Typically following any broad, sweeping legislation, and particularly with legislation as far-reaching as Dodd-Frank, come the cries of unintended consequences. These are the negative impacts on markets and operations, unforeseen by the authors, supporters and even opponents of the original legislation.
Dodd-Frank, while based on strong fundamental principles of market oversight, transparency, fiduciary governance and compensation reform, is not exempt from such unintended consequences, although you could say these consequences are affecting us much earlier than originally anticipated.
These consequences are affecting the way firms run their business and plan their budgets and investments. Historically, firms have three major budget groupings each year. "Run the Bank" (RTB) budgets cover expenditures to keep the lights on in operations and technology. Discretionary "Change the Bank" (DCTB) budgets are used on initiatives to generate new revenue or reduce expenses. Mandatory "Change the Bank" (MCTB) budgets cover the costs of regulatory compliance and other changes that must be implemented for the firm to remain compliant in the markets where it transacts.
With these three budget areas in mind, we've observed five consequences already making their mark, all tied to Dodd-Frank and its remediation cost:
1. DCTB budgets are razor thin and primarily focused on expense reduction initiatives. This is stifling innovation, since the resources typically invested in competitive differentiation on the revenue or expense lines are now being consumed by mandatory regulatory remediation.
2. Remaining DCTB spend is being focused offshore. Whatever DCTB budget remains for revenue growth is being allocated to building up lower cost capacity outside the traditional New York and London financial centers.
3. Pressure to reduce RTB budgets is never-ending. With declining revenues and little or no innovation to drive new revenue, the natural focus is on expense management, but that's hard to do with limited or no DCTB budget.
4. Significant multi-year savings programs are already in place. Nearly all the major global banks and dealers have expense reduction programs with target savings of $1 billion or more over the next three years.
5. There is a race to the bottom in OTC derivatives. As the opportunity for profitability on bespoke, un-cleared OTC transactions wanes, nearly all incumbent OTC dealers and major Futures Commission Merchants (FCMs) are also undergoing significant transformation programs to optimize and reduce the footprint of their operations and IT support infrastructure so they can compete on volume and transaction cost.
Along with these consequences, we’ve also observed five ways that firms are attempting to cope by turning their focus to operations and IT:
1. Fixed operations and IT costs are being converted into variable costs. The established trend of outsourcing continues, and in these days of declining revenues it couldn't be more important. Capital markets participants are focusing more on outsourcing core processes and no longer just going after the low-hanging fruit on the fringes.
2. Fixed cost, full-time equivalent (FTE) headcount is being reduced through vendor "lift-outs." This is a variation on the outsourcing theme, allowing vendors to scale expert staff across clients, and giving the customer immediate balance sheet relief and opportunity for longer term savings. As pressure continues to mount on revenues, we expect to see more and more new and interesting vendor relationships emerge on Wall Street.
3. “Get more from your existing technology” is becoming a mantra. With little or no DCTB budget, firms are looking at how they can get more out of existing vendor and proprietary systems, particularly through consolidation and elimination of duplicate (or worse) functionality and technology.
4. “Get more from your existing tools and frameworks” is another mantra. Firms are trying to get more leverage from existing features in their IT infrastructure, taking better advantage of what they are already paying for.
5. Base salaries and bonuses will continue to trend downward. The glory days of Wall Street compensation may be behind us, and if revenues continue to decline, this could be more than just a current trend. Hopefully, there will be limited negative impact on talent and career opportunities over the long term and that the first four coping strategies will open new doors for career growth in the coming years.
In summary, unintended consequences of Dodd-Frank have quickly created long-lasting impacts on the capital markets industry, but thankfully firms and vendors are evolving to cope with these impacts in some new and some not-so-new ways.
-John Avery is partner, SunGard Global Services