The US is beginning to dominate global investment banking: Implications for Europe

Charles A.E. Goodhart, Dirk Schoenmaker 28 March 2016

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Europe’s banks are in retreat from playing a global investment banking role. This should not be a surprise. It is an often intended consequence of the regulatory impositions of recent years, notably of the ring-fencing requirements of the Vickers Report (2011) and the ban on proprietary trading by Liikanen (2012), but also including the enhanced capital requirements on trading books and other measures. The main concern has been that a medium-sized European country such as the UK or Switzerland or even a larger country like Germany, let alone a tiny country like Iceland or Ireland, would find a global investment bank to be too large and too dangerous to support, should it get into trouble.1 So, one of the intentions of the new set of regulations was to rein back the scale of European investment banking to a more supportable level.

European banks in the global investment banking scene

The EU, of course, has a much larger scale than its individual member countries. If the key issue is the relative scale of the global (investment) bank and state that might have to support it, could a Europe-based global investment bank be possible? We doubt it, primarily because the EU is not a state. It does not have sufficient fiscal competence. Even with the European banking union and European Stability Mechanism, the limits to the mutualisation of losses, e.g. via deposit insurance, mean that the bulk of the losses would still fall on the home country. Moreover, there would be intense rivalry over which country should be its home country, and concerns about state aid and the establishment of a monopolistic institution. While the further unification of the Eurozone might, in due course, allow a Europe-based global investment bank to emerge endogenously, we do not expect it over the next half-decade or so.

So the withdrawal of European banks from a global investment banking role is likely to continue. That will leave the five US ‘bulge-bracket’ banks (Goldman Sachs, Morgan Stanley, JP Morgan, Citigroup, and Bank of America Merrill Lynch) as the sole global investment banks left standing. The most likely result is a four-tier investment banking system.

The first tier will consist of these five US global giants. The second tier will consist of strong regional players, such as Deutsche Bank, Barclays, and Rothschild in Europe and CITIC in the Asia-Pacific region. HSBC is in between, with both European and Asia-Pacific roots. The third tier consists of the national banks’ investment banking arms. They will service (most of) the investment banking needs of their own corporates and public sector bodies, except in the case of the very biggest and most international institutions (which will want global support from the US banks) or in cases of complex, specialist advice. Examples of this third tier are Australian and Canadian banks, which support their own corporates and public sector bodies without extending into global investment banking. The fourth tier consists of small, specialist, advisory, and wealth management boutiques.

Why should it matter if in all the European countries the local banks’ investment banking activities should retrench to this more limited local role? After all, there are few claims that Australia and Canada have somehow lost out by not participating in global investment banking. We review the arguments further in the column. We also investigate the development of the relative market shares of US and European investment banks in Europe. It appears that the US investment banks are about to surpass their European counterparts in the European investment banking market. We discuss the policy implications in our concluding remarks.

The rise of US and decline of European investment banks in Europe

While the US investment banks are the global leaders, what is their share in the European investment banking market? The Thomson Reuters investment bank league tables rank investment banks by market share. These tables typically cover four major segments: M&A, equity, bonds, and loans (i.e. syndicated loans). We have calculated the weighted average of investment banking proceeds of the top 20 players across these four segments for Europe (i.e. the market share in each segment is weighted by the relative size of that market segment in total investment banking business). Global data are usually split into Americas, EMEA (Europe, Middle East, and Africa), Asia-Pacific and Japan, but we have only EMEA data. However, Europe comprises the vast majority of EMEA investment banking. Data are taken from Thomson Reuters and cover the period from 2005 to 2015 (see, for example, Thomson Reuters 2016). To select the top 20, we take the 11-year average across all investment banks, and use that ranking for all years.

Figure 1 summarises the results (Goodhart and Schoenmaker 2016). The market share of EU and Swiss investment banks has declined since 2010/11, while the share of US investment banks (the big five and Lazards) increased from 35% in 2011 to 45% in 2015. It should be noted that the evolution of the regional market shares reflects partly the broader banking crisis dynamics. US investment banks were the first to be hit in the Global Crisis and declined from 40% in 2009 to 35% in 2011, but recovered after the decisive recapitalisation exercise enforced by the US Treasury. The Swiss decline set in in 2010 and the EU decline in 2011. However, the European share of the investment banking market remains significant.

Nevertheless, Figure 1 shows an underlying structural trend, whereby EU and Swiss investment banks are downsizing. If the trend were to continue, US investment banks would take the prime spot from their EU counterparts soon, possibly already in 2016.

Figure 1. Investment banks by origin, EMEA market shares (%)

Source: Goodhart and Schoenmaker (2016)

Concerns for Europe

We now turn to the consequences of the rise of US investment banks and the decline of their European counterparts. Why should it matter if in all the European countries, the local banks’ investment banking roles retrench to a more limited local role? After all, there are few claims that Australia and Canada, which are largely served by local banks, have somehow lost out by not participating in global investment banking.

Regulatory dialogue

There are perhaps three inter-related arguments why leaving global investment banking to the big five American banks might be problematic.

  • The first is that this could leave Europe at greater risk from possibly ill-advised American political or regulatory intervention.

Oudéa (2015) wrote that:

“In the last crisis, American banks came under intense pressure to reduce their European assets. Having banks able to finance European companies is an essential part of the EU’s economic sovereignty. Europe’s industrial champions will be at a serious disadvantage if they cannot rely on access to capital when their rivals in America and China can.”

While this danger exists, it was already present before the withdrawal of European banks from global investment banking. Since the US dollar and US financial markets play the central role in the financial system, the US is in a position to enforce its demands on acceptable counterparty transactions and to dominate, for good or ill, the international monetary policy scene, whether or not the big five US banks are the only global ‘bulge-bracket’ banks left standing.

Moreover, the European Commission has started to put clauses in directives to give themselves the powers to recognise or not the equivalence of US, Swiss and other countries’ regulation and supervision (e.g. in the Financial Conglomerates Directive). The European Commission and the US authorities therefore set up an EU-US Regulatory Dialogue to discuss bilateral regulation issues. In some cases, the parties reached consensus (e.g. exemption of European banks from the leverage ratio for their operations and recognition of US prudential regulation and supervision as equivalent for financial conglomerates). In other cases, there is no consensus. A case in point is the accounting rules. While Europe adheres to the IFRS (International Financial Reporting Standards), the US sticks to its US GAAP (General Accepted Accounting Principles).

Competition

Five is not a large number.

  • So, a second argument is that this will leave global investment banking much more concentrated.

Is this not potentially dangerous? Perhaps, but these five banks still compete quite ferociously, so margins are not rising all that much. The current economic pressures, especially of much greater capital requirements, impact the US banks just as much as on European banks through the Basel 3 framework. What would happen if one, some or all of these US banks decided to follow the European banks and to withdraw from providing global investment banking services in Europe, especially in London?

To a great extent, greater concentration, higher margins, and less liquid markets are the inevitable cost of imposing much higher prudential requirements. If much more capital is required to backstop risk-taking in such activities, then margins must rise until the capital employed in such activities earns the (risk-adjusted) equilibrium rate. This means that weaker competitors must depart, and concentration rises until equilibrium is restored. It is arguable that the sooner such equilibrium is once again reached, the better. Perhaps it would be good, rather than bad, if one or two of the US big five also packed up and left?

European banking becoming parochial?

  • The third argument is that current developments are inducing European banks more and more to concentrate on their national roles and clients in their investment banking operations rather than taking a wider European stance.

Deutsche Bank and Barclays are the only Europeans left in the top seven for the EMEA market. But they are likely to lose their positions because Deutsche Bank is currently undergoing a major reorganisation and Barclays is in the process of executing the Vickers split. In the investment banking field, the only pan-European banks will all soon be American. This has the corollary, for good or bad, that European national and EU-level authorities, such as the European Commission, will have rather less direct control over them. A key part of the European financial system is slipping out of the grasp of the European authorities.

It seems anomalous that, at a time when the European authorities are trying to establish a banking union and a capital markets union, the effect of their regulatory reforms has been to cause EU banks to concentrate their focus on their national roles, leaving the US banks as the only pan-European actors on this particular stage. But does it matter that the European authorities are left dependent on banks over which they have less ability to subject them to their demands?

There are concerns about US dominance in European investment banking. These are related to information advantages and soft relationships. The question arises whether US investment banks as outsiders are sufficiently knowledgeable about European corporates. Moreover, what is the loyalty of these US banks to European corporates in times of distress? Next, there are concerns about corporate culture. Not long after successfully taming the Global Crisis, US financial firms resumed their practice of paying high salaries and bonuses. In contrast, Europe enacted caps on bonus payments. The large US investment banks are already trying to exempt their high-flyers in London from these EU rules, by arguing that these managers have a ‘global’ role and should therefore be remunerated by international rather than European standards.

Policy response and conclusions

The European banking system is downsizing, partly because of on-going problems, partly because Europe is overbanked (Langfield and Pagano 2016). That should run its course. The consequence is that the big US investment banks will be the sole leaders in the global investment banking market, as the Europeans, including the Swiss, are in retreat. Thus the big five Americans are getting into pole position in the European investment banking market.

What should be the policy response? First, we look at the political side. With the decline of European banking (both in general and specifically investment banking), Europe’s hand in the EU-US regulatory dialogue is diminishing. Nevertheless, the European Commission is advised to strengthen its position in the EU-US bilateral negotiations and keep on viewing its banking industry as a strategic sector. The emerging role of the ECB, on both the monetary and supervisory sides, can be used in these negotiations. Of the 30 global systemically important banks (so-called G-SIBS), eight are located in the US and eight in the EU banking union area. A further four G-SIBs and the European head offices of the US investment banks are based in the UK under the supervisory watch of the Bank of England. The European Commission, the ECB, and the Bank of England should therefore jointly develop a strategic agenda with European priorities for their dealings with the US authorities. As in the US, this strategic agenda should be discussed with, and supported by, the industry. A strong and united front would enhance Europe’s position.

Second, we turn to the supervisory side. While Europe may lose some political clout, the supervisory implications are not a problem for it. With the move to capital markets union, the European supervisory architecture can handle the gatekeepers, which are becoming more US-dominated. The European Securities and Markets Authority (ESMA) has powers under the Regulation on Credit Rating Agencies to licence and supervise the European operations of the primarily US-based credit rating agencies. Similarly, the relevant directives (Second Banking Directive and Markets in Financial Instruments Directive) give the relevant European supervisors (in this case the Prudential Regulatory Authority and the Financial Conduct Authority) powers over the London-based European operations of the US investment banks.

Third, the large corporates could themselves take precautions. For the bigger financing operations, a corporate typically hires a banking syndicate, which is a group of investment banks that jointly underwrite and distribute a new security offering, or jointly lend money to the corporate. European corporates would be well advised to include at least one (large) European investment bank in this syndicate, also in good times when they do not need them. That could help them in bad times, when US banks might be reluctant for whatever reason (including more detached decision-making). The involvement of a (local) European investment bank in the syndicate is not only useful for loyalty but also information reasons. Because of their local roots, the European banks have an information advantage over their US peers, which keep offices in New York and London. The practice of giving a European investment bank at least one place in further US-dominated banking syndicates could help to avoid complete dependence on the whims of the big US investment banks.

Finally, as the underlying financial architecture for banking union and capital markets union is still under construction, we do not expect big changes in the European financial landscape in the short term. If, however, further steps are taken to complete banking union as suggested in the Five Presidents Report (2015), including European deposit insurance with a fiscal backstop by the European Stability Mechanism, a truly European banking system might emerge with strong regional and potentially global players. But that is only speculation.

References

Financial Times (2015a), ‘Top European bankers warn of US threat to their future’, 12 October

Financial Times (2015b), ‘Europe will always need investment banking’, 16 October

Gapper, J (2015) ‘A global retreat for European banks’, Financial Times, 22 October

Goodhart, C and D Schoenmaker (2016), ‘The US dominates global investment banking: Does it matter for Europe?’, Policy Contribution 2016/06, Bruegel.

Langfield, S and M Pagano (2016), ‘Bank bias in Europe: effects on systemic risk and growth’, Economic Policy 31(85): 51-106

Liikanen Report (2012), High-level Expert Group on Reforming the Structure of the EU Banking Sector, Final Report, Brussels

Oudéa, F (2015), ‘Europe needs homegrown bulge bracket banks’, Financial Times, 12 October

The Economist (2015) ‘European banks: Banking and nothingness’, 17 October

The Five Presidents’ Report (2015) The Five Presidents' Report: Completing Europe's Economic and Monetary Union, Brussels

Thomson Reuters (2016) ‘Global Investment Banking Review, Full Year 2015’, Thomson Reuters Deals Business Intelligence, New York

Vickers Report (2011) Final Report: Recommendations, Independent Commission on Banking, London, available at http://bankingcommission.independent.gov.uk/

Endnotes

[1] See for example commentary by Martin Wolf in the Financial Times and other recent coverage: Financial Times (2015a, 2015b), Gapper (2015), Oudéa (2015) and The Economist (2015).

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Topics:  Financial markets Financial regulation and banking

Tags:  investment banking, US banks, European investment banks

Emeritus Professor in the Financial Markets Group, London School of Economics

Professor of Banking and Finance at the Rotterdam School of Management, Erasmus University Rotterdam; Senior Fellow, Bruegel; and Research Fellow, CEPR

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