KBW Talks Big Banks

In the latest All Things Financial KBW Podcast, Keefe, Bruyette & Woods analysts discuss changes going on in brokerage and investment banking. On the mega-bank side Deutsche Bank announced a restructuring plan to significantly shrink its investment bank, one of the largest in the globe and a division they had grown aggressively in the U.S. since their purchase of Bankers Trust in the 1990s. On the mid-size brokers side there was the Piper Jaffrey merge with Sandler O’Neill, Autonomous sold to Sanford Bernstein, and FIG Partners merged into Janney Montgomery Scott during the first half of this year.

On this week’s podcast, KBW’s Brian Gardner is the moderator with guests, Brian Kleinhanzl who covers the universal banks which include the largest U.S. investment banks and Mike Brown, who works with Brian on the universal banks and covers independent investment banks and broker dealers.

The following is an excerpt from the podcast.

GARDNER: Tell us about what is driving the shutdown of much of Deutsche’s investment banking operations and specifically what they are doing?

KLEINHANZL:  I’ll start with a little background for investors not following Deutsche Bank (DB) closely. Looking back to early July, Deutsche Bank announced its “radical transformation” restructuring plan to significantly downsize its investment bank and reduce costs by 2022. With the radical transformation, Deutsche Bank plans to exit the vast majority of the Equities Sales & Trading business and reduce the amount of capital used by the Fixed Income Sales & Trading business. Now, Deutsche isn’t get rid of the whole business and the company will maintain a focused equity capital markets business and it will retain an equity and macro research capacity with a targeted equity sales force. Also, specifically in the FICC – or fixed income, currencies and commodities — business, Deutsche announced that the bank will resize its Fixed Income business, in particular its Rates business, and will accelerate the wind-down of the non-strategic portfolio. I would say that, overall, DB is making some pretty large change as they are cutting over 18 thousand employees and roughly 6 billion euros from expenses in the three and half years.

GARDNER: Brian – what does this mean for the big U.S. banks? Did they talk about Deutsche and any new opportunities on their earnings conference calls this week?

KLEINHANZL: I guess to start, what we know thus far about beneficiaries is that Deutsche Bank has entered into a preliminary agreement with BNP Paribas (BNPQY) to move DB’s prime finance and electronic equities clients to BNP. We should point out that Bloomberg has reported that DB’s clients are already moving to other providers instead of BNP so it remains to be seen how much actually moves over to BNP. Now, as it relates to U.S. banks, the largest banks were generally quiet about the potential revenue gains from Deutsche Bank this quarter. JPMorgan did indicate that prime brokerage client balances reached an all-time high, but the company did not attribute this to Deutsche Bank market share gains explicitly. In early July, we attempted to size the benefit by allocating Deutsche Bank’s equity sales and trading revenue to each large investment bank based on market share and we found the potential EPS benefit to be modest. Basically, we found that if all DB’s equity trading revenues were allocated pro rata to the other large U.S. investment banks then EPS could increase roughly 1% for Goldman and Morgan Stanley as the most impacted. Again, some of DB’s revenues are likely moving to BNP so the ultimate impact could be pretty small for U.S. banks. To put the transformation in perspective, DB generated $2.3 billion of equities trading revenue in 2018 and that represented 4.6% of total revenues that the top 12 trading banks generated last year. At one point in time the revenues at DB were larger but they have decreased almost 40% in the last three years alone. The way we see it, DB’s retrenchment from Equities is a modest positive for the U.S. Universals as it means there is less competitors in the space, so market shares can potentially increase. As it relates to FICC restructuring, Deutsche’s moves should be more positive for the likes of JPMorgan and Citigroup, which are larger in flow trading businesses.

In the end, the way we are looking at is that less competition should be a positive for revenue and market share longer term. One way to look at it is that Deutsche Bank had the potential of becoming an irrational competitor in the market to boost revenues but that should not be the case going forward now.

GARDNER: What do you see driving the consolidation in the mid-cap space?

BROWN: The consolidation story really goes hand and hand with the continuation of the secular fee pressures facing the industry. Fee compression has made life for broker-dealers challenging which in turn has led to consolidation in the space. While angst related to MIFID II regulations has been getting a lot of air-time lately, fee pressure is not a new phenomenon and brokers have been grappling with fee pressures since the 70s. But it has accelerated in the past decade or so, driven by technology and changes to market structure. Then if you think about the regulatory environment, that has also created direct and indirect revenue pressures for the industry, through onerous capital and liquidity rules, as well Volcker. The direct impacts have been more outsized for the bank holding companies, but there has also been an indirect and meaningful impact on liquidity and client activity in markets broadly, further exacerbating revenue pressures at broker-dealers. So coming back to your question Brian, consolidation has been driven by 1.) the need to scale up to contend with a smaller wallet and heightened regulatory and tech costs, and 2. shift to areas more insulated from fee pressures such as investment banking.

On the first point, the equities side of the business has been grappling with this issue for decades but it has picked up steam with the roll out of MIFID II. Right now, firms are looking to improve best execution and research capabilities to competitively position in the evolving MIFID II world. Some are investing to do so while others have acquired. For potential targets, the ability to be a part of a larger firm is attractive due to the stability provided from a more diverse business mix, plus larger firms can provide benefits such as broader distribution, access to a balance sheet, and of course cost synergies.

On the second point, investment banking is one of the few areas across financial services that isn’t experiencing fee pressure, so what we have seen is a concerted effort to focus growth on investment banking and tangential businesses. And that’s driven M&A in the space as well.

GARDNER: Mike – our own sector, financial services, was part of the three deals I mentioned at the beginning. Is there something in our vertical driving consolidation in your view?

BROWN: So we’ve seen three transformative deals in the brokers space this year related to financials and many of the drivers I just mentioned underpinned those transactions but I think the desire to grow in financials, as well as fintech and payments, makes sense for a lot reasons.

Thinking about the Autonomous acquisition by Alliance Bernstein (AB), that was truly a play to broaden research coverage for financials globally, and the acquisition gave AB considerable depth and breadth in the FIG space. Financials represent nearly 17% of the S&P Global 1200. It is a big, broad and complex vertical with significant regulatory and accounting challenges so the ability to add value for clients is powerful. From Autonomous’ side, selling to AB provides access to broader distribution and of course stability. As I mentioned earlier that stability can be valuable to smaller, specialist shops with exposure to one sector, particularly one as cyclical as financials. Then for the Janney Montgomery’s acquisition of FIG and Piper Jaffrey’s acquisition of Sandler O’Neill in addition to the benefit on the S&T side the business, the advisory and capital raising opportunity in the financials space is very attractive. From an advisory perspective, the financials sector has been strong, Year to Date Announced volumes for financials are 8.5% higher than the same time last year and last year was up 8% year over year. In the bank space, high regulatory costs and the need to invest in digital capabilities continues to drive consolidation. Large-cap bank deals, which have been dormant since the crisis, have made a recent resurgence including the BB&T Corp. (BBT) /SunTrust (STI) Banks deal and the Chemical Financial and TCF Financial merger of equals, and we could see more deals of similar size as the large regional banks aim to bolster digital capabilities to compete with the Universal Banks. Then in the small and mid-cap space the need for consolidation remains compelling. We’ve seen a tremendous pick up in deal activity since 2016 and there are still nearly 5,200 banks in the U.S. On the fintech side, the merchant acquiring side has been very active this year, with the FISERV/First Data transaction, Fidelity National Information’s acquisition of WorldPay, and Global Payments and Total Systems Services. Overall, the opportunity set across financials remains robust, in our view.

GARDNER: Is there a further wave of consolidation coming and if it does what is driving it?

BROWN:  Our expectation is that we’ll continue to see consolidation in the space. Fee compression and the continued need to invest in tech are powerful trends that will continue to drive consolidation and reduce capacity in the broker space. In advisory for financials specifically, market share on the league tablebased on deal value really drops off after the bulge bracket firms and a few top specialist firms, so I see a clear opportunity for those in the 5-15 position to consolidate and become larger contenders in the financials space.

GARDNER: What is the strategy towards investment banking and trading/brokerage at the big banks? How much money can they make in the business?

KLEINHANZL: Well, they can make a lot of money in the business but the problem is the revenue pool has been shrinking for years. For example, we again look at the top 12 investment banks and these banks generated roughly $50 billion of revenues in the equity trading business last year and another $69 billion in FICC revenues.  That’s roughly $120 billion combined revenues just from trading alone. The challenge for the industry is the shrinking revenue pool that we mentioned. Between 2012 and 2018, FICC revenues declined 31% as volatility has been generally low but there is also secular pressure facing the industry. Equities revenues are up 18% over that time so less pressure but there is ongoing pressure in cash equities as the growth drivers for equity has been electronic trading, prime broker, and derivatives. Looking forward, if volatility picks up then perhaps revenues could accelerate more meaningfully but as it stands today we are looking for total trading revenues to be down -3% in 2019 for the large U.S. investment banks and then from there we only expect 1% growth in 2020. So when you think about the revenue pool opportunity I would say that Flat really is the new Up.

GARDNER: The premier investment bank in the U.S. seems to be moving into all kinds of things that aren’t traditional investment banking. Just what is Goldman Sachs (GS) up to and can they make money doing whatever it is that they are doing?

KLEINHANZL: Goldman is interesting and up to a lot of new things these days. Goldman is primarily expanding outside the investment banking and trading businesses and we would argue that the expansion points to ongoing pressure in traditional capital markets revenues over the long term, in our view.  Now, the most recent announcement was that they were partnering with Apple to offer a credit card for consumers. The Apple card should roll out more broadly this summer and Goldman is expecting more meaningful growth in 2020. Goldman is also building out a cash management or transaction banking platform and the company will use the new platform for its own cash management needs initially. Again, Goldman is diversifying away from the trading business although perhaps cash management has some dotted line synergy with trading but the synergy is likely small. Of course, all this investment is coming at a cost. On Goldman’s second-quarter earnings conference call, management noted that Marcus, Apple Card and the new Transaction Banking platform has resulted in pre-tax income declining $275 million thus far in 2019. That decline in income has equated to a roughly 60 basis points drag on ROE. The hope is that Goldman will see better growth in 2020 and beyond as a result of all the new ventures they are pursuing. We remain skeptical as these ventures are all new businesses to Goldman so we do not have high expectations for incremental revenue growth at this point in time.\