According to a survey released today by the IBM Institute for Business Value, 90% of financial markets executives and government officials believe the returns of the past are over. As the financial markets industry radically restructures, firms will have to adapt to a new lower-margin landscape where they will need to specialize around services that clients value. The IBM study predicts significant consolidation in segments wrought with over-capacity such as investment banking, asset management, and wealth management. Enhanced regulation and transparency will also eliminate opacity, with previously high-margin activities becoming commoditized.
The IBM Institute for Business Value surveyed 2,754 industry participants, including 1,076 individual investors and 1,678 executives and public officials, to determine how financial markets firms should prepare for the future. The report, "Toward transparency and sustainability — Building a new financial order," found that respondents were in broad agreement on the need to eliminate complexity and excess and move to a more transparent, sustainable market. They also agreed on the need for effective regulation not only to avoid the mistakes of the past, but also to prevent new ones in the future — but they feared that poor regulation may hinder necessary innovation.
Over 90% of executives and government officials believe the industry will unbundle — apparently "wealth destruction leads to self reflection" — and the industry is specializing by thinking through 1) what to do, 2) what not to do, and 3) how to specialize around what the client values. Survey respondents expect the winners of Wall Street to gravitate toward three areas of specialty:
Beta transactors: the majority of financial markets firms will concentrate on utility services (trading, asset management, etc.) that provide the infrastructure required to facilitate market-making in the same way that water companies provide the reservoirs, purification processes and pipes required to deliver clean water.
Advisors: a smaller number of firms will concentrate on providing advice — such as wealth management or mergers and acquisitions advice.
Alpha seekers: a handful of private equity firms, hedge funds and boutique investment houses, none of which are "too large to fail," will focus on generating high returns from high-risk investments.
"The three trends — towards specialization, client orientation and improved efficiency — are triggering a restructuring wave on a greater scale then ever before, eroding margins and forcing all firms to reconsider their value propositions and their core business models," said Shanker Ramamurthy, global managing partner for Banking and Financial Markets at IBM Global Business Services. "The new industry will not only lack some of the great brand names of the past, but will also lack many of its past characteristics " from excessive risk taking, opacity and leverage, to massively high returns."
For some time, firms made vast profits by exploiting pockets of opacity in the market and did little to refine management or control systems, to improve transparency or to connect with their clients, the survey suggests. Respondents to the IBM survey said that improved client service and efficiency will be critical for competitive survival in a new lower-margin financial order, a finding consistent with other more mature industries. In the future, firms will need "smarter" systems that can continuously assess their risks and returns across each line of business and adjust their business mix accordingly. At the same time these systems will also enable firms to refine client service through improved understand of profitability by business line and product as well as by individual client.
This is all extremely convenient for IBM, which two weeks ago announced the creation of a new consulting organization dedicated to the market for advanced business analytics and business optimization.
"Banks have been used to a level of volatility and business cyclicality, and are currently slashing headcount and closing business lines in order to save money, just as they have done in previous downturns. However, in the current restructuring radical efficiency improvements will be required for survival," added Ramamurthy. "Indeed IBM's analysis suggests that the current wave of redundancies and divestitures will provide insufficient savings and that firms will need to seek further efficiency improvements of 20% or more as they face the need for a level of transformation and radical business model reform not seen in previous downturns."
Although growth is expected to be sluggish through 2012; it will depend on a firm's ability to thrive in an increasingly transparent environment. For example, hedge funds (and their prime brokerage service providers as a result) will come under severe pressure as transparency reveals that the majority of funds are not delivering on their "alpha promise." Meanwhile flow businesses (derivatives in particular), passive investments and infrastructure providers such as custodians, clearing firms and exchanges will grow as a result of increased transparency and a movement away from risk assumption towards risk mitigation.
Further findings in the report include:
-Providers and clients are disconnected 79% of the time (what clients actually value and will pay for vs. what providers think their clients value and will pay for).
-80% of firms ranked themselves as moderate to poor in delivering on their brand promises of client-centricity, agility and stability (brand promises are for multiple stakeholders including clients, governments and employees).
-Over 60% of clients believe their provider isn't acting in the best interest of the client; and nearly 60% of providers agree that they are not acting in their clients' best interest.
-The buy side understands client behavior to a greater extent vs. the sell side — but there is still room for improvement even on the buy side.
-When asked about the new world order, financial executives and government officials ranked as number one the need for greater transparency, second the need to address capital and liquidity and third the misalignment between firms' incentives and the needs of governments and individual consumers.
-70% of executives are concerned that the government will 'overshoot' and over-prioritize financial stability at the expense of innovation.