Financial regulation and quantitative easing (QE) are at the heart of a huge shift in liquidity risk from banks to the buy-side, which is increasingly a concern for policy makers. We expect liquidity in sell-side markets to deteriorate further, as regulation shrinks banks’ capacity another 10-15% over the next two years. Our interviews with asset managers found concerns over scarcer secondary market liquidity, particularly in credit.
Regulatory risks are rising for asset managers, as policy makers increasingly fret about the risks to financial stability from QE exit and market structure changes. Our base case is for an incremental approach that involves stress testing of select funds and a range of micro reforms. This could add an extra cost of 1-5% to asset managers.
Diminishing returns on capital from market making demand even greater efficiency, dexterity and scale from wholesale banks to achieve 10-12% returns. More firms will trim this business, ultimately leaving a potentially attractive prize for those able to endure.
We expect banks to shrink balance sheet further
Share of 2014 balance sheet and expected reduction
1What is this year’s report about?
This year’s report considers the impact of reduced liquidity along the entire securities value chain. Beyond our traditional focus on the sell-side we review the impact on the buy-side which we believe is likely to come under significantly more regulatory scrutiny as regulators struggle to balance desires to reduce the riskiness and interconnectedness between banks, to ensure that asset managers have sufficient liquidity to deliver on promises to their investors, and to preserve companies’ flexibility to issue in a wide range of markets and tenors.
2What is the main concern about liquidity risk?
We’ve found that liquidity risks in the industry have materially shifted to the buy-side and asset owners. Retail investors now hold about 20% of credit in daily redeemable mutual funds, whereas on the other side a severe reduction in sell-side balance sheet has reduced liquidity of the assets held.
3Which markets will be most affected?
Credit markets are the thorniest to solve. There is an unresolved conflict in regulators’ desires to reduce the interconnectedness between banks and ensure that asset managers have sufficient liquidity to deliver on promises to their investors as well as have companies flexibility to issue in a wide range of markets.
4What about investment banks?
Industry return on equity (ROE) is at 7% and even when we remove fines and non-core we only get to 9%. We believe this is a bridge too far for investors. Looking forward, an uneven global recovery and increased volatility bring a mix of tailwinds and headwinds for wholesale banking revenues. We expect re-pricing for capital, policy divergence, and an improving real economy to be key tailwinds. But capacity withdrawal, tougher conditions in credit, lower leverage and turnover in the buy side, and increasing electronification are all headwinds. Under our base case revenues are forecast to grow by about 3% until 2017 which just cancels out the remaining regulatory drag, so management teams will need to deliver 2-3% increase in ROE through business restructuring to hit 10% or more returns on capital.