(This story was originally published in IFR's Review of the
Year 2013, a Thomson Reuters publication)
By Christopher Whittall
LONDON, Dec 17 (IFR) - Fixed-income, currencies and
commodities units have been the banking industry's main cash cow
for years. But that looks to be coming to an end, as business
heads wrestle with new capital, leverage and derivatives trading
2013 is a year fixed-income traders would rather forget.
After a middling first half, things came to a head in the third
quarter when FICC revenues plummeted by as much as 50% compared
to a year ago.
This was quite a wake-up call for a business that had grown
used to producing more than half of investment banks' revenues
over the past decade. Fixed income was faced with the ignominy -
perish the thought - of being propped up by equities and capital
markets units, rather than the other way round.
This set off some frantic soul-searching in an industry
unsure whether the fall-off was a temporary blip that could be
put down to dysfunction in Washington DC and bungled
communication by the Federal Reserve, or a symptom of
irreversible decline brought about by increasingly stringent
"It's been a challenging year across the industry regarding
the traditionally strong fixed-income part of the business,
particularly rates trading, which has dominated the industry's
recovery over the past few years following the financial
crisis," said Andres Recoder, head of markets for EMEA at
FICC's day of reckoning, of course, had been telegraphed
since 2008. Much of the regulation penned in response to the
financial crisis, from Basel III to the US Dodd-Frank Act, is
aimed squarely at its bows.
But the long lead time before implementation - Basel III
does not fully hit until 2018, while the Dodd-Frank reforms only
started in earnest this year - combined with an amenable trading
environment in 2009 and 2010 to mask the extent of the problems
lying in wait.
To help cope with the 2008 crisis, global central banks
injected trillions of dollars of cash into financial markets.
And that helped fixed-income desks rake in record revenues of
US$131bn in 2009 - 16% more than at the height of the structured
credit boom in 2006, according to UBS analysts.
But under the new Basel rules, the lucrative businesses at
the heart of fixed-income trading - such as structured credit or
long-dated swaps - are now to be penalised with hefty capital
Along with a clampdown on proprietary trading, the framework
is intended to prevent banks from racking up large trading
losses that could endanger the wider system. Yet the regulations
also have the effect of constraining banks from reaping huge
returns during the good times.
New rules on derivatives will have a similar effect. The
increase in standardisation and the need to funnel trades
through clearing houses and on to exchanges now threaten to
disintermediate banks, squeezing profitability as compliance
costs rise and margins collapse.
"The confluence of the capital rules and the reforms around
derivatives trading protocols will mean there are some pretty
seismic shifts coming down the track in terms of business
model," said Chris Murphy, head of rates and credit at UBS,
which has taken a more ruthless approach to slimming down its
fixed-income business in response to Basel III than most of its
BLINDSIDED BY LEVERAGE
The regulatory coup de grace came in June 2013, when the
Basel Committee refused to back down from a minimum 3% leverage
ratio. The adoption of this US-centric metric blindsided many
European firms, most of which had not paid much attention to
capital versus total assets.
Traditionally the European tendency to lend directly to
companies rather than underwrite financing in capital markets
had left their balance sheets swollen compared with their US
rivals, even if many of these assets were low-risk and equally
"I'm comfortable with the concept of lower leverage. The
problem is that these rules might unwittingly encourage banks to
retreat from government bonds and repo activity, and buy
leveraged loans and inventory," said Colin Fan, global head of
markets at Deutsche Bank. "We find it hard to believe that is
the outcome regulators want."
As a result of the 3% leverage ratio, RBS analysts reckon
European banks need to cut a further EUR2.9trn - on top of the
EUR3.2trn of assets they shed between May 2012 and September
this year - in order to shore up their capital base.
Firms with historically powerful fixed-income units are
hardest hit. Deutsche Bank and Barclays announced plans to slash
up to EUR400bn from their balance sheets between them in July,
while the UK bank raised GBP5.95bn in fresh equity.
But it is a tough road ahead. Even though the two shed more
than EUR100bn of assets in the third quarter, their leverage
ratios remained unchanged at 2.3% and 2.2%, respectively. Other
European lenders in the line of fire include Credit Suisse,
which opted to scale back its rates business in October, as well
as UBS and Societe Generale.
"The leverage ratio is a huge constraint, but it will have a
greater impact on banks with large legacy fixed-income
businesses," said one banker. "Restructuring balance sheets
always costs more money, and it makes it hard keep staff
NO MORE REPO?
No one is expecting regulators to walk back their changes,
but bankers are clamouring for some tweaks to the rules, such as
allowing greater netting in repo activities as well as between
derivatives and collateral.
"The repo business is the main question. We expect netting
here because otherwise liquidity for government bond trading
will be impacted," said Danielle Sindzingre, global head of
fixed income and currencies at Societe Generale.
Part of the problem is how the different regulations fit
"Even the cumulative impact of currently proposed
regulations is poorly understood. The move towards central
clearing creates a greater need for sourcing and financing
collateral, but repo activity is pretty much the worst thing
that you can do with your balance sheet under the leverage
ratio," said UBS' Murphy.
"The focus on leverage is somewhat perversely incentivising
banks to make their balance sheets more risky, not less."
This means low-margin financing activities - such as revolving
credit facilities for corporates - will either have to reprice
or fall into obscurity.
So on what areas will banks focus? In terms of legacy
assets, hundreds of millions of dollars worth of derivatives
books have been earmarked for bilateral collapses. As regards
new business, there will be an emphasis on clearing derivatives
to avoid inflating balance sheets.
Many are also betting heavily on electronic trading, and are
piling money into new systems.
"Those that don't embrace an electronic trading approach
will struggle with the leverage ratio," said DB's Fan. "Our top
10 counterparties account for 60% to 70% of our derivatives
volumes under CRD IV, and the vast majority of that is
Such a move relies on robust volumes to make up for
collapsing margins. However, talk of being a "flow monster" in
fixed income has dissipated of late, as senior bankers focus
instead on their top 50 or 100 clients.
The hope is those clients will offer enough high-margin,
solutions-based business to offset the more meagre returns
gleaned from flow trading, which is increasingly viewed as a way
to recycle risk rather than generate profits.
"2013 has been a very challenging environment - it's the
first time in a number of years that there is no clear strategy
for everyone," said Thibaut de Roux, head of global markets for
EMEA at HSBC. "Banks aren't able to deliver every product to
every customer. They need to choose what their client base is,
and look to service it."
Meanwhile many European banks are grumbling about the head
start US banks have in tackling the leverage rules, as well as
the uneven application across jurisdictions. Some of this is
likely to be offset by US regulators' preference for a higher
ratio of up to 6%.
"Banks are being impacted in different ways, and we can
still see some trends of consolidation in the FICC space as
barriers to entry [and to staying] continue to rise," said
Citigroup's Recoder. "US franchises certainly seem to be doing
better during this part of the cycle."
And for now, at least, there is a notable correlation
between firms with higher leverage ratios and those with strong
FICC trading results. Deutsche bank analysts singled out
Citigroup, HSBC and JP Morgan in a November report as "global
commercial powerhouses" with "winning business models".
Their share of FICC revenues has risen to 27% this year
compared to 23% in 2012 and 17% pre-crisis. All three have
leverage ratios over 4%.
So for all its current woes, fixed income has a history of
confounding those who have written its obituary prematurely. The
sector may be down, but it is surely too early to say it's out.
(Reporting by Christopher Whittall, Editing by Matthew Davies)