Page 1 of 3

WHEN JPMORGAN CHASE & CO. CEO JAMIE DIMON admitted to at least $2 billion in losses on a complex derivatives trade in the second quarter of this year, he may well have signaled the end of an era for big global banks. Until then it was clear why investors paid up for such institutions: Banks with a big capital markets franchise made oodles of money, especially for fixed income, commodities and currencies — the so-called FICC business, as the industry categorizes its trading operations. The capital markets business represented nearly two thirds of the revenues at the top 13 global banks as recently as 2010, according to research by consulting firm McKinsey & Co.

But this rosy picture is about to change dramatically as a result of slumping demand and a slew of new rules and regulations for leading global banks. Demands for higher capital; new definitions of what constitutes risk-weighted assets, against which they must reserve capital; and now, thanks to JPMorgan’s losses, heightened demands for restrictions on virtually any proprietary trading or risky hedging, will impact the FICC business at most banks, hurting their profits and forcing them to rethink their strategies. Some business lines are likely to be closed or sold off.

“There will be major changes at the big banks,” says Roy Smith, a longtime partner at Goldman, Sachs & Co. who now teaches finance at New York University’s Leonard N. Stern School of Business. “I suspect all of these businesses will have to be regeared. You may have three or four of the top ten investment banks veering off into significantly different business or so de-emphasizing fixed income that they will leave a lot of ground to be picked up by others.”

These changes are already forcing sweeping reductions in staff and substantial cuts in the traditional year-end bonuses that fixed-income traders have long taken as a birthright. Could the age of the fixed-income master of the universe, as characterized by Michael Lewis in Liar’s Poker and Tom Wolfe in The Bonfire of the Vanities, be coming to a close?

JPMorgan is already paying a heavy price for its derivatives loss, which Dimon confessed “violates our own principles” on acceptable risk-taking. The CEO canceled a planned $15 billion share buyback in the wake of the trading loss, causing the bank’s share price to plummet and leading analysts to wonder whether JPMorgan is still worth a premium. But because the losses occurred in the chief investment office, which attempts to mitigate risk by investing excess deposits, rather than in the investment bank, some analysts believe that when the smoke clears, JPMorgan will remain among a select group of bulge-bracket investment banks that controls even more of the pie in FICC trading.

Christopher Wheeler, banking analyst at Mediobanca Securities in London, predicts that the three banks with the deepest pockets — Barclays, Deutsche Bank and JPMorgan — will end up capturing greater market share. “They are the ones who are not having to force themselves into looking at getting out of any of these businesses,” Wheeler says. “JPMorgan is too tough a cookie and too well regarded to suffer much.”

Others aren’t so sure, simply because the regulatory landscape may change more radically than anticipated. “There will be some things, fair or not, that the banks won’t be able to do as freely as they were before,” says NYU’s Smith. “Most of the systemic risk in the world is concentrated in 20 banks.”

The new capital requirements not only make it more expensive for the investment banks to carry out their traditional FICC business, they open the market to new players that will provide potentially stiff competition. Smaller banks like Jefferies Group, which are not considered systemically important, will face lower capital requirements and thus be able to compete with lower prices. In addition, asset manager BlackRock, which has huge liquid assets, announced in April that it was starting a bond-trading platform called Aladdin Trading Network that allows institutional investors to bypass traditional market makers. Aladdin “would be particularly detrimental to firms that derive a significant proportion of total revenues from FICC,” according to a report by Moody’s Investors Service. Moody’s named Barclays, Deutsche Bank and Goldman Sachs Group as the most vulnerable outfits.

For three decades the fixed income, commodities and currencies business has been the cash cow of investment banks. The term “FICC” dates from 1981, when Goldman Sachs acquired commodities dealer J. Aron & Co. as well as its CEO, Lloyd Blankfein. And Goldman rode the FICC boom better than most, generating an astonishing $23.2 billion in revenue from the business — more than 50 percent of the firm’s total — in 2009. But that is all likely to change under the crush of reduced trading and increased regulation.

McKinsey, in a report titled “Day of Reckoning?,” estimated the costs of the new regulations by sector and concluded that the investment banks’ overall return on equity would fall from about 20 percent to 7 percent. The report said that with mitigation efforts banks could limit the decline to only 11 or 12 percent, but that’s still an enormous drop from the business’s traditional level of profitability.

Hardest hit, in the McKinsey analysis, were the rates business (government bonds and interest rate swaps) and structured credit, where ROE may fall by 80 to 85 percent. Commodities trading ROE would decline from 20 percent to 8 percent, according to the report. And McKinsey saw ROE for foreign exchange trading falling from 30 percent to 16 percent.

The market for interest rate swaps is by far the largest derivatives segment, and it is “seen [by regulators] as the culprit for the financial crisis,” observes Max Neukirchen, who coauthored the report and is a partner at Mc­Kinsey in New York, working in the risk management practice.

The other areas of FICC seen as likely to be most heavily impacted are structured credit, which consists of portfolios of credit hedged by a number of credit default swaps, and structured rates, a combination of interest rate swaps, sometimes across currencies. Neukirchen says regulators believe these products are more risky and less transparent — a belief that the JPMorgan loss has clearly strengthened.



Institutional Investor
asked the major banks about McKinsey’s estimates, but only Morgan Stanley was willing to comment.

“The broad framework [of the report] is correct. I don’t think there is any question about that,” says Kenneth deRegt, global head of fixed-income sales. “The capital requirements are going to impact firms and fixed income in a number of different ways.” But deRegt would give no specific estimates of the impact on his business.

A more indirect answer came from Goldman Sachs CFO David Viniar, who was asked by an analyst during the bank’s first-quarter-results conference call what impact the new regulations would have on Goldman’s mortgage debt and securitization business. “It’s hard to see that business for us or anyone else under those rules making sense, and I think you’d have to see a big pullback,” Viniar said.

The new regulations come on top of what has been a substantial decline in fixed-income trading since the financial crisis. Coalition Development, a London-based analytics firm focused on investment banking, says fixed income was the weakest business for the top ten global investment banks last year, with revenues falling 25 percent from 2010. Revenues were down a full third from the boom year of 2009. According to Coalition’s study, credit’s contribution to banks’ revenues has fallen from 21 percent in 2009 to only 8 percent last year. Securitization revenues were down by two thirds.

Not surprisingly, the top ten investment banks have slashed their head counts, especially in those two trading areas, Coalition reports. The number of revenue-producing employees fell 6 percent globally in the 12 months through early April, the firm says.

Second-tier investment banks were hit equally hard. At France’s Société Générale, fixed-income revenue plummeted 31 percent last year, and the head of the investment bank, Michel Péretié, departed, along with a number of top executives in fixed income. At BNP Paribas revenue in fixed income was down 18.8 percent, excluding losses from sovereign bond sales.

Most of the big banks saw an improvement in their fixed-income business in this year’s first quarter, but revenues were still well below the previous year’s levels. JPMorgan’s investment bank did the best, with fixed-income revenue hitting $4.6 billion, but that was 11 percent below the year-earlier amount. At Citigroup fixed-income revenue reached $3.6 billion, a 4 percent decline; Goldman Sachs reported a 20 percent fall in FICC, to $3.46 billion. At Bank of America Merrill Lynch, FICC revenue was $4.1 billion in the first quarter, up from $3.7 billion a year ago. But April was “absolutely brutal,” and “the credit market evaporated,” says Mediobanca’s Wheeler. As a result, J.P. Morgan Cazenove, the London-based JP­Morgan investment banking unit that compiles an investment bank ranking, is forecasting a 20 to 25 percent decline in industry FICC business in the second quarter compared with the first, but says the decline will be even steeper if the environment worsens. “Deteriorating macro news flow,” principally the possibility that Greece could exit the euro, means FICC revenue is likely to be down 32 percent in the second quarter, the bank said.

Single Page    1 | 2 | 3
Related Topics: JPMorgan· Jamie Dimon· FICC