Published in September 2016 by David Williams, Partner at Banking and Capital Markets EY Advisory
What should the high-performance investment bank of the future look like? That may sound like an unusual question given the current challenges faced by the sector, but it is one that needs to be answered for one simple reason – investment banking must innovate now so it can seize the opportunity and play a full role serving the real economy over the coming years.
Eight years after the financial fallout of 2008 and faced with stubbornly high structural costs, heavy capital charges and stagnant revenues, investment banks’ returns on equity (ROE) continue to disappoint. Rather than take a long-term approach to future growth, many capital markets firms are still primarily focused on firefighting – delivering changes mandated by regulators or driven by external threats – rather than innovating.
This brings its own set of problems. The combination of complexity and unrelenting pressure to meet regulatory deadlines is causing organizational fatigue within banks. This is clouding management decision-making exactly at a time when investment banking leaders should be looking further ahead. When investment banks do take a step back, they will see a landscape being shaped by a series of megatrends that offer major opportunities. They include:
- Increasing prosperity
- An explosion of entrepreneurial growth
- Increasingly connected global trade routes
The core purpose of investment banks, to flow capital around the real economy, to facilitate global trade and to manage risk, continue to be valid. If anything, the opportunity increases rather than shrinks. Added to which, the personas behind the clients that they service are increasingly millennial, while there is a relentless reshaping of business through digital technologies.
That’s where FinTech comes in.
Finding the right FinTech fit
Digital innovation is nothing new in the capital markets. Investment banks were early adopters of digital technology, and the technological advances they made in the front office for trading and analysis arguably outpaced the developments in many other industries. In some cases, however, notably with the rapid increase of high-frequency trading, and product innovation that went a step too far, the industry arguably became a hostage to its own technological innovation.
The next generation of digital innovation has to be more balanced. It must enable a trading culture that is sustainable and it must incorporate the benefits of digital innovation into all parts of the business, creating a leaner, more connected ecosystem.
Today, there are more than 5,000 FinTech firms currently in operation and the proliferation of these financial technology start-ups is increasing as they take advantage of today’s low costs of technology platform development and the current lack of innovation within banks.
New technology can be harnessed to further innovate the front office. Take the world of advanced analytics, for example. There are new offerings around predicting trading patterns, understanding investor behavior and sentiment, and providing more accurate data visualization provide obvious advantages for the trading desk and the research and marketing departments. Then there’s the potential of game-changing technologies like blockchain and artificial intelligence (AI), which in the longer term have the potential to address structural costs in the middle and back offices where costs have increased as a result of under-investment during better times.
In simple terms, we believe investment banks should embrace a FinTech adoption strategy that identifies long-term potential while prioritizing short-term gains. A new joint report from EY and Innovate Finance titled Capital Markets: innovation and the FinTech landscape, evaluated the most prominent FinTech trends and assessed both their potential to shape investment banking and when they will begin to have an effect.
As Figure 1 [below] shows, it’s clear that, at present, investment banking firms should be looking for the quick win by harnessing the efficiency savings offered by some of the more mature FinTech trends even as they look forward to what these highly promising (but still relatively untested) technologies can offer.
We believe the investment banking sector should look at innovation in much the same way that it would plan a multi-year portfolio. Some established technologies already offer short-term returns for firms both on an enterprise level and for specific point solutions. Cloud computing is approaching maturity, and its core benefits in the form of lower costs, reduced capital expenditure, scalability, flexibility and speed of setup are well understood. However, investment banks continue to have some reservations about the cloud from a risk management point of view and regulatory considerations remain over data privacy, location and transfer. As a result, many firms are opting to adopt private cloud which provides some, but not all, benefits of the technology.
Process and service externalization is another concept that offers real short-term opportunities. In general, externalization offerings (which include managed services, platform-as-a-service and industry utilities) share the underlying principle that the service can be performed more effectively — whether that means at a lower cost, greater speed, higher quality or lower risk, or a combination of some or all of these — by an external third party than it can within the investment banking firm.
Then there’s the fast-moving field of robotic process automation (RPA) that can replace clerical roles and processes and help to reduce costs (typically by 50% to 70% for high-frequency tasks) while delivering dramatically improved quality, consistency, reliability, control, traceability and increased agility.
How investment banks and FinTech should engage each other
Identifying the need to innovate in the right areas of the business is just the first part of the puzzle. The next step is choosing the right technology partners for an investment bank, and this can be a challenging process not least because of capital market’s complex infrastructure, operating model and culture. FinTech companies tend to have a far stronger understanding of technology than they do the intricacies of capital markets. At the same time, investment banks are expected to deliver short-term returns while the benefits of technology-led innovation normally are realized in the long-term.
For FinTech to succeed, it is crucial that corporate culture makes clear that innovation is expected — and indeed required — of leaders within the organization. The firm also needs a governance framework that supports efficient innovation. And it must support a way of working that allows innovation initiatives to “fail fast” and encourage the lessons learned to be built into future cycles.
How innovation is integrated into the operating structure of investment banks also plays a big part in its long-term effectiveness. Some firms have adopted a centralized approach whereby they establish a dedicated innovation team operating under a chief innovation officer (CIO) that is distinct from the firm’s business units. Others prefer a decentralized model where individual business units run their own projects and work independently with the external FinTech marketplace.
Both models have their own merits but we believe that investment banks should embrace a hybrid model if they are to have the structure and also the flexibility needed to really take advantage of the FinTech revolution. Our hybrid model exists under the premise that a defined, distinct innovation team helps to set the right tone and message, and that innovation needs clear leadership.
However, it also works under the premise that the distance between pure innovators and business units needs to be compressed as much as possible. We believe that the best of both worlds is a focused central team, with representatives (selected for having innovation in their DNA) seconded in from business units. With this model in place FinTech innovation is both championed at the highest level and is allied to the strategic business needs of individual business units.
The future ecosystem
At the start of this article we posed the pressing question: what should the high-performance investment bank of the future look like? Based on the trends that we see emerging in capital markets it is already clear that the investment bank of the very near future will look nothing like ones that have come before.
Moving forward, investment banks will look to improve agility and reduce cost by assembling components that exist externally in the marketplace. The talent and intellectual property in the front office will be supported by AI and analytics to best serve clients. Best-in-class trading platforms are likely to be supported by a highly automated, and potentially largely externalized, blockchain-enabled, back office. As B2B platforms and marketplaces evolve further in the real economy, expect to see investment banking channels embedded within these. Collaboration will be key, even between competitors, where the white labeling of services could become more common as the industry rejects replication of costs in favor of a smarter approach.
It is not realistic for today’s investment banks to adapt to this model overnight. Ultimately, in today’s FinTech environment everything is ripe for innovation, so for capital markets firms, now is the time to evolve, or risk facing ongoing challenges to deliver acceptable ROE for years to come.