Investment banks around the world have been reeling from a cyclical downturn in underwriting and trading profits and from long-term structural shifts that have made their core business less attractive. These are the firms that underwrite securities, trade a variety of financial instruments and currencies, and provide associated advisory services—for instance, in mergers and acquisitions. In today’s environment, most investment banks are reassessing their strategies for growth and their management of internal operations, but nowhere is this soul-searching more intense than in Europe.

A specific set of difficulties afflicts the players in this region: a broad but undistinctive product offering, a high level of costs, and a lack of the international distribution network that is essential to true global success. Worse still, such is the state of the industry that even addressing these shortcomings will not guarantee an attractive role for European investment banks. More creative solutions will almost certainly be required.

Europe’s predicament

The root of the current predicament for European investment banks lies in their failure to respond to the changes that have taken place in their external environment over the past decade: the globalization of capital, the growing sophistication of issuers (such as governments and corporations) and investors (such as insurers and mutual funds), and the central role of the dollar in global investment flows.

The global marketplace

The globalization of capital markets has made it possible for users of capital to lower their funding costs by tapping into multiple markets, and for investors to earn better returns by diversifying their holdings across many countries and currencies. As a result, it has become much more important for investment banks to offer issuers and investors products that span the global market. Indeed, those banks without global capabilities will find it difficult to offer a tailored "solution" to an institution’s financial problem. As in most industries, solutions carry far higher margins than products.

Despite the global spread and growth of such large product markets as government bonds (Exhibit 1), few of Europe’s banks have developed the distribution channels they need in order to offer and trade in these instruments worldwide. Even those European banks that have invested significantly in developing international products have not been able to build true expertise. The result: a broad but undistinctive product line, and the global cost base that these products require.

The unbundling of services

Investment banks have been forced to enhance their product offerings as issuers and investors have developed more sophisticated needs. It is common for customers to shop for the best deals and to work with several banks, each operating in an area where it has particular expertise. A company might select one bank for M&A advisory services, another for securities issuance, yet another for commercial banking services, still another for interest rate management, and so on.

In practice, large corporations’ purchase patterns might look like those illustrated in Exhibit 2, which shows a leading European multinational’s usage of banks: a clear example of a "horses for courses" selection policy. The rising importance of expertise has inevitably led to a decline in banks’ ability to leverage their relationship in one product family, such as lending, into another, such as bond or stock underwriting.

A similar change has occurred among investors. Pension fund managers, insurance companies, unit trust and mutual fund managers, and other large investors are unbundling their purchasing decisions to meet the specific risk/return characteristics of their different clients. This specialized purchasing behavior, which often includes the need for global research in specific industries or topics (for example, currency outlook) on the part of institutions, has left those banks that lack the necessary range of expertise at a serious disadvantage. Too often, they have been unable to advance beyond selling their own domestic products to international investors.

In fairness, the growing sophistication of customers has not hurt only the European investment banks. American commercial banks operating in Europe have also abandoned their aspiration of building a broad-based "one-stop" lending and securities business. They too have realized that the skills involved in, say, structuring, pricing, and researching equities have little in common with those needed for success in commercial banking products, such as syndicated lending. They have also found that the clients with whom they need to build strong relationships to sell commercial banking products—typically company treasurers—are different from those they would have to cultivate—usually finance directors, or even chief executive officers—if they were to do well in the issuance and distribution of equities.

Most US commercial banks in Europe have by now withdrawn from securities underwriting and advisory services. Instead, they focus on providing commercial bank services like international payments, custody, and lending, as well as offering advanced versions of the old treasury function, including debt and derivatives. Japanese banks have been shaken by the same industry forces; having failed to expand their services beyond lending and low-margin Eurobond issuance, many are currently considering the appropriate breadth of their businesses in Europe.

The unbundling of services, which has precipitated a fall in the value of generalist relationships and a rise in the importance of product expertise and specific product-based relationships, has worked against Europe’s investment banks, as well as other commercial banks.

The main beneficiaries of the focus on expertise have been the US "bulge bracket" firms like Goldman Sachs, Morgan Stanley, and Merrill Lynch. Through the late 1980s and early 1990s, these companies successfully transferred the competencies they had developed in the tough US market—in advisory services, securities and distribution, and currency and interest rate management—to Europe. Together with their worldwide placing capability, their long-standing relationships with investors in the United States, and the breadth of their product range, these competencies enable them to offer broad-based solutions rather than simple products.

This is not an argument that "products" are more important than "relationships"—the truth is far more subtle. Deep relationships with key decision makers are the keys to transforming products into tailored solutions. However, in today’s environment, the simple price of admission is true product distinctiveness in several global product areas.

The best example of unbundled purchasing and the importance of expertise is the advisory business, where bulge bracket firms or "pure" investment banks have dominated. In the highly lucrative cross-border M&A business of the past decade, for example, the top six are made up of three US bulge bracket banks, one M&A boutique (Wasserstein Perella), and just two European investment banks (S. G. Warburg and Lazard), with not a single European universal bank¹ in sight (Exhibit 3). Even more telling, perhaps, is the share of domestic M&A markets now being captured by foreign institutions (Exhibit 4).

The greenback

The third major problem for Europe’s investment banks is the continued importance of the dollar and, more profoundly, of the role of US investors. It is exceedingly difficult for European banks to intermediate global capital flows when a full one-third of all stock market capitalization—and, just as an example, 60 percent of mutual fund managed money—is in the United States (Exhibit 5). The importance of US capabilities is heightened in the area of trading, where many opportunities need a dollar "leg" to them. Finally, many product innovations originate in the United States, where markets are extremely liquid and competitive. Skill and knowledge transfers from the US remain an important—although arguably declining—ingredient of success.

Industry restructuring

Although the forces at work, as we have seen, put European banks in a particularly difficult position, the story does not stop here. The plain fact is that the entire industry, including even the strongest US firms, is going through convulsions. Increased competition has squeezed margins and escalated salaries across the board. Exhibit 6 illustrates the long-term structural decline in profitability that has emerged over the past decade. Together with the cyclical downturn in trading and underwriting revenues, this has led to the painful current restructuring in the industry.

In recent months, most attention has been focused on the dramatic decline in trading and underwriting income that has afflicted many players. The bad news is that low profits are likely to persist for some time—at least until rates fall. The relationship between trading profits and interest rates is shown in Exhibit 7. Put simply, banks’ heavy reliance on trading, which compels them to keep an inventory of products, means that most are structurally long—and thus highly vulnerable to rising interest rates, particularly if rates shoot up as quickly as they have during 1994.

All the attention devoted to cyclical problems, however, masks the real difficulties facing the industry. Look again at Exhibit 6: even the bumper year of 1993 did not come anywhere near the profitability of the early 1980s. Investment banking has always been highly volatile, and recent history is no exception. However, structural forces are making the industry unattractive for the average player—viewed across a complete cycle—from a shareholder point of view. Among them, three of these forces in particular should be the focus of senior management concern: structural overcapacity, the shift away from intermediaries, and the uneven distribution of economic value between labor and shareholders.

Overcapacity

Margins on some products have declined by 30 percent in the last five years

Global products such as Eurobonds, swaps, and advisory services are now being offered by almost every player, not just the very largest firms. As in most industries, it is the marginal capacity that sets the price level. The continued attempt by second-tier institutions to enter the derivatives market, for example, drives down margins even though these banks tend not to be large-scale players. Margins on some products have declined by 30 percent in the last five years. The prices that banks can charge for initial public and secondary equity offerings is also down by as much as a quarter.

The reason why so much overcapacity remains is that, in many banks, the real profitability of individual businesses has been hidden in bundled accounting systems, a particularly acute problem for universal banks. Only recently has the true scale of shareholder value destruction among many forms of lending, plain vanilla swaps, and large corporate foreign exchange businesses come to light. Now that figures are increasingly available, it will be interesting to see whether the top management of universal banks will continue to subsidize their investment banking activities with profits from their retail banking franchise.

A further cause of overcapacity lies in the tendency of many governments and business communities in Europe (and Asia) to go way beyond the requirements of shareholder returns in urging their national banks—exactly as many did with airlines—to "plant the flag" around the globe.

The commoditization of products may well grow worse as more and more banks try to offer one another’s product lines

The commoditization of products may well grow worse as more and more banks try to offer one another’s product lines. With the 1933 Glass-Steagall Act (which separates commercial and investment banking) gradually falling away in the United States, and the eventual recovery of the Japanese banks, it is probable that many product areas, such as fixed income origination and many simple derivatives, will become as unattractive as simple lending is today.

The shift away from intermediaries

A clear structural shift is taking place in the balance of power between banks and the users and suppliers of capital for which they act as intermediaries. And things are likely to get even worse for the banks. The top-tier international investors already account for a large share of institutionally managed money, a concentration that is deepening. This increase in bargaining power will allow more powerful professional fund managers to negotiate even tighter margins and, in some cases, bypass intermediaries altogether and go directly to companies and projects in need of capital.

A parallel growth in negotiating power is also taking place among issuers. A large number of corporations now have highly trained staff capable of performing functions that were traditionally the preserve of banks. Perhaps the best example is in M&A, where many large companies are beginning to carry out the transactions themselves. As in any industry, when power concentrates in suppliers and end users, the value remaining for intermediaries contracts. Investment banks are being squeezed between increasingly large and sophisticated investors on one side and issuers on the other.

Labor costs

As with any industry that relies on attracting the best talent, labor costs constitute both the largest component in the cost structures of investment banks and the chief factor in their remaining competitive. In general, the employees of investment banks have done much better than their shareholders (Exhibit 8). While compensation has risen steadily over the years, volatility in business performance has been absorbed by the shareholders. There are two reasons why this situation has come about.

First, the labor market is very liquid in the major financial centers. Shaped by US practices, which have traditionally provided few incentives for loyalty, the industry is now at the mercy of a highly skilled labor pool motivated purely by short-term compensation. Second, management is failing to discriminate adequately between rewarding individual performance and paying a return tied to market conditions. The result of these two financial factors is compensation stickiness, whereby total pay does not vary sufficiently with business conditions.

An unintended but equally damaging feature of the current pay structure is its risk incentives. Bonus payments to individuals are extremely asymmetrical with shareholder interests: bankers and traders who make a lot of money get paid very well; those who lose a lot get paid less—but not in proportion to the loss to shareholders. Not surprisingly, the incentive to take high risks is enormous, particularly for traders.

This state of affairs cannot continue forever. Overcapacity, the decline in the value of intermediation, and the lack of a sound compensation structure have all taken their toll. Returns are not sufficiently high to compensate for the business risk. Have shareholders finally had enough?

For both structural and cyclical reasons, the industry is simply not attractive for the average players. This poses a fundamental strategic question for senior management. Should they stay in the business? Is it worth more to someone else? How can their bank find a focus which generates attractive returns over time?

Strategic choices

The strategic choices that banks make must be shaped by a vision of which roles might be attractive in the medium to long term, matched with an objective assessment of their ability to fill these roles. Building global, broad-based capabilities is certainly an option, but there are others which are worthy of serious consideration.

Global banks

The high volatility of individual product markets also makes managing a portfolio of products and countries a sound move

It is clear that the ability to intermediate on a global scale with a broad range of products is highly attractive from the perspectives of both issuers and investors. The high volatility of individual product markets also makes managing a portfolio of products and countries a sound move. Moreover, such breadth of opportunities helps banks to attract and retain top-quality people, especially outside their home base.

It is unlikely that trading profits will consistently cover the overhead costs associated with a global bank

Unfortunately, there is room for only a few global, broad-based players. Presence in multiple financial markets and products entails cost structures—particularly in information technology and operations—that can be prohibitively high. As margins continue to shrink, volume becomes more critical to success. This shrinkage has already caused consolidation in such areas as international payments and custody. As recent history has demonstrated, it is unlikely that trading profits will consistently cover the overhead costs associated with a global bank.

The situation represents a serious challenge for European banks. Not only must they determine whether there is room for them to be one of the handful that prospers, but they must also weigh up the risks of getting there—and they are substantial. Building the necessary capabilities internally would be slow and might not generate critical mass. Buying in teams of people has a rather checkered history of success. A major acquisition, even if strategically sound, would carry considerable implementation risks. In a business where people and professional culture are most of the game, crafting an integrated entity that succeeds in exploiting the intended synergies must be regarded as a high risk venture.

Considering the difficulty of achieving a global, broad-based role, and the uncertainty over whether such a thing would even be attractive, it seems prudent for European banks to explore other options. So far, alternative roles have received surprisingly little attention, though they may now be getting their due, thanks to the harsh industry environment.

A focused role

Fortunately, multiple products and markets, combined with the rapid pace of change, furnish a rich array of potential ways to compete. The objective must be to define a role that can be defended against the corrosive forces described above that are undermining profitability. While many options exist, including combinations of roles for different products or countries, a quick review of three potential roles will illustrate the point:

Some European banks could offer origination, trading, and advisory products to clients where deep local market knowledge is critical

Geographic focus. Some banks could offer a broad range of products focused on a single geographic region. Thus, a European bank would not attempt to compete with the US bulge bracket banks in products like global equity offerings, but would offer origination, trading, and advisory products to European clients where deep local market knowledge and relationships were critical. Such a strategy would require distribution to investors in the United States, but not a large-scale origination business. Early examples of geographic players include Peregrine and Jardine Fleming in Asia.

Product focus. Specialization in product families may also grant banks sufficient distinctiveness to protect their margins. This might involve completely reformulating existing product families or creating new ones. An early experiment in the former is the completely reegineered trade and payments business of HSBC. This combines a genuinely new technology with a series of creative strategic alliances around the globe, the most recent being with Wells Fargo in California. There is significant potential for creating new families; for example, the convergence of sophisticated structured derivatives, commodity indexes, and wholesale insurance/reinsurance could provide a truly distinctive risk management package far beyond what is offered to corporates today.

Customer group focus. Attractive returns will also be captured by banks focusing on customer groups with distinct needs. In Europe, as in the US during the 1980s, big rewards will accrue to the first banks to serve a customer group that has not normally had access to the capital market. An example of this strategy in the US is Donaldson Lufkin Jenrette, who focus on subinvestment-grade companies with a broad set of debt, equity, and advisory products.

Successfully implementing any of these focused strategies will be challenging and risky, precisely because they have not been done before. This is exactly the point; only new, creative, and distinctive roles are likely to earn sustainable returns over time given the current state of the industry.

The value that might be captured by following these strategies must, of course, be compared with the value of the business to others. The mergers and acquisitions departments of investment banks have long marketed this advice to corporations; it is now time for them to apply the same logic to their own activities.

Designing the organization

Designing the appropriate organization for wholesale businesses is at least as important as the strategic decision in determining success. These businesses are based on highly skilled individuals and are completely dependent on their motivation and leadership. Moreover, the organization itself must be flexible enough to respond to major swings in business volume and opportunity; people and capital must be very fluid across organizational boundaries. This fluidity is required of information as well. The sharing of insights between one part of the organization and another must occur rapidly and horizontally; the opportunities will not wait for knowledge to be passed up and down a chain of command. These features are difficult to design into an organization, and are radically different from the characteristics of many of today’s European banks. To achieve the required change, senior management should focus on four core issues:

1. How should the compensation structure be designed? As discussed above, current compensation practices not only undermine industry attractiveness from a shareholder perspective, but also create incentives for excessive risk taking. In order to address these issues, a compensation structure must contain four key characteristics. It must:

• Reward loyalty and provide significant incentives for long-term service.
• Ensure that levels of compensation in aggregate are set such that business volatility is shared between employees and shareholders.
• Allow large increases and decreases in pay for individuals in a symmetric manner with shareholder exposure.
• Drive individual bonus levels off clearly separable measures of individual achievement, collaborative behavior, and firm results.

Taken together, these characteristics very much resemble a partnership structure. However, implementing these principles will not be popular. Some firms are already moving toward longer-term equity stakes for portions of the bonus, and this has generated the expected disruption. Nevertheless, as Warren Buffet, respected investor and acting chairman of Salomon Brothers, wrote in October 1991 in his Report on the Company’s Standing and Outlook, announcing the third-quarter’s results and his compensation plans for the firm: "[If people choose to leave,] other men and women who share our thinking and values will be given added responsibilities and opportunities. In the end, we must have people to match our principles, not the reverse."

2. How to install a performance ethic? European banks (and others) have historically found it difficult to create a culture that demands initiative and requires accountability to the highest standards. Much of the problem stems from a rigid, multi-layer pyramid of management, combined with an over-reliance on committees which dampens initiative and clouds responsibility. High-performance organizations in this business are structured completely differently; they have a flat structure, with a large body of relatively equal senior executives responsible for narrowly defined areas. Expectations at this level are clear in terms of performance, closure, and contribution to other areas, and transparent to others. Poor performers are not tolerated by colleagues.

Teams allow far more flexibility in gathering skills from all parts of the organization and promote information and skill transfer around common goals

3. How to design permeable organizational boundaries? European banks in particular have been afflicted by the difficulties of moving people and capital rapidly between organizational units. Too often, fiefdoms emerge around product lines or countries that make rapid change in response to market opportunities difficult to execute. These political empires can no longer be tolerated in today’s environment. Teams, far more than formal reporting structures, must dominate the work environment. Teams allow far more flexibility in gathering skills from all parts of the organization and promote information and skill transfer around common goals such as clients or new products. When working well, individuals will consider that their association to the team serving a particular client is as strong as to the product line.

4. How to attract and develop the best people? European banks have struggled to attract top quality people outside their home markets, in part because of a reputation that young, talented individuals—particularly foreigners—would not be given sufficient opportunity. This must change. Merit rather than seniority must be the watchword. The very best international talent will be attracted by organizations that allow as much responsibility as early as performance dictates. The development of skills must also be given higher priority. Today, the occasional training program and a bonus check are all the feedback an individual receives. Personnel policies that separate development from evaluation and focus on providing coaching, and an agreed future development plan in respect to transaction type, job rotation, and training are critically needed.

These four issues are at the very heart of designing a high-performing organization for the wholesale markets. Success on these dimensions will be as difficult—but are as important—as the business strategy issues.

The next two years will be a defining period for investment banking. Many of these upcoming strategic moves will be irreversible and will alter the competitive landscape for all players. European players must aggressively define their own role, or it will be defined for them. The current downturn and industry restructuring are indeed painful, but they also present a unique opportunity for European players to chart a new course.