In the city of London and down on Wall Street investment bankers are grappling with some once-in-a-generation size issues. Near the top of everyone’s list is how to re-shape, re-engineer and re-fit research departments. This goes beyond a straight-forward cost reduction exercise. Investment banks have to think beyond the cutting heads phase, to how research will be plugged into the investment bank in future. How should it be structured? And above all: How it will be paid for?
On either side of the Atlantic, the FSA and the SEC have been burning the midnight oil of late developing new guidelines for the conduct of research professionals in investment banks. Some have interpreted this as the final chapter in what has been one of the industry’s most turbulent periods. They are wrong, however. These guidelines and the so-called Spitzer settlement actually marked only the early part of what will inevitably be a challenging and painful, yet clearly necessary, restructuring of research divisions. While the focus has been on the detail around the new guidelines which is important, what is really at stake is the underlying cost structure of research. In its present form, such a structure is simply unsustainable.
Investment banks have to square the circle of the research conundrum. Few would take issue that research is a ‘must-have’ for investment banks in order for them to compete their chosen markets. But the present bear market has exposed the reality: there is a huge mismatch between the research division’s current cost base and the new business economics of investment banking. Put simply: as currently structured investment banks cannot afford a research function, but nor can they live without it. So what options do banks have to ‘right-size’ research?
Investment banks need to address both short- and long-term agendas. Here we will discuss the short-term actions required to enhance the efficiency and effectiveness of research services. The bull market of the 1990s masked the cross-subsidies that underpin the business models of large integrated banking groups. Shine a light on these costs and they show that investment banks – we estimate – spent in excess of $8bn in 2000 on all forms of research (Exhibit 1). However, such costs are no longer sustainable. As a result, this figure could fall to around $4bn by 2005.
There is clearly huge pressure to right-size research. This is not surprising even from a cursory examination of the figures. A more detailed investigation into distribution of costs within a research function is outlined in Exhibit 2. Our analysis shows that 75% of the cost base is spent on compensation packages. The most recent bonus round suggests that salaries are on the wane – it is likely that they will never return to the vast sums awarded during the tech-boom. The remaining costs are spread across property, technology and operations. We estimate at an industry level there are probably in excess of $1.5 bn of non-compensation costs from which savings could be made.
In tackling these issues, investment banks need to define which elements of the research function they need to retain. The research ‘value chain’ could be divided between core and non-core activities. Core activities relate to content development. The insights and advice the research function generates are often critical in differentiating a bank from its rivals. At the same time many support functions do not differentiate the bank and offer opportunities to deliver significant operating cost savings.
It is important that decisions based on re-engineering the research process are linked to longer-term decisions. Such decisions might include serving different markets, such as institutional, hedge fund, or private clients.
In responding to this changing environment, an evaluation of the potential options for both core and non-core capabilities could have significant benefits. Core research functions are likely to be kept in-house. In doing so, the four ‘C’s’ need to be addressed:
o Content: How many analysts are required to provide the depth and quality of content required to differentiate the investment bank? In the long term, which clients – retail, institutional, hedge funds, banking – should they service? Already, we have seen the merging of debt and equity departments, for example at Morgan Stanley, Dresdner Kleinwort Wasserstein and Goldman Sachs, partly driven by the need to reduce costs.
o Compensation: What level of remuneration is required to retain quality analysts and how should this pay be structured? The vast majority of cost savings will be made from head-count reductions and reducing bonus packages. However, the thorny issue of how to reward star performers within such an environment still remains.
o Compliance: Post-Spitzer compliance is going to play a major role in operation for research functions in future. How big does this function need to be? What reporting structure should it use? How can its integrity and objectivity be ensured? What email audit systems and firewalls need to be installed? What are the key questions around compliance that require solutions?
o Coverage: New business economics mean it is no longer possible to maintain the depth and breadth of market coverage. The key questions are: Which sectors and companies need to be covered? How should the coverage cull be best executed?
With regard to non-core activities, past discussions on cost repositioning have faltered due to the lack of business pressure. Today, however, the situation is very different: the pressure is significant and it’s growing. To date, investment banks have adopted separate approaches in meeting cost reduction objectives. Now is the right time for a radical re-evaluation of potential options for change to ensure future survival such as industry utilities that could provide industry wide publication services, for instance. Investment banks need to tackle the four ‘Cs’ relating to their non-core activities:
o Cost reduction: There are significant and immediate cost reductions surrounding non-core functions. For example, we have found in some banks that up to 40% of non-core costs are real estate related. As a result, the potential for savings is huge: either move such functions to cheaper non-metropolitan sites or locate them offshore completely.
o Collaboration: Multi-firm approaches can build on the similar situation currently found in most major investment banks. Such collaborative ventures can drive large cost reductions and provide significant bottom-line benefits. We estimate that consolidating the back-office research units of two large investment banks could result in annual savings of 30% for each firm. However, it is also important to be aware that this is a higher risk/reward strategy.
o Complexity: The wholesale re-engineering of the research value chain offers a once-in-a-decade opportunity to clarify procedures and reporting lines. The complexity of surrounding the research value chain could increase as several initiatives are kicked-off to separate core and non-core processes. It is critical that during this period of change, complexity is reduced.
o Culture: Perhaps one of the most significant hurdles facing investment banks in right-sizing research departments is to meet the demands of the new era of capital markets is internal culture. When the market was booming and revenues were plentiful, a blind eye was turned to the issues of reporting structures, the efficacy of support operations and the clarity of reporting channels. Many research functions became highly unstructured. During this time a number of vested interested developed which today potentially block the path to reform.
Michelle Forczek is a specialist in capital markets at Deloitte Consulting and Chris Gentle is director of Deloitte Research Both authors are based in London and part of the global financial services practice.