No Revenue Without Conviction

Directionless investors are conspiring with weak macro-economic conditions to unsettle a business model dependent not just on activity, but short selling, leverage and spreads, says Dominic Hobson, editor in chief of Global Custodian.

Theoretically, the volatility of recent weeks is good for the securities industry. Unfortunately, the volatility is a symptom not of different convictions about the future course of market values, but a lack of conviction about what to invest in. Investors are taking longer to decide between asset classes, and between fund managers to look after them.

If there are fewer and slower buyers, there are fewer sellers too. One reason the market fall of May 6 was so precipitous was the lack of short-covering to break the fall. Without short sellers, there is less demand to borrow stock. The institutional investors which lend their portfolios, the custodian banks which act as their agents, and the prime brokers which on-lend the stock to hedge funds, have seen securities lending revenues shrivel.

In markets without conviction, there is also less appetite for leverage. Banks are reluctant to lend to each other, and to anybody at maturities that stretch more than a short distance into the future. Regulators, anxious to suppress the amplitude of the financial cycle, are tightening credit further, by driving up the cost of capital and driving out the hidden means of lending. Less leverage means less activity by fund managers, and less revenue for the custodian and investment banks.

But no aspect of the current macro-economic environment is squeezing banks of both kinds harder than low rates of interest. Though banks have increased the revenues they earn from fees, they still depend on collecting spreads on their own investments, client cash, advancing credit to clients, and dealing in the FX markets. Not only is demand for credit down, but net interest margin is hard to widen when interest rates are close to zero.

In the last 12 months, both custodians and prime brokers have found themselves in the unusual position of making less money, even as transaction volumes have risen and market values improved, and their buy-side clients have raised more assets. It is not cheering for them to know that this phenomenon has secular components (such as the increased use of central counterparties reducing transaction volumes) as well as a cyclical side, but macro-economic conditions are proving deeply unhelpful to banks. With regulators threatening simultaneously to load them with both higher costs and increased risks, these are not great days in which to be a banker.