Written By: Susan Smithfield – International Director
Recovery in Europe is picking up. In the United States, the conditions seem to be also favorable for businesses with lower taxes, with low unemployment rates providing disposable income and driving demand. In China, gross domestic product (GDP) growth for 2018 is expected to be above 6 percentage points, despite regulatory restrictions on outbound foreign direct investments. The global economy as a whole is expecting a bright year. The International Monetary Fund (IMF), among other international organizations, has raised its forecast for global growth by 0.2 percent to 3.9 percent in 2018. The conditions seem to provide a rather stable—or at least less unstable than before—investment environment.
The main beneficiaries, of course, are investors, both professional and institutional. The shape of the industry suggests that investment banks stand to benefit the most, led by the biggest players, such as Goldman Sachs and Morgan Stanley. Investment banks, in general, could see an uptick in profitability and could capitalize on existing opportunities stemming from bigger global goods trade volumes, higher oil prices providing more purchasing power, and less uncertainty regarding global economic policies and geopolitical risks. At the end of last year, Moody’s changed the credit rating of global investment banks from stable to positive.
A few years earlier, investment banks were struggling with legacy structures that prevented them from achieving their full potential. Their traditional structures commanded high costs, mostly higher than their costs of capital, and they were no longer feasible for the post-crisis economic and financial landscape, although US banks performed better than their European peers.
Higher volatility could be the case in 2018.
The recent rating upgrade by Moody’s was based on historically low market volatility levels (the CBOE Volatility Index, VIX, being below 16 for most of 2017). Early in 2018, market volatility picked up as the majorUS and global indices declined. If the rest of 2018 witnesses further increase in volatility, this could provide investment banks with an even better investment environment, as higher volatility will stimulate capital flows to both equities and fixed-income securities.
Change in monetary policy
Whether the transition by global central banks from expansionary monetary policy to normal policy will be a smooth or rough ride is still not clear. A key risk remains in that global growth could be associated with unwanted levels of inflation, which may warrant remedies by central banks, prompting them to act more swiftly. However, it is likely that the move towards a normalized policy would be gradual, and shock therapies will be avoided. A normalized policy is generally positive for equities but has a slightly negative effect on bonds.
ICOs on the rise
Initially skeptical, investment banks are likely to give more attention to initial coin offerings (ICOs) as an alternative way of raising funds. ICOs were successful in raising $3.88 billion in 2017, and have raised $2.87 billion thus far in 2018 for tech companies. The main benefiting categories of companies funded by ICOs are communication companies, finance companies, and trading and investing companies, together receiving around 69 percent of the funding. The uptrend is likely to continue, but it requires fast response from investment banks to capture the opportunity, albeit regulations still have to catch up in that area.
Ease at the end of the regulatory cycle
Regulatory rollback after regulatory tightening following the crisis had an earlier head start in the US than it did in Europe, especially with US President Donald Trump’s policies. Regardless of the direction of regulations in the future, regulatory certainty seems to be positive for investment banks and capital markets overall. Some of the regulations introduced earlier in the US improved the resilience of the financial system, particularly those related to capital requirements, liquidity and intensive stress tests. Other requirements did not consider the differences in the asset structure of different financial institutions and were excessively demanding to the point that they weighed heavily on profitability. Despite this, those regulations might have protected those institutions from risks.
Approval of Basel IV
In December 2017, the Basel IV requirements were approved, and there was a general consensus that the financial system today can handle shocks much better than it did in the past. The regulations following the crisis have succeeded in making markets more efficient, fair and robust. They have fostered a climate of good governance and compliance. But this means only a decrease in regulatory momentum rather than a complete halt. In fact, the disruption in the banking industry and the advent of blockchain and digital currencies, as well as the move towards digitization, may pose further constraints on banks investing in those technologies.
Dropping the separation between commercial- and investment-banking operations.
One key regulation that was dropped eventually by the European Union (EU) was the separation of retail banking on one hand, and wholesale and investment banking on the other. The evidence for the effectiveness of such regulation points in both directions. Research papers on the topic suggested that the financial meltdown of 2008 did not occur because the two types of banking operation were merged together. Furthermore, this combination of commercial and investment banking did not particularly benefit the banks. However, one key conclusion was that the more internallydiversified banks are, the more they are similar, and the more they are prone to systemic risk. The upshot was that it would be commendable for the regulator to prevent financial institutions from becoming increasingly homogenous—which they tend to be in the long run. Financial institutions that are similar to one another have similar risk-tolerance levels and thus can collapse at the same time, posing a risk to the financial system as a whole.
In conclusion, dropping this regulation can add more stability to the operating environment of investment banks. This will encourage banks to operate in their specialized areas while having the structures of their choice, and choose their operating-model modes independently and with more agility.
Investment banks are likely to enjoy a positive year, notwithstanding the key hurdles that remain ahead. Fintech companies, powered by artificial intelligence and supported by governments, are likely to pose a threat to investment banks, although fintechs may drive those banks to become more adaptive and deliver better solutions to customers and investors alike. Additionally, capital markets in the EU still need to do better to catch up with their American counterparts, especially considering their lower share to GDP in Europe compared to the US, with Brexit and separation from sophisticated capital markets in the United Kingdombeing the main culprit. This may affect investment banks with narrower global reach and operations. Yet, in general, with better revenue expected in the next 12 months, investment banks may have the resources needed to offset those challenges.