LONDON (Reuters Breakingviews) - Be careful what you wish for. That’s the phrase haunting the world’s largest investment banks as they lick their wounds after a painful fourth quarter. For years, bankers complained that markets were too calm. But when bonds and stocks tumbled in the last few months of 2018, almost all trading divisions suffered. It doesn’t bode well for business if markets stay choppy.
Before the financial crisis, Wall Street firms and their European rivals loaded up their balance sheets with bets on stocks and bonds. These days, they mostly intermediate between buyers and sellers. New capital charges make it less attractive to hold onto risky positions – particularly illiquid assets that are hard to sell in a rush. In the United States, the rule named after former Federal Reserve Chairman Paul Volcker banned banks from certain types of proprietary bets.
In theory, banks should therefore do well when financial markets are active, regardless of whether prices are rising or falling. Indeed, for many years after the crisis, bankers grumbled that markets were not volatile enough. They blamed ultra-low interest rates, and central banks buying government bonds, for dampening price movements and trading volumes.
So you might have expected investment bankers to cheer the return of volatility in the final months of 2018. There’s no doubt that markets were choppy. Most asset classes declined, from equities to investment-grade bonds. The premium, or spread, that investors demand to hold riskier high-yield bonds rose sharply. Asian stock markets suffered their biggest fourth-quarter drop since 2008. The Vix Index, a measure of market volatility, trebled between the beginning of October and Christmas.
Yet the impact on investment banks’ top lines was far from positive. Combined revenue from corporate finance and trading at the eight largest U.S. and European investment banks – JPMorgan, Goldman Sachs, Morgan Stanley, Bank of America, UBS, Barclays, Deutsche Bank and Credit Suisse – dropped 5 percent year-on-year, according to figures compiled by Breakingviews. The Wall Street firms fared better, with a collective 3 percent drop, while revenue at their European counterparts fell 11 percent.
The headline figure hides a wide range of outcomes between business lines and financial institutions. The biggest losers, however, were the divisions that trade fixed income, currencies and commodities: total revenue from this activity at the eight banks dropped by 16 percent in the fourth quarter. Even though credit spreads widened, activity levels remained subdued. Bankers attribute this partly to nervousness among investors about the economic outlook, as well as a reluctance among portfolio managers to take big new positions near the end of the year. “We need buyers to be in a position to rebalance risk,” the CEO of one big wholesale bank complains.
(See graphic tmsnrt.rs/2Vm1plH )
Corporate finance activity also suffered, as companies cancelled bond issues and pulled initial public offerings in order to wait for calmer conditions. However, equity trading picked up, particularly for Wall Street banks, where revenue rose 10 percent. This was partly because computer-driven funds responded to volatility by adjusting their positions. Bankers also point to a surge in demand from investors and companies to hedge their equity exposures.
Even then, the spoils were divided unevenly. Banks like UBS reported lower demand for equity derivatives, as wealthy clients in Asia pulled back from buying structured products. Equity trading revenue at the four European banks was flat year-on-year. Meanwhile, the volatility also caught some by surprise. BNP Paribas, for example, suffered losses on index derivatives it was using to hedge a North American trading business: revenue at its equities division dropped 70 percent.
Meanwhile, volatile markets also hurt banks by pushing up capital requirements for their trading businesses. Value at risk, an estimate of how much a bank could lose in a day from falling markets, is a key input in the models used to determine how much capital it needs. So market ructions can put pressure on banks’ solvency ratios, discouraging them from boosting activity. Five of the eight banks reported an increased VAR in the fourth quarter, though differing methodologies mean the figures are hard to compare.
If nothing else, the fourth quarter has prompted bankers to change their language. Where they once bemoaned a lack of volatility, they now blame instability for keeping companies and investors on the sidelines. As political turbulence seems unlikely to disappear anytime soon, complaining about a lack of stability may become bankers’ new catchphrase.
Reuters Breakingviews is the world's leading source of agenda-setting financial insight. As the Reuters brand for financial commentary, we dissect the big business and economic stories as they break around the world every day. A global team of about 30 correspondents in New York, London, Hong Kong and other major cities provides expert analysis in real time.
Sign up for a free trial of our full service at https://www.breakingviews.com/trial and follow us on Twitter @Breakingviews and at www.breakingviews.com. All opinions expressed are those of the authors.