Investment Banking Business Model

2. Recent times are witness to the turbulence in securities and capital markets arena with investment banks
facing viability issues as never before. The new operating environment is characterized by liquidity and
regulatory change requiring increasing capital requirements resulting in higher costs, lower revenues and
even lower returns. This is further compounded by market conditions fuelled by the economic interest rate
environment. A new strategy is required based on the operating market of each financial institution in
view of the interest rate environment and the customer base, and design new products to meet the need.
The new operating environment requires a fresh look at profit and volume levels to sustain viability, the
legacy of the past is for historic reference.
The market risk framework requires significantly more capital, almost double from current levels, for risk
weighted assets due to stressed value-at-risk for all products, plus incremental risk charge for non-
securitized products, plus comprehensive-risk-measure for credit/rates products and for proprietary
trading, plus counterparty-credit-risk charge driven by credit value adjustment charge for OTC and non-
cleared trades, lower margin for cleared deals and leverage. This coupled with increasing liquidity
coverage requirements and lack of sufficient liquidity in the markets magnifies the issue. The impact on
certain businesses is likely to be:

3. Flow rates is significantly affected by market risk and counterparty credit risk with an estimate of about
two-third to three-quarter of OTC derivatives moving to central counterparty clearing houses. Structured
rates is affected by the credit value adjustment charge and market risk rules. Flow credit business based
on standardized products (eg. exchange traded, iTrax, CDX, etc.) with short maturities severely affected
by new market risk rules. Structured credit impacted by stressed value at risk charge, incremental risk
charge, securitization risk charge, and correlation trading requirements. Re-securitization, collateralized
debt obligations and credit default swap businesses will see severe decline in volume due to higher capital
requirements. Proprietary trading is severely impacted by market risk requirements. Equity derivatives is
affected by credit value adjustment charge, while flow equity derivatives can offset the counterparty credit
risk charge by moving to central clearing. Prime Services continues to be stable as it is not significantly
impacted by market/counterparty risk charge, but is impacted by capital and leverage ratios. Significant
increased cost of funding and liquidity due to regulation is a contributory factor in profitability, as a result
universal banks will see a substantial decline in profitability level as well.
The above structural shift requires a change in the business model.
Managing the new demands in the operating environment is key to redesigning the business model. Astute
market segmentation to identify niche areas and design products to suit the need will prove very profitable
in retaining customers and market position.
A critical component in the operating environment is economic interest rate. Managing in a high, low or
negative interest rate environment requires distinct strategies. Global banks will require a separate strategy
for each environment in which they operate, thus making standardization difficult and requiring a separate
view of returns/margins in each different environment even with the same business line.

4. While all eyes are focussed on revenue management, loss management is a key component often ignored
– at what point to recognise a loss and time period to address/realize the loss, as it impacts profits and
capital levels significantly.
It may be prudent to exit businesses where market position is weak, illiquidity is high in portfolios,
regulatory cost distorts returns, and volatility is not compensated by margins. Staff skills and technology
capability is critical to operational viability.
This also necessitates efficient and active risk management, the risk function as a result must be positioned
upfront together with business to capitalize on opportunities and facilitate controls. This factor alone
brings about a culture change to investment banking.
Leveraging the legal structure of the global banks to align to local regulators and jurisdictions to take
advantage of marginally lower tax and capital requirement for deal making and booking can be very
beneficial.
Re-engineering front to back infrastructure for productivity improvements, increased agility, reduced
errors and low touch trade management will help lower operational cost.
Integrating the investment bank business model with other business areas such as commercial and
corporate banking, wealth and asset management to exploit capabilities and cross sell will generate
revenues and lower costs.

5. The above measures will enable a more viable and sustainable investment banking business model.