must be improved, although
created to draw them into new how this will be achieved in full
international agreements. remains to be seen.
Looking to the future
Deriving a definitive forecast from lending and terms of lending.
The real winners will these trends is not our intention. Historically, allowing political
Rather, it is crucial to understand that priorities to direct bank lending
be those who have each of the five factors listed above has seldom been successful. For
will be important—no matter which the moment, there remains broad
been brave enough scenario we consider most likely. agreement that even where a gov-
to use this downturn ernment has invested considerable
Two important variables will deter- sums of taxpayer money, banks
to acquire new market mine the shape of financial markets should be run at arm’s length from
share at steeply in the immediate future: how the politicians. However, this general
economy recovers and how those agreement has not entirely muted
discounted prices. markets are regulated. These two calls for using the financial
factors are obviously intertwined. system for largely political ends.
Overzealous financial regulation
could hinder an economic recovery, The danger is that as recession
for example, just as a quick econom- progresses, political priorities
ic recovery could cool the current overcome the best of government
enthusiasm for tougher regulation. intentions to refrain from unduly
influencing banking operations.
Looking ahead, Accenture envi-
sions three plausible scenarios for • Businesses or activities deemed
capital markets, each with its own “too risky” by regulators are
challenges. either discouraged or disallowed.
By stipulating what sorts of prod-
1. Deep regulatory engagement ucts are allowed, or by closely
Governments around the world circumscribing products, regula-
have invested unprecedented sums tors will discourage the kind of
of taxpayer money in their banks, financial innovation and product
just when recession is biting deeply creation that sustained margins
into the global economy. In the first and, at least in part, returns over
scenario, in an attempt to protect the past decade. Yields would fall
these investments as well as to shield in the broader financial markets as
electorates from the worst ravages of demand drives up prices, and any
the economic downturn, governments, economic recovery would be slowed
through their regulators, take a highly by a lack of dynamic capital.
active role in banking operations.
• Regulators seek to influence,
Under this scenario: if not set, executive compensa-
tion. The question of whether pre-
• Regulators determine, or help vailing executive compensation
Number 2 to guide, broad levels of bank schemes in the capital markets
Leverage ratios at banks rose over the past decade and then began to spike in late 2007 as share prices fell. The five banks
that had the highest leverage ratios since 2000 peaked at a ratio of 2,300 percent total debt-to-market capitalization.
Selected banks’ leverage ratios
Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009
Source: Bloomberg; Accenture research
encourage disproportionate risk services. Wide-ranging regulation
is a matter of considerable debate. would largely be dictated to the in-
For the moment, in those cases dustry, which could become a seri-
where no public money has been ous burden. For example, regulatory
sought for a bailout, there is little compliance costs could rise consid-
regulators are proposing to do. erably. As a consequence, competi-
tion would be reduced across capital
But where there has been a markets as entrepreneurial firms
government injection of public would be discouraged from entering
funds, there will undoubtedly be markets due to high initial costs
some danger of the regulation of and lower potential returns.
executive compensation. This may
lead to a flight of talent to lightly 2. Ragged recovery
regulated funds, where far higher This scenario, which we consider
compensation (for taking far the most likely, foresees a normal
higher risk) can be earned away recovery in due course. A ragged
from the glare of public oversight. recovery is, in many ways, proof
Whatever the outcome, executive that life is fair. Those financial
compensation will remain a highly institutions that were most exces-
incendiary political issue as long as sive in their risk taking in the past
taxpayer money is involved. would be punished. The survivors
would be those that had been con-
• Regulatory compliance becomes servative in their lending, effective
a major expense and an effective in their risk management, or large
Number 2 barrier to entry into financial enough to withstand losses.
However, the real winners would ing basis. The cost of regulation
be those who have been brave under this arrangement would rise
enough to use this downturn and may, in the process, curtail new
to acquire new market share at entrants into the market. But this
steeply discounted prices. will have only a marginal effect on
A renewed emphasis on transpar-
ency and liquidity is a certainty 3. Rapid recovery
and will be a feature of all three Unlikely as this now might seem,
scenarios. But in a ragged recovery, the potential for the global econo-
once the financial markets begin to my to recover more rapidly than is
recover, so too will the desire for being forecast must be considered.
Innovation is likely to outperformance. For banks that have For the capital markets, the most
had difficulty coping with illiquid important feature of this scenario
shift to products that financial products on their balance would be a rapid return of those
transparently meet sheets, the solution is not to aban- underlying factors that drove the
don innovation but to move product business during the past few years:
a specific need and innovation and complexity to new demand for financial products and
organizational structures that can the push into emerging markets.
to emerging-markets cope with the changing marketplace.
financial products Considerable amounts of investor
The potential for financial product capital have been withdrawn from
where sustained innovation is no more likely to fade markets over the course of 2007 and
outperformance is than human ingenuity. In a ragged 2008. In a rapid recovery, this money
recovery, complex and potentially would quickly reenter markets. This
realistically possible. illiquid products are going to be would not only automatically repair
manufactured, sold and held by enti- many balance sheets and boost pen-
ties that can cope with illiquidity. sion funds, it would also provide
Furthermore, innovation is likely to capital for a renewed expansion.
shift from complex products to prod-
ucts that transparently meet a specific While there would be a new
need and emerging-markets financial regulatory regime, the expanding
products where sustained outperfor- recovery would reduce the political
mance is realistically possible. pressure to use intrusive or draco-
nian measures to punish bankers.
As for regulation, under this scenario: Under this scenario:
• Regulators take a supervisory • Regulators take a supervisory and
and directing role only in those directing role only in those banks
firms they have rescued. they have rescued.
• New dynamic risk measures are • New dynamic risk measures are
utilized by both investors and utilized by both investors and
• It is accepted that mistakes have • Pressure for new regulations is
been made by both firms and lessened and international agree-
regulators, and that the concerned ment becomes more difficult.
parties work together on the next
generation of regulation. None of our scenarios foresees
product complexity as it existed
Regulation would seek to be prin- pre-crisis. However, a rapid recovery
ciples-based and flexible enough to would quickly create demand for
respond to changing circumstances new products. This would lead
within the wider market. This will to both a complexity of products
push regulators and the regulated drawn from across silos and a
Number 2 to work cooperatively on an ongo-