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Mastering value migration in banking (BCG)

The Boston Consulting Group returns with the sixth instalment of its annual report series  on the global capital markets industry. In this report, the authors deliberate on the inevitable merging of tech and finance, broader market narratives, key market developments, trends and strategies.

A new report by Boston Consulting Group, entitled “Mastering the Value Migration,” examines the regulatory and technological changes within the financial industry that have continued to accelerate seismic revenue shifts from traditional to non-traditional banks. In addition to providing an incisive exposition on the blurring of lines between financial and tech firms, it also explores how firms can leverage on the increasing digitalization of the global capital market and ends by investigating the operational repercussions of failing to adapt.

What is the value migration?

Although the rate of decline in investment banking (IB) revenues has slowed down, it reflects the effects of prevailing trends that continue to shift global revenue pools from traditional banks to non-banks. Within the context of this report, this shift is referred to as the “value migration.”

The value migration is manifested in shifts of global revenue from:

  • Smaller IBs to large, universal banks
  • Generalist banks to boutique banks
  • Regulated to unregulated markets
  • Non-tech to tech capabilities
  • Players without data advantage to those who do

While the effects of value migration may be hindered by impending deregulation and the phasing out of quantitative easing, the trend in itself is unlikely to stop as there are a few key forces endogenous to the industry  that will continue to push and shape the evolution of the market. These key forces are:

Evolving regulatory dynamics

Looming regulatory updates in the US and Europe are set to manifest as roadblocks which favour non-bank competitors over conventional financial institutions. Stakeholders in Europe still have not come to a conclusive agreement on the introduction of capital floors to Basel III (now Basel IV); of which if passed, imposes lower capital requirements stemming from internal models. EU banks are particularly concerned with the impact it will have on project structured and finance profitability at a time where increased global infrastructure is much needed. In contrast, the European Central Bank (ECB) is moving forward with targeted reviews of internal models that may lead to a spike in capital requirements instead. The report observes that US banks have continued to outperform their European counterparts in coping with regulatory uncertainties.

The intertwining of value creation and technology

The systemic promotion of ‘lit’ markets (defined as the wide dissemination of reported pre-trade and post trade pricing via technology and the internet) is expected to continue in the US and EU, accelerating the value migration from supermarket-style banks and regional bank players. This also feeds into the rise in principal trading firms across electronically traded assets.

The increasing digitalization of capital markets has caused the very fabric of the ideal capital market workforce to resemble that of tech companies. As it stands, 30% of capital market workers have overlapping skill sets with typical tech workers, especially in specialties that deal with data analytics, emerging tech trends (blockchain) and software development.

The report’s longitudinal TSR (total shareholder return) analysis concludes that information providers have in fact, provided more value to the investor than investment banks over the past 5 years. Upon further evaluation, the report outlines the types of firms who are on top of their game:

  1. Firms that lead the market in their respective business segments by leveraging on scale;
  2. Niche-focused firms (if they cannot exploit scale) that develop superior, focused solutions;
  3. Institutions with fewer capital constraints (boutique IBs and non banks have less regulatory burden compared to traditional banks);
  4. Firms that demonstrate commitment to deploying technology and digital innovation (big data and analytics, in particular), or are diversifying into the segment if they have not already done so.

The report contends that these two compounding key forces culminate in the push for digital transformation, and stresses that banks (especially IBs) which fail to digitally innovate in all aspects are unlikely to survive in the rapidly changing ecosystem.

Revenue performance

The report’s longitudinal analysis also provides several insights on the current and future directions of revenue growth within the context of an increasingly digitalized global capital market.

Annual revenue

FICCs (fixed income, currencies and commodities) are the standout performers for 2016; having benefitted from the higher volatility as a direct result of Brexit. Even so, the return on equity of FICCs remains low due to the high cost of capital. In response IBs have taken calculated steps to reducing operational cost — although the report notes that resultant cost savings have been cancelled out by litigation and regulatory fines.

Future revenue growth

Exchanges ( broadly defined as revenue streams from listings, exchange and revenue execution, market data, clearing and post trade services) are projected to have the highest CAGR in the next 4 years. The revenue growth of information providers comes at a close second (7%).  On the other end of the spectrum, the CAGR of IBs is likely to stagnate at 2%.

While banking revenue has visibly slipped, players in other ecosystems have prospered. An increase in new venues has led to a mirrored spike in competition for trading revenue. This has forced firms to diversify into non trading revenue streams; most ostensibly, in data and tech. In 2016, revenue from indices, benchmarking, market data and feeds experienced an organic growth of 6%. Revenue from software analytics in particular went up by an identical 6% to USD 10 billion as a result of an uptick in passive investing.

Institutional reinvention in the face of change

Extrapolating on the results of the analysis, the authors conclude that firms which embrace the intertwining of capital markets with data and tech are most likely to success in maximizing total shareholder return in the long run. The report highlights several strategies that institutions can use to better adapt:

  1. Information providers should move towards providing software and analytics services. Large information providers should also consider diversifying distribution channels beyond the desktop model and further catering to the needs of passive investors by expanding on proprietary indices and benchmark offerings.
  2. Exchange and venues should aim at providing full-service platforms. Major exchanges and clearing bases should also target the high-margin, high-growth segment by placing less emphasis on cash and identifying novel sources of info.
  3. Instead of limiting internal data usage to trading, banks can use internal data to providing smarter CRM. Internal data can also be monetized for external market participants (for i.e, Risk Metrics, a spin-off from JP Morgan Labs). Regional IBs, boutiques and dealers should refrain from having a generalist approach and focus on core strengths and niches in order to produce superior, differentiated offerings.

On a more systemic level, the authors recommend that firms should develop a clear, articulated approach to data information, of which should encompass revenue growth sources and ways to capitalize on them. Without formulating a digitally oriented operating model, it is unlikely that an institution can adapt as quickly as it wants to. This means:

  1. Prioritizing digital transformation on the upper echelons of the corporate hierarchy
  2. Complementing a digitally aligned leadership with digitally talented workforce
  3. Emulating tech and non bank firms in seamlessly integrating tech and IT functions
  4. Diversifying in the data and software space through M&A and consolidation, as the data and software industry is highly fragmented
  5. Taking a proactive approach to regulating change, which means actively participating in the narrative and taking a seat at the table — doing so allows for preemptive action.

On a conclusory note, the report agrees that the road to digital transformation will be tumultuous, but navigated skillfully will result in leaner and more adaptive organizations that are better equipped in seizing opportunities provided by continued market change and upheaval.

The full report can be accessed here.

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