While falling fees pressure revenues for funds, banks are anticipating room to grow revenues and earnings from a moderating pace of regulation and accelerating tech efficiencies.
Morgan Stanley Bluepapers, a product of our Research Division, involve collaboration from analysts, economists and strategists across the globe and address long-term, structural business changes that are reshaping the fundamentals of entire economies and industries around the globe.
For the past decade, while bankers have been squeezing costs to claw back profitability, fund managers have enjoyed steadily rising revenues and returns.
Now, the tables are turning.
Banks and asset managers are about to trade places, according to a recent collaborative Bluepaper from Morgan Stanley and the consultancy Oliver Wyman on the state and fate of the financial industry. Asset managers, such as mutual funds, are facing growing pressure from low-fee passive investment tools—such as exchanged-traded funds (ETFs)—that are diverting their volumes and pressuring revenues. Meanwhile, banks may benefit from a more stable regulatory environment, which could free up excess capital that can be put to work, at the same time as years of investment in tech upgrades and innovations start to pay off.
After four years of falling revenues, single-digit returns and waves of restructuring, banks can now see a clear path to above-hurdle returns.
“A tempering of regulation, improving revenues, and new technology look set to drive wholesale bank returns up by 13%-14% by 2019,” says Betsy Graseck, Head of Global Banks and Diversified Financials Research and U.S. Large Cap Bank Analyst at Morgan Stanley. Meanwhile, in the bear case, asset managers could see their revenues shrink by as much as 30% over the same period, says Christian Edelmann of Oliver Wyman.
One clear winner: Consumers, who will benefit from lower asset management fees on their 401(K) retirement plans and other fund investments. Meanwhile, more capital and liquidity in global capital markets could lower credit spreads, making it easier for businesses to take out loans to finance growth, replace aging equipment, or hire new employees. All of those developments would be good news for economic growth.
Headwinds and Tailwinds
For banks, the potential easing of capital requirements is a key swing factor. Following the global financial crisis in 2008, global regulators implemented new rules aimed at preventing any future meltdowns. No one expects a rewriting of that regulatory framework. Rather, the current assumptions are based on a more quantitative approach to ongoing financial stress tests, a tempering of liquidity and capital ratios, and other measures. Given those conditions, “Our base case factors in a 20% reinvestment of excess capital, about $20 billion, over the next five years, primarily in the U.S.,” says Graseck. European banks will also benefit, to a degree, says Magdalena Stoklosa, Head of European Financials Research for Morgan Stanley, as additional requirements come through in a less onerous form.
Growing business confidence, rising interest rates, elevated volatility, and increased capital capacity are all strong tailwinds; however, despite the improved revenue outlook, “we don't expect the headwinds of recent years to be entirely reversed” says Graseck. Changes in client behavior and market structure are here to stay, and few banks will be re-entering shuttered business lines. Morgan Stanley’s base case forecasts a 2% annualized rate of revenue growth over the next three years, with industry returns at 13%-14%.
The bull case dares to dream. “If the U.S. administration’s tax reform, fiscal stimulus, and deregulation agenda is achieved, we would expect much stronger revenue growth and more capital release,” Graseck says. In the bull case: banks could grow revenues at an annualized rate of 7%, with industry returns in the 17%-19% range.
Beating the Market Is Hard
For asset managers, the reverse is true. “The effects of quantitative easing and bank regulation have driven a $100 billion divergence in revenue performance in favor of asset managers since 2011, a dynamic that looks set for at least a partial inversion,” says Michael Cyprys, Broker and Asset Manager Analyst at Morgan Stanley.
Asset managers will have to change their game. As more investors have diverted their flows to passive funds, asset managers must begin to do what their banking brethren have already done: cut costs and consolidate, Cyprys says.
That doesn’t mean active fund managers will go the way of the dinosaur. On the contrary, “asset managers are rethinking and re-engineering core active management, as seizing alpha opportunities becomes more critical than ever,” Cyprys says. But their focus may now switch to once niche areas, such as alternative investments.
Innovation Takes Center Stage
For both banks and asset managers, the implementation of new technologies will be crucial. Advances in robotics and artificial intelligence, in particular, have dramatically expanded the possibilities to automate costly processes. Major opportunities for savings exist throughout the organizations in control functions, operations, and the front office. “We estimate that banks can release 12%-15% of total expenses over the next five years by deploying currently available technology,” says Graseck, adding that reinvestments and inflationary effects could drive a net 2%-4% decline in expenses at the wholesale division of these banks.
But technology is also changing the way markets operate, opening the door for new competitors. Financial technology companies aiming to disrupt traditional markets have already carved out roles in foreign exchange, cash equities and listed derivatives, Edelmann says. “They deploy best-in-class technology and data analytics to compete head-on with major banks. We estimate $2 billion to $3 billion of revenues potentially in play for these models,” he says. Indeed, smaller banks may be forced to the sidelines, while larger banks will need to reinvest to remain competitive.
Nevertheless, after four years of falling revenues, single-digit returns and waves of restructuring, wholesale banks can now see a path to above-hurdle returns. “Their attention is shifting toward capturing growth and driving earnings,” says Graseck, adding: “Efficient delivery of capital, analytics and insights, transaction execution, and client support will define the winners.”
For more Morgan Stanley Research on the outlook for the financial industry, ask your Morgan Stanley representative or Financial Advisor for the full report, “The World Turned Upside Down” (Mar 17, 2017). Plus, more Ideas.
