Bank clients see cross-sell pressure in swaps and clearing

European regulators are starting to look at competition in investment banking, with concern focusing on barriers to entry, bundling and concentration risks – issues banks claim have been aggravated by post-crisis reform. Catherine Contiguglia asks whether clients are getting a fair deal

Competition: are clients getting a good deal?

A lot of investment banking businesses might not look competitive to outsiders – the number of providers is fairly small and in some cases is shrinking; loss-making units are allowed to wheeze along indefinitely if they help hook more profitable activity; barriers to entry are high, pricing can be opaque and customers are in some cases being asked to swallow significant hikes.

It's a picture that worries European regulators, which have launched a number of initiatives to test how robust competition is and try to ensure customers are getting a fair deal. But the picture that emerges from conversations with banks and their clients is nuanced. For the most part, customers recognise some of the concerns – the growing pressure to give each bank a share of lucrative business, for example – but largely believe they have enough choice to get value for money, and enough information to judge that for themselves.

But Risk only spoke to six bank clients for this article – users of execution desks for over-the-counter derivatives and cash products, as well as debt and equity financing, and derivatives clearing, among other services. By and large, these were big companies, and should have been able to look out for themselves. Their experiences may not match those of smaller firms.

There is a lot at stake for the industry. If regulators decide there are problems with cross-selling – that it encourages mis-selling, for example, or makes pricing too confusing – they will call into question one of the strategic pillars on which much of today's fixed-income business is based. If they want to address concentration, it might mean lowering some of the regulatory burdens the banking industry now faces.

Since 2006, sell-side revenues in the securities business have dropped by 20%, according to research published in March by Morgan Stanley and consultancy firm Oliver Wyman. The report estimates return on equity for the top 15 global banks in 2014 was 7%, taking into account litigation costs and non-core businesses. Allocated equity increases due to regulation took 1.5% off industry returns in 2014, says the report, and a 2% decline in revenue due to weak rates and forex performance brought returns down another 0.5%.

The fact is, increasing regulation translates into increasing costs. What you would do in any business is to look at where you are making money, and where you are losing it

Boosting that number means deciding which businesses to keep, but also how to squeeze the most value out of every client relationship.

"This is a longer-term trend that has been accelerated by regulatory pressure and capital scarcity. It encourages investment banks to think about how to maximise the risk-based profitability of each customer or customer group by looking across multiple products and regions. However, banks must be careful when they think holistically about a client – and as they look to cross-sell or withdraw products – because they also need to be addressing various regulators' demands for transparency, appropriate conduct and fairness at the same time. That can be a tricky balance," says Jamie Woodhouse, London-based managing director of finance and risk for Accenture in the UK and Ireland.

Tricky, perhaps, but a balancing act banks can hardly avoid, argues Jérôme Bernard, head of the large French clients division at Crédit Agricole CIB in Paris: "The fact is, increasing regulation translates into increasing costs. What you would do in any business is to look at where you are making money, and where you are losing it. We tend to believe the client relationship is at the heart of our business. So we've delegated responsibilities to senior bankers to optimise relationships. While before we would have done it in more of an Excel-spreadsheet way, we are asking bankers to commit to this and seriously look at the long-term relationship."

The issue of competition in investment and corporate banking services has been raised in a February report from the UK's Financial Conduct Authority (FCA), as well as the Bank of England's Fair and Effective Markets Review launched last June. The FCA industry survey raised concerns about bundling of services and transparency in corporate and investment banking, as well as market concentration and minimum fees in client clearing, and will be followed by a market study of corporate and investment banking, details of which are to be published this May.

Market concentration

Market participants say concentration is most common in struggling businesses, such as fixed-income trading and client clearing – fewer banks are willing to provide the services due to higher regulatory costs and unattractive market conditions.

Further consolidation is expected in fixed income, where low interest rates have been a major drag, with flow rates consuming around 40% of industry capital while only generating 5–10% of profit before tax, according to the Oliver Wyman and Morgan Stanley report (figure 1). Credit trading also faces higher regulatory costs, which the report estimates will cause dealers to shrink the balance sheet for that business by up to 15% as they prepare for the arrival of new trading book rules – planned for year-end (Risk March 2015 and www.risk.net/2401536). This could be a self-sustaining trend, if asset managers try to safeguard their own access to liquidity by building closer ties with a smaller pool of dealers.

"The trend is to work towards more consolidation of relationships on both sides. For asset managers we talked to, it's about being relevant to the sell side, and making sure you're not the tail client. The fear that you are being cut off is certainly out there in a world of tighter liquidity and restrictive balance sheets," says Christian Edelmann, head of Oliver Wyman's global corporate and institutional banking and wealth and asset management practices.

Two asset managers that spoke to Risk agreed they concentrate a significant portion of their spending with a small number of large banks, but largely to take advantage of better pricing. This concentration is even more visible at smaller firms, they say, which have a smaller wallet with which to appeal to banks, and have less capacity to manage counterparties.

"Largely, if you look at the major five or 10 dealers we all know and love, they're all pretty good at the same things. So the choice comes down to relationships, and the buy-side trader will want to stick with the same two dealers where he thinks he can get a better price," says the head of risk management at a Connecticut-based asset manager.

In other words, clients may be choosing concentration. But in the current market, it remains a matter of choice – what regulators are worried about is a situation in which concentration is forced on customers. The OTC clearing business is starting to look like an increasingly good case study.

Most of the big dealers offer a client clearing business for swaps, the original strategic rationale being that clients would sign up with a handful of providers and give most of their execution business to those banks. But the costs of the business have mounted and the delays to Europe's clearing timetable mean expected revenues have been slow to materialise. Three banks have so far quit the business, and others have reined in their ambitions. On April 24, Risk revealed Nomura is now reviewing the future of the business.

In addition, the expected ties between clearing and execution have been weakened, as clients drift towards the use of swap trading platforms.

"As activity has moved to a more electronic style of trading, there is less involvement of a sales person, and so clearing from a sales relationship coverage point of view has become less of a strong argument," says a London-based head of execution and client clearing at a European bank.

As a result, the business is under more pressure to justify its existence, and costs are rising. One way of doing this has been the implementation of minimum fees, a practice cited as a cause for concern in the FCA report, but which industry sources say has become all but standard practice.

"Smaller participants in client clearing, which tended to be more aggressive from a pricing perspective and accommodative to clients with lower trading volumes, have exited the market, and now you can see minimum fees taking root across the industry. It'll depend on the bank, but on the low end it can be $5,000 per month, and on the high end it can be as high as $30,000 per month. If a client's trade volumes are fairly low, those minimums can be prohibitively expensive," says Luke Zubrod, director of risk and regulatory advisory at Chatham Financial.

Dealers argue they have no choice: "If you charged a client not doing enough activity the same as one doing a high volume of business, you'd lose money. So you have to charge a minimum amount for access to the service. In the commercial space, that is a rational action, and I don't think you can legislate or regulate your way around that," says the London-based head of European OTC clearing at a US bank.

Most recently, banks have sought to pass on the costs to customers by raising clearing fees. Risk recently reported that Goldman Sachs is raising its fees by 75 basis points, primarily to cover leverage ratio-related costs, and that at least three other clearing banks were looking to do the same.

While the FCA report highlighted concerns about increased concentration, the regulator also concluded it was too early to devote a market study to the business, because some of the relevant regulations are still in the works. It cited Europe's review of the Markets in Financial Instruments Directive as an example.

Cross selling

One way of justifying below-hurdle returns is to cross-sell other products – a loss-leading business is not necessarily a problem if it underpins client relationships that are profitable in the round.

"A number of institutions have specific incentive programmes to ensure cross-desk or cross-business line collaboration happens," says Oliver Wyman's Edelmann.

Crédit Agricole CIB's Bernard argues customers benefit, as well as banks: "If you had no cross-selling, and you looked for each transaction to stand on its own merit, it would be much more expensive for a large bank lending to corporates. It would be uneconomical for everyone. You have to think about what business you expect to do with the client in exchange for providing them with resources that are part of your costs and equity. If you commit these resources, and then find the client isn't providing you with the business, you will be fairly unhappy and would see the client as being unfair."

Regulators are wary, though, highlighting a number of potential concerns, including clients being pressured to buy services they don't need, uncompetitive pricing and the creation of barriers to entry.

Corporate clients agree post-crisis regulation is resulting in a harder sell from banks, which want them to take more ancillary services, while corporate risk management consulting firms say they have seen clients pushed to take services they didn't need or that were not compared with market prices.

In one instance in the past six months, consultancy firm Vedanta Hedging had a hotelier client refinancing around £125 million of debt at a new bank. As part of the five-year financing facility, the bank told the corporate it would also need an interest rate hedge to reduce the risk. "We said to the bank on behalf of the client, ‘Look, if you think this borrower needs some hedging, show us the evidence'," says Abhishek Sachdev, Vedanta's founder. His firm found interest rates would have to increase by around 15% before the client would be in breach of its covenants.

"We provided that information to the bank, and they said, ‘Ok, that's fine, but you still have to have hedging', and did not provide any other rationale. It doesn't make sense; you don't sell someone insurance if they don't need it," he adds.

Jackie Bowie, chief executive of financial risk advisory firm JC Rathbone Associates, says she has seen the same kind of behaviour: "The cross-selling element is very current, particularly in areas where the bank is the debt provider from its own balance sheet or is running a bond issue. Even when the bank is not underwriting or taking on any balance sheet risk, in this environment it is absolutely incentivised to see what else it can load into a transaction to make more money. And I think it's difficult for the client or corporate to say, ‘Do I really need this?'"

None of the four corporates that spoke to Risk for this article claimed they were being mis-sold products, but all agreed banks are pushing for a greater share of their business.

"Banks playing the ‘regulation card' to justify the intensifying call for ancillary business for every cent of balance sheet used has become a lot more common and noticeable since 2012. The pressure felt on the receiving end depends on the size of the corporate and how much ancillary business there is to share. Corporates with larger bank wallets are less dependent on bank lending because they have good access to capital markets. However, smaller companies have a harder time, as proved by my experiences interacting with peers in other companies," says a London-based assistant treasurer at a large UK corporate.

Another corporate that has mainly required financing services over the past year says a highly competitive lending market has increased pressure on banks to sell clients more profitable ancillary services.

"A lot of liquidity in the market has pushed prices lower. But on the back of that, there are some difficult conversations, and it is obvious the relationship managers are under a lot of pressure to get as much ancillary business as possible," says the head of treasury at a UK corporate.

Examples corporates give of cross-sold services include lending along with hedging, fixed income or cash management business.

"The bank sees lending as buying a ticket to try to cross-sell other products, but there is absolutely transparency for large corporates. However, for smaller corporates with fewer banking relationships and less business, you hear about bundling, typically of lending and derivatives. In that case, it is much less transparent because it's a matter of negotiation," says one head of treasury at an Italian corporate.

One chief financial officer at a UK asset manager largely involved in managing mutual funds, says harsher capital regimes have made banks reluctant to hold its short-term deposits. "As a result, they are less keen to take on such money, and will only do so if there is a wider banking relationship that is benefiting them on an aggregate basis," he says.

From other asset managers more involved in derivatives and prime brokerage services, the feedback is a bit different. As is the situation with OTC clearing, they say banks are intent on making each business individually sustainable.

"The Street used to view it as an overall relationship between the dealer and a client, where they were willing to lose a bit of money on some businesses if it helped with the broader relationship. What has changed over the past couple of years is every business is standalone with ROE targets. Each desk is fighting for its own business," says the head of risk management at the Connecticut-based asset management firm.

In his experience, relationship managers are losing ground as banks cut costs. "I know one dealer where an outstanding relationship manager was let go as part of the rounds of cost cutting. As a relationship manager, you're basically saying ‘I deserve part of the credit for that profit'. Now the individual desks are being held under the microscope, they are less willing to give the relationship manager credit," he adds.

This could be reinforced by a growing focus on best execution requirements. While there is not always a set definition of best execution, many asset managers feel it simply boils down to the best price, which means banks have to be increasingly transparent about their pricing and makes cross-subsidisation arguments a little harder to win.

"There seems to be two emerging themes. One is this kind of unbundling of services, and the other is best execution and what defines best execution. They intertwine at some point. People increasingly have a bias towards cleanliness in the process and in the products and focus on what the price of each piece is," says the US-based head of fixed income at one market-maker.

Transparency

If clients end up footing the bill for the additional regulation banks face, there is a silver lining: in some cases, they are also getting more transparency. The bill might be bigger, but at least it's now itemised.

"You've seen a lot more attention focused on repricing in Europe over the past six to nine months. Banks are saying, ‘This is what I am providing you, and this is the cost attached to those services that makes the relationship unprofitable. You need to remunerate us for liquidity cost, counterparty cost and market risk and servicing. So either I have to change the way I serve you, or you need to accept a higher price'," says Daniele Chiarella, Frankfurt-based head of the global corporate and investment banking practice at consulting firm McKinsey.

One example comes from the market-making business, where a combination of cost-cutting and new rules is resulting in more electronic trading for fixed-income instruments, including OTC derivatives. Some of the trading venues facilitate interdealer hedging and liquidity provision, while others allow all-to-all trading. The growing volumes allow buy-side firms to get a clearer sense of what the best bid or offer is at any point in time, and could bring about a revolution in best execution policies, which have traditionally been fairly flexible in OTC markets (Risk October 2014).

"The dominant trend is for asset managers to concentrate their business to get better terms – as in any other industry, if you concentrate on fewer players you can get some economies of scale. But investors also want to know they have a range of options for different markets and some insurance policies up their sleeves. One thing to do is to feed these new electronic platforms," says Huw van Steenis, head of European financial services research at Morgan Stanley in London.

In other wholesale businesses, such as capital markets services, clients say they feel confident that more regulation will also translate into greater transparency.
"I think it has improved, and also you can use advisory services like accountancy firms to get more transparency to make sure you are getting best execution," says the head of treasury at a UK corporate.

"I think things are definitely getting better. Large banks have been under pressure for a number of years. They have paid billions of dollars across Europe and the US, and the last thing they want is to get slapped on the wrist and pay another couple of billion dollars in penalties," says Thierry Monjauze, London-based head of European operations for boutique bank Harris Williams & Co.

Barriers to entry

While regulation might be encouraging more transparency, it can also make life more difficult for new entrants. Some investment banking services, such as mergers and acquisitions advisory, do not consume balance sheet and thus abound with small boutique firms. However, others, including capital markets services, execution and client clearing, all require increasing levels of capital that make it nearly impossible for new entrants to take on the incumbent players.

In theory, that might stifle competition and make it easier for cartel-style pricing to emerge – another concern for regulators. Customers that spoke to Risk for this article do not share those fears.

"In terms of barriers to entry, I would say they are highest in debt capital markets and derivatives – it's such a big investment in people and systems. But a large number of players are already in that market, so from a competition perspective, I don't think a new set of entrants is going to do very much," says the assistant treasurer at the UK corporate.

Other clients see healthy competition among providers of capital markets and advisory services. However, when it comes to derivatives execution and clearing, some fear the shrinking market could ultimately undermine competition, and even pose a threat to market stability.

"The significant bulwark of regulatory requirements erects a kind of barrier to entry. If you have designs on entering this market, the amount of regulations with which you need to be familiar and operationally capable of addressing are extraordinary. It's hard to imagine new entrants looking to become a swap dealer or client clearer. The cost and complexity really favours the incumbents, the largest players in the market. I think concentration is and will be an issue, and not likely an issue that will be solved," says Chatham's Zubrod.

For market-making, the potential solution offered by all-to-all competition on electronic platforms has its limits, some say – credit markets, for example, are less amenable to exchange-style trading (Risk April 2015).

"There are plenty of people offering services in electronic trading, but none of them have a footprint. You need to have buy-in from dealers and the buy side, and both are not embracing it. You need a first mover, like a Pimco or BlackRock, to choose a winner, and then everyone will follow. But they aren't incentivised to do it. So the barrier to entry is industry buy-in," says the head of risk management at the asset management firm.