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IBM Business Consulting Services

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An IBM Institute for Business Value executive brief

Three steps to focused executionCapturing the sell-side upside

IBM Business Consulting Services, through the IBM Institute for Business Value, develops

fact-based strategic insights for senior business executives around critical industry-specific

and cross-industry issues. This executive brief is based on an in-depth study by the Institute’s

research team. It is part of an ongoing commitment by IBM Business Consulting Services to

provide analysis and viewpoints that help companies realize business value. You may contact

the authors or send an e-mail to [email protected] for more information.

Capturing the sell-side upside IBM Business Consulting Services1

Executive summaryThe precipitous decline in world markets has ended, but uncertainty remains high. Bulge bracket firms must figure out how to thrive in this type of environment.

• Margins are shrinking in virtually every line of business. Overcapacity from the 1990s bull market continues to weigh on profitability. Commoditization is squeez-ing profits in fixed income and equity trading, as well as simple debt and equity underwriting. Research will not likely survive as a pure cost center.

• To compensate for margin pressure, firms are taking on historically significant levels of risk.

• Shifting client expectations are changing the way bulge bracket firms sell and deliver goods and services. Many investment managers and corporate clients are seeking “one-stop shops” that provide a full range of products and services, from simple and discrete to complex and bundled.

• Competition is rushing in from new sources, including universal, European and boutique banks, data vendors and electronic trading networks – and even clients.

• Regulatory uncertainty is threatening to drive up compliance costs and distract firms from focusing on revenue generation.

Tomorrow’s leaders will be those who leverage timely innovation to trump growing competition and manage persistent uncertainty. Reactive approaches to boom and bust cycles, fixation on short-term results and reluctance to use external specialists are no longer viable options. In short, a fundamental rethink of the business is required:

• Adopt a portfolio strategy. Taking a top-down view of the business can help firms analyze existing activities and client segments to determine sources of emerging and declining value. This analysis can guide them as they divest underperforming businesses and pursue revenue diversification initiatives.

• Optimize the operating model. Firms can rationalize client coverage by aligning client knowledge, internal resources, product offerings and delivery capabilities across lines of business. They can improve delivery effectiveness (and risk and compliance monitoring) by consolidating platforms, managing data and ratio-nalizing workflows across the firm. Pursuing sourcing options for non-core and sub-optimal capabilities can drive efficiency, flexibility and resilience.

• Transform firm culture. The right management structure can help firms pursue growth opportunities and drive expense discipline and risk management. Employee incentives should promote long-term business goals and relationship building over short-term results. Partnering with external parties can help firms assemble capabilities in emerging markets and high-growth product areas, as well as for non-core activities and shared processes.

Contents

1 Executive summary

2 An industry in transition

10 Recommendations

19 Conclusion

19 About the authors

19 About IBM Business Consulting Services

20 References


An industry in transitionFor today’s bulge bracket firms, there are no longer any easy returns. During the historic boom markets of the late 1990s, profits were easy to come by. But as nature abhors a vacuum, so the laws of microeconomics abhor excess profits. When trading volume exploded, capital markets firms expanded their size and reach to chase a larger share of the outsized revenues. Unfortunately, this added capacity made adjusting to the market downturn of the early 2000s particularly painful.

Today, bulge bracket firms have largely succeeded in reducing costs and improving the efficiency of their operations, but the overall outlook for their traditional businesses remains mixed. Market indices and revenues have begun to rebound, but automation and changing client demands are squeezing margins in equity and fixed income trading. In areas with rising demand and higher growth potential, such as prime brokerage and investment banking services, a new wave of competitors, both traditional and nontraditional, is threatening the primacy of bulge bracket firms.

In short, the time has come for hard strategic decisions. With global markets as risky as ever, bulge bracket firms must figure out how to survive without the easy returns they enjoyed in the past.

Markets rebound, but uncertainty and risk remainOverall, bulge bracket firms enjoyed a modestly good year in 2004. But the global economic recovery continued to experience false starts, and performance was not uniform across all capital markets activities. Persistent, structural uncertainty continued to erode investor confidence and hamper corporate growth, leaving the securities industry vulnerable to unforeseeable disruptions.

Global GDP continued its steady climb in 2004, reaching US$37.8 trillion from US$36.3 trillion in 2003.1 Equity market capitalization also continued to grow. After surging nearly 37 percent in 2003, to US$31.2 trillion, global equity markets added another US$4.5 trillion in 2004 to reach US$35.7 trillion (topping a previous peak of US$31.3 trillion in 2000 for the first time).2

As stock indices have maintained their buoyancy, so too have the industry’s volume-driven revenues, which grew by 1.5 percent in 2004, to nearly US$108 billion (see Figure 1). Near-term trading volume will likely remain firm as investor confidence recovers, but maintaining margins will remain an issue.


The rebound did spur a recovery in return on equity (ROE) for capital markets firms. Bulge bracket firms grew ROE from a low of 11.2 percent in 2001 to 15.7 percent in 2004.4 In fact, the securities industry as a whole has been outperforming the S&P 500 since mid-2003.5

Figure 1. Industry revenue increased marginally in 2004, and earnings volatility remains an issue.

Prime brokerage revenues were a key contributor to the industry upturn. Although most firms do not break out prime brokerage revenues, performance over the past three years has been truly impressive. On a per-year average, prime brokerage generated margins of 38 percent on US$9 billion of revenue for sell-side firms.6 Performance has been driven largely by prime brokerage’s main client segment: hedge funds. CSFB states that hedge funds now account for at least 35 percent of its equity trading commissions (other estimates place this figure at upwards of 50 percent.)7 On the fixed income side, there are conflicting views on trading revenue contribution. According to some analysts, hedge funds drive 7 percent of fixed income revenues for investment banks, while other observers say they play a much larger role.8 Traditionally based on services such as reporting, securities lending, trade settlement and custody, prime brokerage has evolved into a broader business that supports hedge funds in many other activities, from trade execution and customized trading strategies to risk and compliance services.

The consensus forecast

for U.S. equity markets

is a return of 7.3 percent

for 2005, according to

a survey of 49 leading

investment managers.3

0

20

40

60

80

100

120

140

160

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%Re

venu

e US

$ bi

llion

s

Profi t margin (percent)

Profi t marginRevenue

Note: A 2004 is actual through Q3 and SIA estimate for Q4.Source: Securities Industry Association Fact Book 2004; IBM Institute for Business Value analysis.

U.S. securities industry net revenue and pre-tax profi t margin, 1990-2004A

(US$ billions, percentage)


Hedge funds remain attractiveHedge fund assets expanded by a compounded annual growth rate (CAGR) of 42 percent in 2004, breaking the US$1 trillion mark in July and ending the year at US$1.2 trillion.9 Europe far outpaced other regions, with a CAGR of 80 percent.10 At the end of 2004, there were an estimated 7,000 hedge fund firms worldwide. Growth is likely to remain strong as a new wave of demand from institutional investors (particularly in the U.S. and Japan) pushes institutional assets from US$66 billion in 2003 to an expected US$300 billion in five years. As global hedge fund assets continue to swell by an estimated 20 percent annually, these clients will remain an attractive segment for sell-side firms.11

But despite the strong short-term outlook, prime brokerage risks becoming a victim of its own success as new players seek to enter the high-margin business of servicing hedge funds. Goldman Sachs, Morgan Stanley and Bear Stearns – who today share a combined 79 percent of the prime brokerage market12 – are likely to see robust challenges mounted to their industry leadership. As new entrants undercut established firms to win business, margins will likely trend downward toward a level of normal economic profit, with product and service innovation being key differentiators.

For 2005, equity and fixed income trading face declining margins despite a positive revenue outlook. With interest rates all but certain to rise, fixed income is unlikely to match the steep volume gains it has seen over the past two years. Automation will continue to squeeze equity trading margins despite a strong revenue outlook for 2005. Overall, commoditization of the trading business has rendered client trading revenue a much less important source of profit than it has been historically. This is not a cyclical swing but a new reality of doing business in an electronically connected market. For example, in mid-2003, the average return for Wall Street equity sales and trading was about 5 percent on the capital invested.13

Compare that with the relative financial success firms have enjoyed in other lines of business. Within the same mid-2003 time frame, Morgan Stanley, Bear Stearns and Goldman averaged an approximate 13 percent return on equity for all activities, while prime brokerage yields around 17 percent ROE for Bear Stearns.14 To achieve these higher returns consistently, Wall Street firms will have to stay one step ahead of commoditization in their lines of business.

The prime brokerage squeeze

raises the question of where

the market is headed. Will it

go the way of fixed income and

equity trading, where firms

have little choice but to remain

despite narrowing margins?

Or will it eventually resemble

money market and municipal

bond underwriting, which have

come to be dominated by a

few players? At present, it is

simply too early to tell.


Figure 2. Substantial increases in investment banking activities drove a revenue rebound in 2004.

On the investment banking side, 2004 saw a resurgence in M&A advisory and under-writing revenues (see Figure 2). M&A was especially strong, with the total number of deals completed in 2004 nearly equaling that of the previous three years combined.15 And although the market outlook remains positive in terms of the number of deals, increased competition will likely weigh on profits over the long term. The advisory business faces threats from universal banks, unconflicted boutiques and a trend among clients to bring these activities in-house. While prices are unlikely to decline substantially for the highest-value M&A advisory services, growth could stall as clients take on more of these activities themselves. In addition, like trading, standard investment banking activities are facing near-term margin and pricing pressure, making simple equity and debt underwriting less reliable as sources of profit.

0

10

20

30

40

50

60

1998 1999 2000 2001 2002 2003 2004

Total 39 -3 13

M&A/Advisory 21 -24 39Equity underwriting 36 -24 29Fixed income -9 9 3underwriting

Fixed income 48 26 13trading

Equity trading 58 -15 8

98-00 00-03 03-04

51B

9%7%7%

50%

28%

467%6%8%

50%

29%

3813%

8%7%

41%

32%

44

13%8%8%

33%

38%

50

15%

13%

6%

23%

44%

38

12%9%

27%

34%

26

20%13%13%20%

34%

17%

Note: AIncludes only capital markets and investing banking arms of: Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Stearns, note that expenses will be higher than revenues as revenues are not fi rmwide; BFor 2004, fi rst three quarters data for Merrill Lynch are included, four quarters of data included for other fi rms.Source: IBM Institute for Business Value analysis of company annual reports.

Selected lines of business revenue mix for large, traditional sell-side fi rmsA, 1998-2004(all other revenues excluded, US$ billions) CAGR


Clients learn to squeeze feesWhen Triad Hospitals sought to refinance its more expensive debt in 2004, rates began to climb just prior to the issue pricing. With the economics of the deal in jeopardy, Triad leveraged its clout among the multiple lenders with which it had established investment banking relationships. Despite typical fees of 2 percent on high-yield issues (and up to 3.15 percent on smaller deals), Triad was able to squeeze down fees on the US$600 million note to 0.75 percent – shared among five of its bookrunning banks.16

Such client maneuvers are becoming more frequent as underwriting competition on Wall Street intensifies. As banks attempt to maintain their status or advance in league tables, they are offering lower fees on end-of-quarter and end-of-year deals. For example, one Citigroup client recently managed to pay only 0.21 percent on a US$297.3 million high-yield senior notes issue.17 The December move helped Citigroup advance from second place in the 2003 high-yield league tables to first in 2004, surpassing CSFB.18

With margins for investment banking and trading services under pressure, many sell-side firms have been looking for alternative sources of revenue, such as proprietary trading, venture capital, merchant banking, private equity and corporate lending. But as firms shift emphasis and enter these new areas, their risk profiles are changing.

The danger is that firms may be taking on different sets of correlated risk, backed by the balance sheet, that they might not fully be able to measure. For example, between 2003 and 2004, Goldman spent US$4 billion to acquire 30 power plants to complement its existing commodity trading and merchant energy restructuring capabilities.20 In addition to the risk they take on directly in private equity and proprietary trading, firms also face exposure through their clients, whose increasing demands for loans to be bundled with investment banking services could place even more pressure on balance sheets. Over time, some bulge bracket firms may find they lack the controls in place to assume these higher levels of risk.

Client demands are shiftingCompounding the challenges of uncertainty and risk in the marketplace, shifts in client expectations are changing the way bulge bracket firms sell and deliver goods and services. Increasingly, investment managers and corporate clients seek "one-stop shops" that provide a full range of products and services, from simple and discrete to complex and bundled (although they always reserve the right to use boutiques as necessary).

Evidence is mounting that bulge

bracket firms are incurring

more risk to generate the same

amount of revenue. At the top

five investment banks, equity

capital for merchant banking

jumped from 3 percent in 2000-

2002 to 21 percent in 2003.

Aggregate Value at Risk (VaR)

increased by a disturbing 18

percent between October 2003

and September 2004, while

cash surplus decreased at a rate

of 11 percent per year between

2000 and 2003.19


On the sales and trading side, traditional deal structures are under siege as fund managers ask for transparent pricing on a broad, a la carte selection of previously bundled products and services. Faced with pressure to be transparent and cost effective, investment managers are learning to handle trading and research in-house and are demanding low prices on automated products like block trades and algorithmic trades. A growing acceptance and familiarity with technology is enabling these organizations to set up their own internal trading desks and connect directly to the exchanges, bypassing the middleman. To support these trades, they are also enhancing their internal research organizations, which could cut into the value that bulge bracket firms add to their investment management clients.

On the other hand, client segments such as hedge funds are demanding sophis-ticated product combinations. Providing these enhanced offerings – which often include high-volume trading, securities lending, capital and reporting – will require major adjustments from bulge bracket firms, which continue to maintain separate infrastructures and points of contact for their multiple lines of business.

Recent experiences have also altered client demands. In the wake of acute market losses and regulatory scandals, investment managers are requiring flexible delivery options and far greater degrees of transparency. A major driver behind the push for transparency is the regulatory scrutiny being paid to "soft dollar" practices. A May 2004 survey of 520 global institutional investment firms found 65 percent engaged in soft dollar agreements.23 Many of these cover products and service bundles that are likely to be banned by pending regulation. For example, the survey found that 24 percent of soft dollar spending went to market quotes, databases, news and information services, while 2 percent went to consulting, order management systems and other infrastructure.24

At 64 percent, research accounts for the largest share of services currently purchased through soft dollar arrangements.25 While this practice is not slated to be banned, a highly likely development for 2005 is that sell-side firms will be pushed to break out research (along with consulting, technology and trade execution) from their service packages. In this unbundled environment, pricing will likely be more transparent, making it difficult to subsidize expensive research activities by boosting trading commissions. Over time, this development may pressure firms to make their research propositions attractive enough for clients to pay on a standalone basis.

Buy-side internalization is

expected to increase by 18

percent per year

Increasingly, trading desks within

buy-side firms are taking control

of order flow instead of sending

orders via phone and Financial

Information Exchange (FIX) to

brokers. Analysis conducted by

IBM shows that although flow

through FIX is increasing at a

steady clip of 23 percent per

year, this growth is offset by

the decrease in phone orders to

brokers at a rate of 41 percent

per year.21 As a result, the

direct channel (phone and FIX

combined) is expected to shrink

by 18 percent per year through

2007, which would bring total

direct-to-broker trades down from

the current 73.5 percent in 2005

to 60 percent by 2007.22


On the investment banking side, clients are not only demanding a selection of low-margin, simple products, they are also expecting a full range of sophisticated products and financing options (including bundled loans and other risk-sharing measures) and unbiased research. And as with trading activities, investment banking clients are beginning to conduct M&A analysis in-house, a disturbing trend for bulge bracket firms.

Nontraditional players enter a consolidating marketIndustry consolidation continues at a steady pace on Wall Street, with the top ten securities firms controlling 59 percent of revenues and 62 percent of capital in 2003.26 But despite their industry positions, bulge bracket firms face increasing competition from a variety of nontraditional players, including universal banks, European and boutique banks, data vendors and even their own clients.

First, universal banks are leveraging their size and balance sheet advantages to invade Wall Street’s turf (after many failed attempts in the past). With greater leeway to cut prices in one area and charge a premium in another, these giants are able to squeeze the margins of competing bulge bracket firms. Moreover, their roots in traditional banking give universal banks an edge in building cross-servicing platforms, while their large, worldwide client bases provide ample opportunity to cross-sell products and services. In underwriting, for example, universal banks are bundling loans and leveraging their much larger footprints to generate business.

Investment banking: a rapidly growing business for universal banksAs they search for areas of profitable growth, universal banks are at it again. They are aggressively expanding into investment banking, leveraging their large footprints and access to capital to bundle corporate lending. In 2003, HSBC launched a plan to grow its Corporate Investment Banking and Markets (CIBM) business through organic growth and a large acquisition.27 As part of the plan, in July 2004 the firm announced it would hire 700 bankers and spend more than US$400 million over the next two to three years.28

Bank of America plans to spend US$600 million in 2005, adding bankers, traders and salespeople to organically grow its investment banking unit.29 Part of its plan is to expand into Europe by adding 100 employees to compete with traditional Wall Street and European firms.30 The move will allow the giant to leverage what it sees as core competencies in derivatives and foreign exchange and to further its push into debt capital markets.31

Second, as Wall Street firms face a backlash from scandals and SEC allegations of misconduct, European and boutique banks – such as UBS, Hypovereinsbank, Barclays Capital and Rothschild – are rushing in to provide an alternative. Untainted European banks and boutique firms are well positioned to build on existing brands, reputation and expertise with organic or purchased investment banking and trading capabilities.


Third, data vendors and electronic communications networks (ECNs) are combining proven, cost-effective capabilities in analytical execution and processing with competitively priced complementary services. Most significantly, technology is enabling investment managers to go directly to the market for simple trades, cutting out the bulge bracket firms. Instinet, for example, was ranked the top value-added execution provider for buy-side small trades in 2004.32

Finally, bulge bracket firms are seeing a jump in competition from their own clients. As technology drives the disintermediation of direct trading and the internalization of workflows, bulge bracket firms will be hard pressed to continue selling services their clients are able to provide for themselves. Moreover, as corporate clients become more sophisticated, they are internalizing M&A activities. While only 7 percent of deals were completed without advisors in 2000, by the first half of 2004 that number had jumped to 20 percent.33

New regulations, closer scrutiny drive investment in complianceFollowing the corporate scandals of the past few years, several potential regulations – including new soft dollar and research reforms – are working their way through legislatures and government agencies, presenting bulge bracket firms with an added measure of uncertainty.

As the policy developments in the wake of the Enron scandal illustrate, some of these regulations tend to be reactive. When a scandal is exposed, it prompts calls for reform – not the most predictable process. Others – such as new National Market System (NMS) rules for speeding the adoption of electronic markets – may have nothing to do with scandals, yet can add uncertainty nonetheless.

In 2004, regulators announced that Basel II – which requires firms to hold reserves of capital in proportion to their risk exposure – would be applied universally. Now all capital markets firms are required to comply within the same time frame as the 10 largest U.S. banks affected by the original rules. On the downside, the short time frame has clearly added pressure for many organizations. On the upside, Basel II will prompt firms to mitigate risk by establishing controls and taking an enterprise-wide view of their exposure.

Whatever the source, increased regulatory scrutiny can drive compliance costs upward. While industry fines resulting from regulatory scandals are not insignificant (research-related penalties totaled a record US$1.39 billion in 200335), the real impact is felt in the form of lost market capitalization. In fact, downward pressure on market value in the months following a scandal can far and away exceed the cost of the initial fine.

In 2005, Wall Street firms

are expected to spend around

$US2.4 billion, or 12 percent

of their combined IT budget,

on compliance technology

initiatives, an increase of as

much as 25 percent compared

to last year.34


While no one can foresee what shape new regulations will take, firms can be sure that the regulatory environment is anything but static. Increasingly, successful compliance will rely on operating models that are optimized for adaptability. For today’s siloed enterprises, the immediate challenge is to develop the capability to collect and compile data from across the organization.

RecommendationsAs they regroup for future growth, sell-side firms should step back, evaluate their position and decide on a course of action. While every firm in this relatively specialized industry faces unique challenges, there are three common actions each of them can take to respond to an evolving marketplace that demands speed and innovation. The first is to focus on the strategic core of the business by adopting a portfolio strategy. The second – once the firm decides where it is best able to compete – is to align the operating model to realize the most value in executing its chosen strategy. Finally, bulge bracket firms must reorient their cultures around long-term value creation and external partnerships.

Adopt a portfolio strategy

• Analyze existing business activities and client segments to determine sources of emerging and declining value

• Pursue revenue diversification based on capital efficiency, risk levels and contribution to firm strategy• Shut down or divest unprofitable or underperforming businesses, as long as doing so contributes to

the firm’s overall profitability.

Historically, the businesses of typical capital markets firms have been siloed. While the interplay among lines of business – say prime brokerage and investment banking – receives some attention, firms very rarely develop a systematic and continued top-down view of how the elements of the firm interact. To realize the most return for the risk they assume – in other words, if they want to be on the efficient frontier – they will need a much better idea of how the various parts of the business relate to each other (even parts that present no cross-selling opportunities).

First and foremost, firms need to develop a more comprehensive view of where their profits come from and how current trends affect the outlook in those areas. This can give them a sense of where to invest for the next round of growth.


A portfolio view can also help firms to diversify their sources of revenue by purchasing stakes in businesses that are negatively correlated. Investing in businesses with "out- of-phase" cycles can lower volatility. When one enters a slump or takes on new risk, another might be renewing its growth or consolidating its strategy. Overall, such a strategy can enable firms to cope better with marketplace fluctuations.

CSFB grows the business with a portfolio approachCSFB has taken a top-down approach to developing profitable business lines. After analyzing its existing lines, the bank decided to reorganize prime brokerage (hedge fund administration), hedge fund asset management and private equity under one roof.36 With these activities consolidated within the new Alternative Capital Division, the bank is better positioned to service a cohesive set of clients and to measure and control risk. The move is the first of its kind among large firms in the industry. It remains to be seen whether others will follow CSFB’s lead.

Adopting a portfolio perspective across traditional silos provides executives with a clearer picture of the role of loss-leader businesses and client profitability. As big investment managers seek to drive down costs, they increasingly rely on sell-side firms’ trading operations for simple trades. In response, those running the trading relationship may be tempted to scale back service levels. But because these clients often wield tremendous clout as sources of underwriting demand and other business, bulge bracket firms usually accommodate them. In such cases, the sell-side firm’s trading business is often rewarded for the client’s overall contribution to the firm in return for maintaining the relationship.

Component business modelingComponent business modeling (CBM) is one method firms can use to determine which areas of the business truly add differentiating strategic value. Within the modular structure envisioned by CBM, each interlinked component is run as an "independent business" responsible for its own personnel, resources and governance. This clear segregation of activities gives decision-makers a much clearer picture of where value is being created (and makes it easier to monitor risk levels, from a compliance perspective). CBM also adds flexibility. Because components collaborate through standardized, service-level agreements, it makes little difference whether collaboration occurs within firm boundaries or across them. Thus, CBM makes it much easier to source and assemble best-in class capabilities wherever they reside in the marketplace.

Two papers from the IBM Institute for Business Value – "Component business modeling: Financial services firms prepare for an on demand world,"37 and "Uncertainty is certain: Repositioning financial markets firms to operate on demand"38– explore these concepts in further detail.


Figure 3. Modeling the bulge bracket firm as a network of business components.

Optimize the operating model

• Adopt a client coverage model that aligns client knowledge, internal resources, product offerings and delivery capabilities across lines of business.

• Consolidate platforms, manage data and rationalize workflows across the firm to improve delivery effectiveness and the ability to monitor risk and regulatory compliance.

• Pursue sourcing alternatives for non-core and suboptimal capabilities.

Client coverage is one area where bulge bracket firms continue to struggle, largely because they lack a unified culture. Typically, sell-side firms take an entrepre-neurial approach – each salesperson picks up the phone and calls his or her contacts. Needless to say, this ad hoc method of client coverage is not optimal at the firm level. For example, it is likely to overlook client relationships that are not as developed, but where a deeper understanding of the client’s needs could reveal the opportunity for a perfect solution. It can also lead firms to miss cross-selling opportunities, spend too much time on unprofitable clients and deliver lower client satisfaction due to inefficient hand-offs to other lines of business.

Insight

Processing

Manufacturing/client and trade support

Distribution/front office Risk

Strategy and planning

Governance

Trading Sales Advisory and servicingAdvisory and servicing

Client and trade supportProduct manufacturing

Risk

Financial Management

Compliance

Data Common processes Specific processes

Other HR ITSupport infrastructure

Source: IBM Institute for Business Value.


Bulge bracket firms need a more systematic approach to client coverage based on a clear picture of the sources of emerging and declining value. Client segmen-tation is part of the formula. In general, for a given client, the level of service should be commensurate with the impact that client has on the firm’s bottom line. A small money manager, for example, might believe it deserves a high service level, but if it is not willing to pay for it, the bulge bracket firm might want to scale back the cost of serving them to remain profitable. The exception is if the client provides valuable information that is worth the cost – or if there is unrealized future revenue potential. To assess the value of the relationship, bulge bracket firms can analyze their clients using five criteria: current profit, transaction frequency, need for advice, market insight and current client share.

Another challenge is to encourage the appropriate sharing of resources. No one has cracked the code yet, but firms can begin to do things more effectively today. In the area of prime brokerage client servicing models, for example, sell-side firms can find it difficult to conduct seamless hand-offs to – and receive timely responses from – the various product lines. The use of client knowledge is another area for improvement. At investment banks, for example, the main relationship manager covering a firm rarely receives timely information on what is happening at the account. Such information may "bubble up," but just as likely will not. (In fact, the way one leading firm finds out how much business it does with a major investment manager over the course of a year is to ask the client.) Overcoming this problem will require incentives to share information – a large cultural challenge for bulge bracket firms.

Universal banks are farther along in their ability to segment clients. With their retail expertise, they have the systems and culture in place to understand their profitability on a per-client basis. Now they are transferring these capabilities from their lower-margin lending business to investment banking. By and large, bulge bracket firms have not matched these levels of investment. When margins were high in investment banking, there was little incentive to change, but now incumbents must be much more rigorous and disciplined in their approach to client segmentation.

In addition to better client coverage, bulge bracket firms also need to drive efficiency, flexibility and resilience. On the equities side, trade automation is lowering costs by enabling firms to reduce headcount. To spread such efficiencies, sell-side firms are turning their automation efforts to much more complex fixed income and derivatives trades. (But as these technologies mature and NMS regulation takes hold, clients will likely begin to handle these trades themselves, as is now done with equities.)


Despite their traditional tendency to handle activities internally, many bulge bracket firms have realized the value of leveraging global resources, especially in the area of captive offshore operations. Now they are developing the capability to partner with external providers for data, software and services. Morgan Stanley and J.P. Morgan, for example, are pioneers in equity analyst research sourcing, and many Wall Street firms are considering emulating this strategy.

Bear Stearns optimizes its client coverage modelTo mitigate the competitive threat of combined commercial and investment banking, Bear Stearns is solidifying its relationships with targeted clients. It established processes to measure and monitor results at top-tier accounts by tracking revenue improvement, share gains and fully loaded costs of servicing.39 As a result of this effort, Bear Stearns reported a 15 percent increase in revenues from these "focus accounts."40 It also created a COO role within investment banking who is accountable for holding weekly banker progress reviews, monthly group head business outlook and quarterly business unit reviews. The COO jointly signs off on focus accounts and incentives for combining multiple products within one deal.41 This coordinated approach is designed to drive discipline and efficiency, as incentives for combining multiple products within one deal decrease the cost of sale and increase revenue. For example, one high-incentive deal would combine global industries, asset-backed banking, debt capital markets, treasury, derivatives, repo and fixed income sales and trading. Bear Stearns is also providing

"relationship loans" to deepen its ties with select clients.

Transform firm culture

• Adopt management structures that drive expense discipline and risk management while enabling pursuit of growth opportunities

• Provide employee incentives that promote long-term business goals and relationship building over short-term results

• Develop ability to partner with external parties to gain capabilities in emerging markets and high-

growth products areas, as well as for non-core activities and shared processes.

Bulge bracket firms have an unfortunate tendency to ramp up steeply during the boom years, then cut dramatically during the bust. This reactive stance is especially problematic when it comes to personnel, which is far and away the largest cost at bulge bracket firms (see Figure 4). Too often, firms respond to upswings with a costly round of hiring and training, only to go through a costly and traumatic round of layoffs when the market turns sour. One large investment bank, for example, cut its payroll by a third during the recent downturn. While no one knows exactly when peaks and valleys come, everyone knows that they will come. The challenge is to move to a model that mitigates this needless and hugely expensive exercise.


Figure 4. Compensation accounts for the largest share of expenses at bulge bracket firms.

Compensation accounts for more than 60 percent of total expenses at large sell-side firms. This represents a major target for cost reductions. Some firms have set a long-term goal of reducing personnel costs to 50 percent of total expenses.42 But because bankers and traders are in such high demand (and are therefore profes-sionally mobile), firms need to take care to develop incentive structures that balance employee retention with overall costs.

In addition to reducing headcount, many firms also reacted to the latest downturn by consolidating locations, exiting geographies and cutting product lines and services. These steps do indeed represent ways to save money, but by reducing capacity and capabilities they also leave firms poorly positioned for the inevitable market rebound. As Figure 5 shows, taking a savvier approach to cost-cutting can leave firms more competitive. Switching vendors or adopting open source software can reduce the cost of inputs. Moving processes online using standard, Web-based systems or streamlining trade processing can increase efficiency. Outsourcing IT and processes can refine infrastructure to better suit the emerging needs of the business.

0

10

20

30

40

50

60

1998 1999 2000 2001 2002 2003 2004

Total 23 -5 8OthersC 8 2 -11Professional servicesB 32 -1 27Marketing and 14 -17 15business developmentTechnology 13 -5 -5Brokerage/exchange 8 6 9Occupancy 14 5 -6

Compensation 29 -6 11

98-00 00-03 03-04

39

7%10%6%5%

51%

8%4%

5%8%4%4%

67%

7%4%

6%8%4%4%

67%

6%5%

5%9%5%5%

60%

11%5%

5%10%6%6%

62%

7%5% 4%

8%6%6%

64%

8%6% 4%

7%6%5%

65%

6%7%

50

60 58

4952

56D

Note: AIncludes: total fi rm expenses for Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Stearns, expenses are higher than revenues as revenues are only for selected businesses; BProfessional services includes employment agency, consulting, auditing, legal fees; COthers include depreciation, goodwill amortization, fraud, restructuring charges, offi ce supplies; DFor 2004, fi rst three quarters data for Merrill Lynch are included, four quarters of data included for other fi rms.Source: IBM Institute for Business Value analysis of company annual reports.

Total expense mix for large, traditional sell-side fi rmsA, 1998-2004(all expenses included, US$ billions) CAGR


Figure 5. Some approaches to cost-cutting are longer-lived than others.

Bulge bracket firms also need to gear their incentive packages toward long-term goals and relationship-building, rather than remain fixated on quick wins. When it comes to employee compensation, most firms rely on short-term, transactional incentives. The common approach is to augment relatively small salaries with large potential bonuses based on the year’s performance. Yet following through with a small bonus in a bad year leaves firms vulnerable to losing top employees. While this is undoubtedly a difficult problem, bulge bracket firms need to explore ways to move to longer-term incentives. Goldman, for example, uses qualitative measurements that take long-term relationships into account.

In addition to balancing incentives toward the longer term, sell-side firms must also learn to play better with others by developing a culture that values partnering with a broad spectrum of specialized organizations, such as application vendors, local governmental organizations and even competitors. To succeed, firms must overcome the mentality that ceding control over a portion of the business inherently means giving up a source of advantage.

UBS partners with Brunswick to enter Russian marketMoving past the go-it-alone mentality can pay off big for capital markets firms as they seek entry into the key emerging markets of China (near term) and Russia (longer term due to political instability). Success in these countries relies on an ability to partner with local organizations and governments. To test the waters in Russia, UBS formed a 50/50 joint venture with the leading Russian investment bank, Brunswick Capital, in 1997.43 Based on initial successes, UBS purchased the remaining stake in August 2004 and named the resulting organization Brunswick UBS. The deal provided UBS with a large footprint for distribution of Russian debt and equity. Now, Wall Street firms like Deutsche Bank, Merrill Lynch and Goldman Sachs seek to rival UBS’ successful model.44

Effi ciency

Reducing capacity

Reducing capabilities

• Layoffs• Consolidating locations • Exiting geographies

• Reducing number of product lines

• Reducing the number of services

• Switching or reducing the number of data providers• Adopting open source software• Relocating selected operations offshore

• Web-enabling processes• Forming an industry utility• STP-enabling processes• Centralizing pricing and modeling tools• Delivering statements online• Optimizing market data and reference data

• Optimizing IT delivery• Outsourcing IT• Outsourcing business processes

Decreasing price of inputs

Increasing effi ciency

Reducing/refi ning infrastructure

Capacity

Source: IBM Institute for Business Value.


In truth, there are far fewer sources of advantage than people tend to think. Rather than compete indiscriminately on all fronts (as too many now do), bulge bracket firms can focus their efforts and realize efficiencies by handing commodity activities over to an external specialist. Reference data is one area where this approach makes sense. Capturing and processing the reams of raw data required for capital transactions – such as the issue terms of a particular security – is a costly and labor-intensive process. Yet today firms handle reference data themselves. Each runs its own (often multiple) reference data systems, which is hugely duplicative and gives the firm no extra edge. Overcoming the cooperation hurdle could save these firms enormous amounts of money. Culture and technology go hand in hand in this area, but culture is the bigger issue. Technology is only part of the answer, and not a huge part at that.

Capital markets firms have, for the most part, kept vendors at bay and have been reluctant to achieve the full benefits of integration. In part, high profitability has made the cultures of bulge bracket firms insular. Despite the emergence of specialists in some areas, by and large the cultures of bulge bracket firms are not geared toward seeking outside expertise. Improvements in the area could free bulge bracket firms to focus on the core business. But realizing the advantages of specialization will require new thinking on the part of firm leadership.

Cues from the auto industryIn the area of partnerships, bulge bracket firms could learn from automakers, which long ago recognized the value of cultivating relationships with contract manufacturers.45 Today the auto industry’s open supply chain exemplifies how companies can realize great strides in overall efficiency, flexibility and responsiveness through the widespread use of industry specialists. In fact, the auto industry is so far along the change curve toward specialization that, in some cases, car makers colocate with contract manufacturers to better integrate their systems and operations.

Leading Japanese firms have learned to reduce the high costs associated with integration and supplier management by building relationships with suppliers. Toyota and Honda, for example, use development models that encourage partnering and relationship-building. This orientation not only helps these companies leverage expertise beyond the boundaries of the firm, but also helps them achieve better

prices, higher quality and rapid innovation.

Eventually, close integration with specialists can deliver a clearer picture of business data. From there, it is a short step to developing a portal approach to collaboration. Instead of the vendor pushing information, portals use two-way communication to achieve value for all stakeholders. Imagine the firm’s senior executives using a


security-enhanced information "dashboard" to manage the company based on realtime information. While an automaker might use such a system to keep tabs on inventory, bulge bracket firms would use it to monitor data. For example, an executive could follow a dashboard alert to make sure the vendor cleanses a data issue in realtime. Such a system could be used to prevent trade failures before they happen.

The choice is yours: Where do you want to start?As you ponder your next move, take a moment to consider how your firm reacts to unexpected change. After all, the question is not if but when the next disruptive event will occur. How effectively can you adapt to sudden discontinuities in the environment? How consistently can you optimize capital investments across business lines and geographies? How accurately can you quantify and hedge your risk across the enterprise? Figure 6 presents four scenarios for your consideration.

Figure 6. The industry is changing. Is your firm ready?

Adapt to sudden changes?

Optimize capital investments and hedge risk across business units?

?

?

How well do you...

NASD is demanding a report of fi rm-wide disaster recovery processes and number of failures within the past three years: it is your job to respond quickly and cost-effectively.

The COO has mandated a 15% reduction in fi xed income processing expense: it is your job to determine focus areas and execute.

Your buy-side clients are demanding online access to advice and realtime inventory; simultaneously, the head of M&A advisory in China has asked for additional staff to meet demand: it is your job to determine the most effective use of capital.

Energy is a hot industry; you are simultaneously purchasing power plants, increasing proprietary trading and hiring client service staff for commodity-invested hedge funds: it is your job to report fl uctuating levels of return and risk across all three divisions.

• Do you have consistent recovery processes across geographies and business units?

• Are you able to quantify the cost incurred for meeting the requirement?

• Do you use a dashboard to slice the data for multiple views: by time, geography, responsible employees, process for correction?

• Are you taking advantage of fi xed income functionality improvements within order management and trading systems?

• Have you evaluated target applications that can be consolidated onto one platform to service across lines and geographies?

• Do you have a global process fl ow map to determine application dependencies?

• Can you quickly execute your mandate with no user disruption?

• Can you access data (including risk exposure) in realtime to make an accurate decision?

• Have you established a systematic process, business case template and model for simulating capital allocation decisions within and across silos?

• Are dashboards in place to monitor ongoing results in terms of return on capital?

• Can you identify the person who is accountable for this type of risk exposure within each business?

• Do you have sophisticated models that aggregate trading position data1 with other business activities such as positions of internal hedge funds and positions of prime brokerage clients in realtime?

Note: 1Defi ned as data aggregated in realtime across multiple trading desks within one fl oor, and across multiple trading fl oors.Source: IBM Institute for Business Value.


ConclusionIn today’s globally connected marketplace, even a widespread economic recovery cannot dispel the specter of uncertainty. Indeed, unquantifiable risk is now a permanent fixture of the business landscape. But bulge bracket firms have faced the challenges of commoditization and disintermediation many times before. In each case, they managed to find new sources of profit through innovation. Now the bar is being raised once again, and it is up to Wall Street to answer the challenge. The recommendations offered here can help sell-side firms tap their innate creativity as they once again rethink how their businesses are structured, how they cover their clients, and how their organization and culture can support a more flexible, partnership-focused approach to doing business.

To learn more about strategies for bulge bracket innovation, please e-mail us at [email protected]. To browse other resources for business executives, visit our Web site:

ibm.com/bcs

About the authorsSuzanne L. Dence is a Financial Markets Industry Senior Consultant with the IBM Institute for Business Value. Suzanne can be reached at [email protected].

Daniel W. Latimore, CFA is Executive Director of the IBM Institute for Business Value and leads its Americas practice. Dan can be reached at [email protected].

Mukund Prasad is a Financial Services Consultant with IBM Business Consulting Services. Mukund can be reached at [email protected].

John M. White is a Managing Consultant with the IBM Institute for Business Value. John can be reached at [email protected].

About IBM Business Consulting ServicesWith consultants and professional staff in more than 160 countries globally, IBM Business Consulting Services provides clients with business process and industry expertise, a deep understanding of technology solutions that address specific industry issues, and the ability to design, build, and run those solutions in a way that delivers bottom-line business growth.


References1 World Federation of Exchanges. "December 2004 Focus Newsletter and

Statistics." http://www.world-exchanges.org/WFE/home.asp?menu=307&document=2557

2 Ibid.3 Mercer Investment Consulting. "2005 US Fearless Forecast." January 2005. 4 IBM Institute for Business Value analysis.5 Yahoo Finance.6 IBM Institute for Business Value analysis.7 "Playing with fire," The Banker. December 1, 2004. http://www.thebanker.com/

news/fullstory.php/aid/2395/Playing_with_fire.html8 Ibid.9 IBM Institute for Business Value analysis.10 Ibid.11 Aldrich, David and Marina Lewin. "The Seven Habits of Highly Effective Hedge

Funds." The Alternative Investment Management Association Journal. December 2004. http://www.aima.org/uploads/BONY64.pdf

12 Moskowitz, Eric and Katherine Burton. "Morgan Stanley Grip on Hedge Funds Slips, Bear Gains." Bloomberg News. February 9, 2004.

13 Ibid.14 Ibid.15 IBM Institute for Business Value analysis.16 Shepherd, Bill. "Shaving Fees for the Privileged Few." Investment Dealers’ Digest.

March 7, 2005. http://www.iddmagazine.com/idd/fierce_finance.cfm?id=10250& issueDate=current

17 Ibid.18 Ibid.19 IBM Institute for Business Value analysis.20 Thornton, Emily. "Real power plays on Wall Street." BusinessWeek. November

22, 2004. http://www.businessweek.com/magazine/content/04_47/b3909136_mz020.htm

21 IBM Institute for Business Value analysis.22 Ibid.


23 Securities Industry Association. Soft Dollars & Institutional Brokerage Conference. June 2004. http://www.sia.com/softdollars04/html/presentations.html

24 Ibid.25 Ibid.26 Securities Industry Association. The Securities Industry Fact Book. 2004.27 HSBC Private Bank. "Euromoney Annual Awards for Excellence." [Press release.]

July 19, 2004. http://www.hsbcprivatebank.com/hsbc/rhp/profile?cp=/public/republic/rhp/profile/en/pressroom_euromoney_award.html

28 Treanor, Jill. "HSBC makes record £5bn profit." The Guardian. August 3, 2004. http://money.guardian.co.uk/saving/banks/story/0,12410,1274862,00.html

29 Bank of America. "Bank of America leases space at 50 Rockefeller Plaza to accommodate ongoing growth in New York." [Press release.] January 21, 2005. http://www.bankofamerica.com/newsroom/press/press.cfm?PressID=press.20050121.02.htm

30 "Arrington Mixon." The Banker. May 2004. http://www.thebanker.com/news/fullstory.php/aid/1507/Arrington_Mixon.html

31 IBM Institute for Business Value analysis.32 Instinet. "Instinet Trade Performance Note." March 2005. http://www.instinet.com/

pdf/tradeperformance/InstinetTradingNoteSmallCap_0305.pdf33 Bank of America. "Capital Markets Monthly Picturebook, Industry Overview,

Brokers & Asset Managers." June 2, 2004.34 "Institutional brokerages will spend more for compliance technology." Wall Street

Letter. January 21, 2005.35 IBM Institute for Business Value analysis.36 Credit Suisse First Boston. "CSFB Creates New Alternative Capital Division Led by

Bennett Goodman." [Press release.] March 22, 2004. http://www.csfb.com/news/html/2004/march_22_2004.shtml

37 Latimore, Dan and Greg Robinson. “Component business modeling: Financial ser-vices firms prepare for an on demand world.” IBM Institute for Business Value. 2004.

38 Latimore, Dan, John Raposo and Ian Watson. “Uncertainty is certain: Repositioning financial markets firms to operate on demand.” IBM Institute for Business Value. 2003.

39 Urwin, Jeffrey. "Investment Day – Investment Banking." October 1, 2003. http://www.bearstearns.com/bscportal/research/analysts/investorday/ib_urwin.pdf

40 Ibid.41 Ibid.

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References in this publication to IBM products and services do not imply that IBM intends to make them available in all countries in which IBM operates.

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42 IBM Institute for Business Value analysis.43 UBS Investment Bank. "UBS to acquire Charles Schwab's Capital Markets

Division." [Press release.] August 31, 2004. http://www.ibb.ubs.com/News/august04.shtml

44 Ostrovsky, Arkady. "FINANCE: Competition intensifies: INVESTMENT BANKING IN RUSSIA: Brunswick UBS is a successful model that other investment banks seek to emulate." Gateway to Russia. October 23, 2003. http://www.gateway2russia.com/st/art_156913.php

45 Belzowski, Bruce M., Michael S. Flynn, Morgan Edwards, Linda Ban and Gregory Martin. "Supply chain management: New competitive realities in the automotive value chain." IBM Business Consulting Services. 2004.

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