FICC is dead. Long live FICC?

The long, slow decline of the fixed income business has highlighted the inability of most investment banks to adapt their business models to a changing landscape – and raises serious questions for the future of the entire industry.

Sometimes you have to be cruel to be kind. The fixed income business has been in such poor health for such a long time that it might be kinder to put it out of its misery. The problem is that although it is obvious that the business is ill, it is less clear whether that illness is terminal – and how or whether the investment banking industry can adapt to it if it is.

The fall of FICC has been brutal. In the first quarter of this year revenues fell by 16% in dollar terms, according to my analysis of the fourteen largest investment banks. That wasn’t a one-off: over the four quarters to the end of March, revenues fell by 12%, capping a pretty miserable five years.

This relentless decline has pushed down revenues by more than 40% from their post-crisis bounce in 2009 to their lowest levels in a decade. Over the past five years, the collapse in FICC has blown a $67bn hole in the top line of the biggest investment banks. You have to sell a lot of equities and advise on an awful lot of M&A deals to make up the difference.

This is going to hurt

And it’s going to get a lot worse before it gets better. JP Morgan has warned that its trading revenues could be down by 20% in the second quarter, and Citi thinks the drop could be as bad as 25%. At that rate, FICC revenues in the first half will be down by between 15% and 20% across the industry. And, over the next few years, capital requirements, the Volcker Rule and other regulatory reforms are going to make parts business even less attractive, and that’s even before interest rates go up.

The worry is that the banks’ collective response to this downturn has not been encouraging. After years of headlines about brutal job cuts, tough business decisions and slashed bonuses, you might have expected investment banks to have significantly cut their costs. But instead, they have actually edged up by 1% since 2009 (and only three firms – Goldman Sachs, RBS and UBS – have cut their costs by more than 10%).

If revenues from your biggest business roughly half and your costs stay the same, nasty things are going to happen to your bottom line. Perhaps not surprisingly, relationship between FICC revenues and pretax profits is remarkably linear. As the chart below shows, profits have fallen by exactly the same amount as FICC revenues over the past five years:

These profits are flattered by differences in applying capital requirements and whether firms include legacy businesses in their reporting or hide them under the bed. But it seems pretty clear that the investment banks are uniquely sensitive to the health of the fixed income business.

Structural or cyclical?

This does not bode well if the decline in FICC revenues turns out to be more structural than cyclical. If you assume that regulatory reform has permanently erased one third of the annual run rate of FICC revenues, then the annual run rate should be somewhere between $80bn to $85bn. That implies a fall of a further 10% or so from current levels before things even hit the bottom. If you assume, more optimistically, that half of the recent decline in FICC revenues can be clawed back, that means growth of 15% to 20% could be just around the corner.

The industry is split down the middle. On the bullish side, Gary Cohn at Goldman Sachs said recently that when times are tough people always think things will not recover, Anshu Jain is betting the future of Deutsche Bank on at least a partial recovery in FICC, and Jamie Dimon has encouraged sceptics to think about growth in the longer term.

On the less bullish side, John Gerspach, chief financial officer at Citi, has talked of having to fight harder for a share of a “shrinking pie”. Some banks that had clung on in hope of a recovery are finally throwing in the towel. Whether they believe in a recovery or not, they have accepted that they cannot afford to wait around for it to happen. Barclays, Credit Suisse, RBS and UBS have all pulled back to a greater or lesser extent. Others may yet follow.

Waiting for a miracle?

The worrying thing for those left standing is that there is plenty to suggest that a recovery in FICC might come later rather than sooner. More than two thirds of the investment banks’ business used to come from other financial institutions – often each other – and as the entire industry contracts, that may take some time to recover. Much of the growth in fixed income revenues was the result of 20 years in which debt grew at an unsustainably high rate relative to GDP. And the combination of deleveraging, regulatory reform and more standardisation of derivatives does not bode well for a recovery.

This raises serious questions about the future business model for big investment banks. Those banks that have pulled back are struggling to fill the gap and will always wonder what might have been. Those who are half-heartedly clinging on to parts of the business might be better off pulling out completely. And those who decide to stay the course may yet find themselves in intensive care for some time to come – and will probably have to reinvent themselves and their model on the other side of a recovery – if and when it comes.