Investment banking dreams may die in 2012

Will there be fewer investment banks at the end of 2012? Brutal market conditions forced almost all wholesale banks to cut costs and jobs in 2011. New regulations will force further shrinkage simply to generate acceptable returns. Unless the market picks up soon, smaller players may conclude they’re better off out of the game altogether.

Banks cut thousands of jobs from their wholesale divisions in 2011, as revenues collapsed amidst the euro zone crisis. And new regulations will halve average expected return on equity (ROE) across global investment banks in 2012 to 8.3 percent, according to analysts at JPMorgan, well below the 13 percent needed to cover their cost of equity.

To reach that required return, banks have to shrink further. Even factoring in further headcount reductions of up to 20 percent and a 5 percent cut in non-compensation costs, returns would still be too low. To reach a 13 percent ROE, banks will have to slash pay too – by a hefty 23 percent per head on average, JPMorgan reckons.

Those cuts will not just remove fat, they will also undermine revenue. The most vulnerable banks are those that are already sub-scale. JPMorgan analysts estimate that 2011 revenue at Royal Bank of Scotland, UBS and Societe Generale will be barely half that of industry leaders Goldman Sachs and Deutsche Bank. Nomura too, faces a tough call – its investment bank is losing money in Europe, while the threat of a ratings downgrade could undermine its counterparty status.

No one is yet contemplating quitting – publicly, at least. Nomura reckons that its capital strength and liquidity position will allow it to gain from euro zone turmoil. UBS’s new chief executive, Sergio Ermotti, insists its smaller investment bank is essential to its private bank.

However, there are signs of retreat. The UK government, RBS’s major shareholder, made clear in December that it wants to shrink the investment bank faster. And SocGen has installed its chief financial officer at the head of its investment bank, suggesting a tighter focus on costs.

Closing investment banks is easier said than done. One banker likens them to nuclear plants – the toxic waste has to be managed by expensive staff. So while few banks will kill off their wholesale arms, 2012 may be the year they decide to starve them to death.

Predictions: Breakingviews is publishing a series of articles over the holiday that look ahead to 2012. The pieces will be collected together in the annual ’Predictions Book’, produced in print and electronic form early in the New Year.