Capital markets have changed fundamentally following the global financial crisis. In this chapter we discuss the transition from the pre‐crisis period, when investment banks enjoyed record profit levels, to the world we observe today. We discuss in detail the main measures that the regulators introduced following the crisis and their impact on investment banking business models. We conclude with a discussion on the effects of these changes on the functioning of capital markets.

THE SITUATION PRIOR TO THE GLOBAL FINANCIAL CRISIS

Sales and trading in fixed income and equity instruments and primary market investment banking activities enjoyed a period of tremendous growth from 2000 to 2007. Industry revenues almost doubled to $300bn over this period. This compares to global GDP, which rose 60% in nominal terms over the same period. Investment banks posted record profits and advertised high targets for shareholder returns on equity.

This strong industry growth had several drivers. Benign economic conditions and strong economic growth in most regions globally accelerated asset accumulation and drove up investor appetite for risk assets. Liberalization of banking structures and of national financial systems meant that banks could benefit from a wider array of funding sources and compete in a wider range of markets, leading many to acquire smaller rivals along the way. Financial innovations, such as the invention and adoption of new kinds of derivatives and structured products, and the increased use of leverage when running capital markets operations, enhanced the financial toolkit that banks could deploy to generate revenues.

Banks also managed financial resources in a simpler way than today. Most banks primarily focused on generating revenues and converting leverage into profit. Banks generally manage to “economic capital” as the firm's scarce resource, measuring capital needed using internal statistical models that captured various drivers of risk and resource consumption. Minimum capital requirements imposed by regulators were rarely binding (for example, the expectations of banks' investors as to what tier‐1 capital ratio to maintain were often more stringent than the regulatory minimum ratios), and liquidity was readily accessible in the markets. The usage of capital, leverage, liquidity, or funding was sometimes allocated internally for the purposes of performance measurement and resource prioritization, but the respective trading desks had to cope with relatively few constraints.

And more broadly regulatory constraints were not as stringent as today. For example, there was little in the way of monitoring or capitalization of derivative positions, or meaningful restraints on the amount of total leverage that wholesale banks could deploy. Because of this, banks allocated financial and operational resources to those businesses earning the highest return on economic capital—as a result, growth in structured derivatives, securitization, prime brokerage, and structured credit all accelerated. Equally, a looser standard of governance existed in the back office, with derivatives collateralization often less than complete and over‐the‐counter derivatives had significant settlement backlogs.

In this way, the wholesale banking industry's growth in revenues and profits was driven as much by the relatively permissive regulatory environment and looser financial resource management as by the macroeconomic and market conditions.

OVERVIEW OF REGULATION INTRODUCED 2008–2015

The global financial crisis had many causes and expressed the weaknesses of the financial system in many different ways. Both standalone broker models and global universal banks sustained heavy losses and either went bankrupt, sold themselves to competitors, or in many cases needed public bailouts. However, it was largely the standalone investment bank models that ceased operations altogether as the universal bank models benefited from diversification—although these banks, too, sustained very heavy losses in a few cases. Example weaknesses within the wholesale banks that were identified by regulators included:

• Hidden leverage in the system built up through the use of derivatives, which were largely treated as off–balance sheet exposures and were often not fully capitalized
• Insufficiently sensitive and often underestimated market risk capital charges for traded capital markets products
• A lack of accounting for counterparty credit risk in derivative exposures, which were often less than fully collateralized and without sufficient capital
• A lack of robust liquidity and funding risk frameworks at banks, with an overreliance on short‐term funding backing up often less‐liquid assets
• While still small in absolute terms, a growing reliance on proprietary trading and/or principal risk‐taking to boost profit generation within the context of banking structures often funded partially through retail deposits
• Insufficient compliance and controls frameworks, leading to several large scandals, including the Libor interest rate rigging affair

To tackle these weaknesses, global and national financial regulators introduced a raft of regulatory reforms, the bulk of which were accounted for at the global level by Basel 2.5 and Basel 3, in the United States by the Dodd‐Frank Act, and in Europe by regulatory reforms such as EMIR or MiFID as well as various country‐led initiatives such as the Vickers reform in the UK. While the cumulative weight of regulatory reforms runs to several thousand pages, the principal ambitions from the regulators can be summarized as:

• Increasing the amount and quality of capital that banks (especially banks deemed systemically important) use to back their assets
• Restricting leverage in banks' balance sheets, that is, the ratio of debt to equity
• Improving the liquidity positions of banks
• Ensuring more stable funding (i.e., promoting a longer‐term funding structure with less reliance on short‐term wholesale funding)
• Limiting risk‐taking, in particular preventing banks with retail deposits from taking proprietary trading risks
• Upgrading governance standards, enabling a fundamental change in bank governance and the way boards interact with both management and regulators

These ambitions were expressed in various new post‐crisis rules and approaches. Some prominent examples include:

• Higher standards of capitalization ratios, expressed by core equity and tier‐1 ratios, that is, the amount of capital a bank needs to hold for a given amount of risk‐weighted assets. Basel 3, one of the cornerstones of post‐crisis global financial regulation, forced up minimum ratios to an 8% minimum total capital ratio, plus a 2.5% capital conservation buffer. For many global banks this was a significant hike in the amount and capital—but also in the quality of capital, as previously there had been a large amount of hybrid capital and other capital types allowed to count towards banks' capital, versus the newer approach of a much tighter definition of core capital, that is, primarily tangible common equity.
• Introduction of additional capital buffers for the most complex banks. As part of the authorities' stated desire to tackle the issue of “too big to fail” in the wake of the crisis, after rescues of financial institutions and failures of complex organizations, new rules also forced the most complex financial institutions to hold additional capital buffers of up to 2.5% of RWA (on top of the capital conservation buffer).
• As well as needing to hold more capital for a given level of RWA, risk weightings for assets also increased. The set of regulations known as Basel 2.5 increased market‐risk‐weighted assets. Within Basel 3, new charges for counterparty credit risk were introduced. More recently, newer rules such as the Fundamental Review of the Trading Book and the move to a standardized approach for risk‐weighted assets caused further increases in the amount of capital which banks must use.
• As a complementary measure to the risk capital ratios, Basel 3 introduced the leverage ratio, which was intended to be a measure of total exposures regardless of risk profile. The Basel 3 leverage calculations brought much of previously off–balance sheet activity into the capitalized perimeter. Although many market participants expected the leverage ratio to be intended to be a backstop to the risk capital requirements, the introduction of the leverage ratio has turned out to be a major focus for banks with large capital markets operations, in many cases necessitating widescale optimization programs and putting pressures on balance sheet and inventory.
• Because several of the large stress events of the financial crisis were liquidity related, regulators introduced the liquidity coverage ratio (LCR). It requires banks to hold an amount of highly liquid assets (e.g., cash and government bonds) generally equal to 30 days of net cash outflow. This requirement is supposed to ensure that banks can meet any immediate cash shortages through the sale of liquid assets. Liquid assets generally do not include lending, and so this requirement also restricts lendable assets. In the current interest rate environment this has led to a situation where the cost of funding can be higher than the yield on these liquid assets.
• The net stable funding ratio (NSFR) was designed to strengthen banks' funding positioning by forcing a terming out of the funding profile of banks. The NSFR is yet to be fully phased in and is again expected to increase banks' overall cost of funding capital markets positions.
• The Volcker Rule in the United States stamped out much previous proprietary trading activity and oriented the industry toward a more client activity–focused revenue‐generation model.
• In derivatives, the whole infrastructure of trading was overhauled. Dodd‐Frank in the United States and MiFID in the EU mandated much of the market for simpler derivatives to be executed electronically on exchanges or so‐called swap execution facilities (SEFs), which includes centralized clearing.
• Regulators combined many of the new measures above into consolidated stress‐tests which require banks to hold adequate levels of capital and liquidity to survive simulated periods of severe market volatility. The Fed's Comprehensive Capital Analysis and Review (CCAR) program in the United States has become a major focus point for all large financial institutions.

Many of these regulations were intended to be implemented globally with consistent standards. While a certain amount of initial harmonization was achieved, along several dimensions regional fragmentation of rule application started to appear, for instance, in the timelines for pushing derivatives to be cleared, with the United States leading the way and Europe initially lagging behind. Many regulators have also deployed tougher standards on their home country banks, the “Swiss finish” by FINMA, the Swiss capital markets regulator, being the most prominent example. In summary, the regulatory landscape has become more patchwork and hence increased the complexity of operating international investment banks. It also led to the occasional accusations of an uneven playing field between banks of different jurisdictions.

IMPACTS ON BUSINESS MODELS

The regulatory reform landscape, in combination with stagnant GDP in many markets, particularly in Europe, has started to significantly impact business models. It has affected the industry's revenue‐earning capacity, it has led to a significant increase in costs of operations, and we are starting to see an impact on competition and concentration levels in the industry. We explore these three trends in this section:

1. Reduced revenue‐earning capacity
2. Increased cost of operations
3. Changing competitive landscape

Increased Cost of Operations

As a result of the regulatory reform agenda, banks now need to manage their business against a varied set of financial constraints as shown in the following (Figure 3.1).

In a world of multiple binding constraints, pursuing activity in one area consumes capacity to pursue activities in others—that is the essence of the optimization challenge. However, it is extremely unlikely that any institution will find itself up against all binding constraints at once. This creates a comparative advantage that can be used to pursue new opportunities. For example, an investment banking business with an outsized repo financing book may be up against the leverage‐based capital constraint, but consumes relatively low levels of RWA (risk‐based capital) or liquidity and funding. This will generate capacity to pursue more RWA‐consumptive business (e.g., structured) or more liquidity‐ and funding‐consumptive business (e.g., mortgages) with a relative pricing advantage over risk‐based capital or liquidity and funding constrained competitors, all else equal. Moreover, risk–return comparisons are extremely sensitive to changes in interest rates, which make it even more difficult to draw strategic conclusions.

Against this backdrop, investment banks' strategy setting is increasingly encompassing both franchise‐ and resource‐driven decisions. Franchise‐driven decision making has always been a feature of strategic planning—identifying and prioritizing the “crown jewels” of the franchise where the business enjoys genuine competitive advantages, be they client types, product groups/structures, or geographies. Multidimensional resource‐driven decision‐making is the new frontier, requiring a deeper understanding of how the pursuit of crown jewels creates advantages or disadvantages in the pursuit of other opportunities (and ultimately drives economics).

Banks are responding to this challenge in different ways. Almost all have been upgrading their internal information environment, so that calculations on how much different clients and products are consuming across risk capital, liquidity, and balance sheet can be produced quicker, more accurately, and at a more granular level. Most banks have re‐educated their front office, such that salespeople, traders, and originators are now cognizant of the financial resource implications of positions they are about to create. And a significant subset have started to pass these financial resource costs down to the position level, such that the economics of positions are fully loaded in terms of financial resource costs.

As a result of this, we have seen the cost of operating these businesses going up. Banks have significantly invested in their risk management and compliance capabilities. Running the regulatory reform agenda such as CCAR, the stress‐test operated by the Fed in the United States, can cost tens of millions of dollars. This is happening at a time when banks need to invest in new (digital) capabilities and to “keep the lights on” for—in many cases—hundreds of legacy systems, which can date back to the 1980s. With the future regulatory landscape now clearer, but with new regulations such as the Fundamental Review of the Trading Book set to make the way risk and finance interact with infrastructure even more important, many banks are looking to rationalize their technology estates—again with post‐crisis regulation the driving force.

More, as local regulators step up their efforts to protect home market interests such as depositors, costs of operating in any additional country have gone up tremendously. This is triggered by local capital, liquidity, and funding requirements. In various countries, there are also local language reporting requirements or needs to store data locally which can lead to duplications or inefficiencies when aiming to run a global business.

Changing Competitive Landscape

The shape of investment banks' participation in the markets is evolving in two ways: The banks are becoming more selective in their product and client portfolios, and non‐banks are picking up some of the value chain.

Because of the new regulatory and market pressures, banks have taken a harder look at their own areas of excellence and areas where they lag peers in service provision and this is increasing the dispersion in competitive models. Whereas in the pre‐crisis period, many banks had similar business models leveraging similar strengths, this is no longer true. Looking at the top 20 financial institutions active in sales and trading and investment banking, many different models are observable. Some are corporate‐focused models, typically leveraging strong fixed‐income capabilities such as Rates and FX, looking into adjacencies in transaction banking (e.g., payments cash management, trade finance) to provide a more comprehensive offering to their CFO and corporate treasurer clients. Some are focused on serving institutional investors, primarily with equities capabilities, whereas others are more wealth‐focused, catering to the needs of (ultra)‐high‐net‐worth clients in combination with asset and wealth management arms. Others again are specialists in emerging markets assets and service models with depth in certain geographies and emerging markets products.

All of this has led to a large amount of competitive flux which continues to shake up the competitive structure. As shown in Figure 3.2, the market could see as much as 5% of market share open up in the latest round of strategic restructuring exercises, less than half of which is currently in flight. To put this in context, the market share released in the wave of restructurings and exits from fixed‐income businesses over 2010–14 was equivalent to 4–5% of industry revenues.

Historically, wholesale banks often dominated the entire value chain of securities market‐making (e.g., client coverage, content and advisory, connectivity, execution, post‐trade, clearing and settlement, collateral management). The larger market share competitors generally still do, but several smaller institutions are taking a far more selective approach to the value chain and are dropping out of some activities altogether while non‐bank financial institutions have been picking up market share.

A proliferation in non‐bank market makers has arisen, partially caused by the pressure on bank returns causing retrenchment, and partially caused by improved efficiency in vended solutions enabling more agile trading systems infrastructure in a quasi‐startup environment. Non‐bank proprietary trading firms, electronic market makers, and alternative trading venues now play an important role in securities trading. For instance, Citadel, a hedge fund, was the third biggest market maker by number of trades in U.S. interest rate swaps in Q1 2015. And in May 2016 it was announced that XTX Markets, a computerized trading firm, had risen to fourth in the Euromoney FX rankings. This represents a powerful new source of competition for wholesale banks and one that threatens to disintermediate traditional business models; on the other hand, it also represents an opportunity for a potentially more collaborative relationship between wholesale banks and non‐bank operators.

In most individual business lines within investment banking, concentration has increased. In specific product categories such as Credit and Securitized products, concentration levels have shot up materially (Securitized product sales and trading revenues top‐5 concentration has increased 10 percentage points over this period). As more banks are likely to exit entire business lines, we may end up with rather oligopolistic markets. This may at one point shift the regulatory agenda more toward sustaining a minimum level of competition and avoiding further fallouts—a big task in a business that comes with significant economies of scale.

HOW IT IMPACTS THE FUNCTIONING OF CAPITAL MARKETS

The forces of change imposed on investment banks have also had a broader impact in the securities industry as a whole. There has been a clear shift in value capture. Since 2006 sell‐side revenues have fallen by 20%, whereas buy‐side revenues have risen 45% and market infrastructure has stayed flat. Banks cutting capacity and de‐risking is an important factor. But the macroeconomic climate has also supported this shift as quantitative easing has translated into strong asset growth benefiting asset managers. Low volatility and weak economic recovery continue to depress sell‐side revenues. Revenue capture by market infrastructure providers—including custodians, execution venues, clearinghouses, and data providers—is broadly flat, albeit with significant shifts within this group, mainly toward the tech and data providers.

But risks have also been shifting. The sell‐side is continuing to de‐risk across the board, while risks in the market infrastructure (MI) layer have grown with the introduction of central clearing and initial margins.

The biggest shift has been toward the asset owners. While liquidity provision by banks is falling, AuM in daily redeemable funds has grown rapidly, up 76% since 2008, with >45% of all globally managed assets now sitting in daily redeemable funds, up by 3 percentage points since 2008, with increased investment in less liquid asset classes (e.g., high‐yield credit). With the continued growth of defined contribution (DC) an even larger share of total industry assets sit in retail‐related funds, although DC structures such as 401(k) plans in the United States are stickier since investors can only switch funds rather than redeem outright.

Yet in this new environment, execution conditions have also changed, particularly in cash bond markets. Here, the principal focus lies with liquidity, that is, the ease with which clients can buy and sell securities with limited market impact within a given time period.

Credit trading is a key focus point today, with the prospect of rising U.S. rates adding an additional amount of urgency to the debate. A confluence of a significant surge in primary issuance since the crisis, a strong growth in mutual fund holdings with daily liquidity, and markedly lower dealer inventory levels combines to prompt many market participants to fear a liquidity‐related market dislocation in credit. Debt issuance has grown at a 10% CAGR globally since 2005; primary issuance in 2014 was 2.4 times 2005 levels. Mutual funds offering daily liquidity have more than doubled their holdings of U.S. credit since 2005 and now hold 21% of outstanding securities, compared to 11% in 2005. And dealer balance sheet in corporate credit is down 30% globally since 2010 and we expect another 5–15% to come out.

The ultra‐low interest rate environment pushed investors toward higher‐yielding assets, creating strong demand for corporate credit, while issuers have looked to take advantage of attractive financing terms and to move away from pressured bank lending. Some of the strongest growth has been in HY markets. While there is evidence to suggest little degradation in liquidity in terms of standard measures (for instance, bid–ask spreads or total volumes traded), there is equally much anecdotal evidence that a lack of risk appetite and capacity means that it is harder to execute large (“block”) trades that would traditionally require a dealer to take principal risk and hold a position over a period of time.

The pressures come from a number of sources:

• Most directly, capital and funding costs on dealer inventories have increased 4 to 5 times.
• Many dealers also cite the massive contraction in activity in the single‐name CDS market as a key factor making it harder to hedge and manage risk in corporate bonds (single‐name CDS volumes have dropped ∼70% in response to specific regulatory pressures).
• Many also cite concerns around proprietary trading limits (e.g., Volcker) and earnings volatility as another constraint on risk appetite.
• Many market participants feel that increased requirements on transparency (such as TRACE in the United States) have made providing liquidity through market making more challenging (for example, by recycling risk back into the market in the given “transparency window” once a position has been taken).
• Some also feel that increased buy‐side concentration in credit and the growth of passive strategies (e.g., trackers, ETFs) have contributed to an environment of more correlated flows.

The concern is that while holdings of corporate bonds have materially shifted toward mutual fund structures that offer daily liquidity to their investors, the liquidity of the underlying assets has significantly reduced—although there is actually considerable debate about whether market liquidity has actually reduced so far or whether the impact would only be materially felt in a period of market stress. Dealer inventory is now down to less than 1% of outstanding credit securities globally, or circa 1.5% of mutual fund AuM. In 2005 these statistics were ∼2.5% and ∼19%. Put differently, a recent IMF study suggested it could take 50–60 days for full liquidation of a U.S. high‐yield fund, compared to the 7‐day limit for redemption payments on U.S. funds.

On one hand, improvements in financial technology have enabled the proliferation of electronic sales, which has enabled faster and easier trading for clients at a lower cost than the older voice models. Electronic trading platforms have also introduced new trading protocols, which have benefited market liquidity by increasing the pool of potential participants. On the other hand, the regulatory reforms have driven banks to decrease the total size of trading inventory in products such as investment‐grade and high‐yield bonds, where banks were the traditional matchers of buyers and sellers of bonds. Because of this smaller presence of wholesale banks in the market, there is much anecdotal evidence that institutional investors are finding buying and selling bonds in large size more challenging than 10 years ago; and many investors who are not finding challenges in buying and selling bonds today are concerned that in a market volatility or crisis situation, liquidity conditions would dry up completely as the market‐clearing infrastructure that previously existed could cease to function in any meaningful way.

Moreover, electronic trading and new marketplaces will grow—but will not entirely solve the fundamental concerns. There are a host of initiatives underway to increase electronic trading, establish new data networks, launch new agency execution models, and create new marketplaces. However there are limitations to how far electronification will go in fixed‐income markets in the next few years given instrument heterogeneity. For example 15% of volume in credit is electronically traded today, and even aggressive estimates see it as unlikely to grow to more than 25%. More importantly, electronification doesn't improve liquidity in tail events, per se; this would require more fundamental changes to increase standardization, which in turn would bring trade‐offs for issuance flexibility and investment portfolio construction.

As with much in finance, there are not many easy solutions to the liquidity conundrum as policymakers face an unresolved conflict among regulators' 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. Yet resolution of this conundrum is critical to ensure capital markets remain effective channels of funding to support the global recovery.