mckinsey improving capital markets profitability

Improving Capital Markets Profitability: From a Product To a Client Focus

McKinsey Working Papers on Corporate & Investment Banking | No. 5

July 2014

McKinsey Working Papers on Corporate & Investment Banking

are a series of publications presenting McKinseys latest research

and insights on corporate and investment banking. Incorporating

a broad range of views from McKinsey partners and experts

globally, the papers provide a leadership-level perspective on the

opportunities and challenges facing corporate banking, investment

banking and capital markets businesses worldwide. Their purpose

is to encourage discussion about the future of the industry.

* * *

Kevin BuehlerDirector, New York [email protected]

Daniele ChiarellaDirector, Frankfurt [email protected]

Helmut HeideggerDirector, Vienna [email protected]

Matthieu LemerleDirector, London [email protected]

Akash LalPrincipal, Mumbai [email protected]

Jared MoonPrincipal, London [email protected]

Editorial Board

Improving Capital Markets Profitability: From a Product To a Client Focus

McKinsey Working Papers on Corporate & Investment Banking | No. 5 1

The profitability of global corporate and investment banks is settling to a lower baseline, due in part to regulations that followed the 2008 financial crisis. In a recent white paper,1 McKinsey suggested that without significant revisions to business structures, return on equity for the top 13 capital markets and investment banking (CMIB) units could slip to as low as 4 percent. Banks profits are also hobbled by the market regime prevailing since the financial crisis: monetary policy has induced very low volatility, and severely limited profitable trading opportunities. In this challenging environment, capital markets institutions can unlock significant value in their businesses by changing their approach to gauging profitability, from one that focuses on products to one that also centers on clients. By applying the resulting insights to the allocation of resources for all of their businesses, banks can expand the bottom line of their capital markets units by 10 to 30 percent.

Capital markets banking units recognize the need to develop a better under-standing of the drivers of client profitability in a contracting marketplace. At least seven of the top 10 capital markets banks have undertaken initiatives to better understand client revenues and expenses in order to drive cost savings initiatives and balance sheet reduction. One sales head McKinsey interviewed observed: We need to know how much extra revenue we get from providing an extra touch point or an incremental amount of balance sheet. From their side, clients recognize the value of the approach as well and have increased the scrutiny of services they receive from brokers. In some respects, an in-formation arms race is underway in capital markets, where a strong grasp of client profitability will be crucial to sizing and pricing business opportunities.

Each capital markets segment faces unique pressures. In the U.S., fixed in-come, currencies and commodities (FICC) units face serious challenges as a result of both the Volcker rule and the increasing amount and cost of capital they must retain. European banks are facing separate capital and process requirements for OTC derivatives from European Market Infrastructure Regu-lation rules, and European regulators may yet impose a financial transactions tax. Prime services are dealing with increased capital requirements, as well as a reduction in the leverage carried by clients. The equities business may be less impacted, but must still address regulatory changes to derivatives operations and better manage the cost of services provided to a client base that increasingly executes through lower-paying electronic channels. In all cases, a new framework for measuring profitability will provide the perspec-tive and transparency needed in the new client-centric environment.

1 The Return of Strategy: A Roadmap to Sustainable Performance for Capital Markets and Investment Banking, McKinsey, November 2013.

Improving Capital Markets Profitability: From a Product to a Client Focus2

A disciplined approach to client management

Despite major investments in information technology for their capital markets units, few banks have a clear view of revenues and expenses at the client level. The task is a challenging one. In FICC and other over-the-counter (OTC) trading businesses, revenues are not based on commission schedules but on variables such as the clients ability to influence pricing and the trad-ers discretion in hedging and holding positions. Cost attribution is no easier, as most accounting systems allocate expenses, often subjectively, to trading desks or business units rather than to client accounts. Charges for capital and risk are typically aggregated across portfolios as well. Moreover, com-pensation is typically based on the bottom line of trading desks rather than the contribution to profits of the clients that traders and sales people serve.

However, useful systems for tracking profitability can be developed within reasonable cost and time to market constraints. Depending on a banks expense allocation methods, systems can be extended to report at the client level by monitoring a few key variables. Additionally, the past few years have brought improved methods for capital measurement and management.

Among the major capital markets business lines, equities has a head start in adopting a client profitability orientation. Commission rates have been in decline for years, and the dual nature of the equities business modelsplit between advisory and execution, often without a clear relationship between services and revenueshas pushed managers toward a client focus. FICC and other OTC business lines have more work ahead of them in attempting to shift from a product-centric business model to one focused on clients.

Measuring client profitability

Most banks develop at least simple estimates of client revenues, and some banks go further on client profitability, with basic models that incorporate a few specific estimates of costs. In McKinseys view, a holistic view of clients depends on a framework that loads all client costswhether financial (capital dedicated to customer trades) or organizational (sales, research, trading and operations)against an accounts actual revenues (Exhibit 1).

Revenues. The starting point for a client profitability framework is revenue. As noted, equity units already track commissions by client, but OTC busi-nesses have typically relied on the metric of sales credits, usually derived from volumes traded. The challenge is that due to varying product margins, revenues earned from a client can be very different from the sales credits


generated. Even so, dealers find sales credits to be a familiar and effective tool for managing sales teams. This argues for tracking both estimated rev-enues and sales credits. Many managers are already aware that sales credits are an imperfect measure of productivity, but also realize how difficult it is to upend the existing sales culture. Some banks use sales credits as a basis for estimating revenues by adjusting them for trade quality or observed mark-up. Other banks have started automatically calculating captured spread by using live price quotes to determine real-time distance to mid-market from the executed client price.

Direct and indirect costs. The direct costs of sales, research and tradingprimarily salaries and bonusesare the easiest for managers to understand. Allocating them, however, can be more complex. If a salesperson speaks with a client twice a day and meets with him once a week, she likely spends more time serving that client than just one observed hour. On the other hand, while a trader might never meet a particular client face-to-face, it is

Client protability

Expenses

Revenue Income Best estimate of client revenue based on actual outcome

SalesActual cost to provide sales coverage for each client

ResearchActual cost to provide research services to each client

Trading Actual cost of trading and trading support

Ops and trade processing

Actual cost of capturing, processing and settling trades

Capital, balance sheet, risk-weighted assets

Comprehensive cost of capital and balance sheet

Should reect:

Not all clients are created equalA client economic model should reect differences in clients: Trading styles Pricing power Levels of resource allocation/ consumption Volume of accounts managed

Source: McKinsey Global Corporate & Investment Banking Practice

Exhibit 1

A client protability model must reect all revenue and cost elements of serving a client


unlikely that he has provided no service whatsoever. A client cost allocation approach must be flexible enough to use all interactions, including execu-tions and quotes, and intelligent enough to load these direct observations with those less tangible ones not directly observed. Many banks start with timesheets that capture aggregate time spent with clients as often as monthly. Even more powerful is the use of real time activity metrics from phone, email and trade logs and a centralized meeting calendar used together with travel and entertainment expense ledgers.

Behind every direct service role are equal or greater indirect resources, and determining a rational and fair process for loading their costs to client ac-counts is essential. Such costs include compensation for sales and trading support, compliance, finance and senior management, as well as the costs of technology. Indirect costs can be allocated to client accounts based on the revenues they generate, the direct expenses they incur, or other economic grounds, but those costs must be a part of the calculation to avoid overstat-ing client profitability. Because these indirect costs are so often subjectively assigned to businesses, the best framework will show account profits both with and without these internal allocations, giving managers one view of the business based on what they directly control and another that is consistent with the broader business P&L.

Operations costs. Trading desks seldom pay sufficient attention to the cost of their middle- and back-office operations, in part because banks often do a poor job of allocation. As with revenues and capital charges, the cost of operations varies greatly by client and can have a surprising impact on profitability. With a given product, revenues tend to rise with trade size, while operations costs are more correlated to trade count. Small trades, therefore, can incur the same processing cost as larger ones and thus quickly outstrip revenues (Exhibit 2).

Meanwhile, trades of the same size and revenue can have very different oper-ations costs, depending on simple factors such as the number of subaccount allocations and other special handling requested by clients. Operations costs can be greatly reduced, however, by trading through electronic channels and increasing the proportion of straight-through trades.

Capital costs. Most dealers have improved their capital accounting frame-work, making allocations to individual business lines more efficient. However, the new environment demands a more precise understanding of trades at the client level. Traditional capital accounting tends to view the portfolio of a desk


or unit in the aggregate, netting all positions, whereas a client-focused view takes into account the stories of securities in inventory, rather than viewing them as generic end-of-day positions to be financed.

Cash bond inventory positions can be grouped in three categories. The first is those the firm wants to holdsecurities that a desk believes clients will find attractive or that will appreciate in value. In such cases the firm should bear the cost of capital, rather than charge it to the client that sold the position. Second are securities that the firm may not want to own, but takes into inventory nonetheless to support the selling client. In this instance, capital costs arising from a given position should be attributed to the client for as long as the bond is held. Third are liquid, frequently-traded flow positions. These can be viewed as a conventional pool of securities, with capital charges attributed to all buyers and sellers to price their share of the working capital.

In the case of OTC derivatives, capital treatment is dependent on the nature of the transaction. Liquid swaps that are cleared by a central counterparty can be treated like flow cash securities, where the cost of working capital is allocated across all positions. As transactions become more complex,

Hypothetical 5-year interest rate swap with 5 allocations

Swap Notional

Estimated revenue

Middle ofce

Back ofce

External third-parties

Processing IT

Total processing

Cost ratio

$1,000,000

$119

$196

$420

$314

$97

$1,026

862%

$10,000,000

$1,190

$196

$420

$314

$97

$1,026

86%

$50,000,000

$5,590

$196

$420

$314

$97

$1,026

17%

$100,000,000

$11,900

$196

$420

$314

$97

$1,026

9%

Source: McKinsey Cost Per Trade Study 2012; McKinsey analysis

Exhibit 2

Operations and trade processing expenses have a signicant impact on client protability


however, revenues booked on a particular swap may already take into ac-count capital charges and hedging costs, and systems should avoid charging clients twice for the same cost.

Client profitability profiles

The results of a comprehensive client measurement system can run counter to management intuition on client profitability. An analysis of one banks 2013 results revealed a large number of unprofitable FICC accountsvalue destroyersin-cluding some that also generated high levels of sales credits (Exhibit 3).

A comparison of revenues earned versus capital provided to FICC clients for the same bank yielded similar resultsshowing a similar cluster of accounts near the intercept, where capital is provided but little revenue is delivered in return (Exhibit 4).

Managing from a client profitability framework

Most dealers have processes that identify priority clients and the actions needed to maintain and grow their business. Within an organization, these

Sales credits vs. client protability for U.S. rates

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

-2,000 -1,000 0 1,000 2,000 3,000 4,000 5,000 6,000

Gross sales credits ($000)

Client protability ($000)

Valuedestroyers


Exhibit 3

Traditional sales credits often provide weak signals on client protability


processes often exist both at the firm level and on several product-focused levels. Their effectiveness is, however, uneven. Those areas with greater insight into client profitability generally have a more disciplined approach. In cash equities, for example, most dealers have at least a basic understanding of client-level spending on research and sales costs relative to commission revenues, and thus can incorporate profitability metrics into client management.

In FICC and other OTC business lines, client account management is more art than science. Sales and trading must agree on priorities, while often fundamentally disagreeing on sales credit-based revenues. Resources are apportioned to clients based on these estimated revenues, which can reward clients with lower real revenue with higher levels of service. The reverse can also happen; clients that generate significant real revenues, but low sales credits, might not receive the resources they deserve. When properly designed and implemented, client profitability frameworks can reveal such misallocations, and deliver compelling results. One top 10 global fixed-income firm found that over $200 million was being lost annually to value-destroying clients, so they recalibrated their pricing and resources provided. A second top 10 dealers client profitability system showed that

Capital cost ratio distribution

Client revenue$ thousands

Cost of capital deployed $ thousands

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

0 100 200 300 400 500 600 700 800


Exhibit 4

A comparison of revenues earned and capital provided reveals an inefcient cluster of clients


sales credits were overstating the revenues of certain large clients by nearly 50 percent. The firm reacted by directing these clients low-margin flow trading to lower-cost electronic channels, and leveraging senior sales efforts with additional junior staff. In a third instance, a regional European bank used client profitability to help guide the transformation of several of its capital markets product lines. The bank shifted sales coverage resources away from lower-margin client segments and better focused its capital commitments to more deserving clients.

A client-profitability approach puts all products on an even playing field and helps drive standardization of client management. Any resource deployed, in any product area, can be assessed with a defensible return-on-investment metric. A holistic coverage approach can be managed fairly by tracking the real cost invested by one product area versus the real revenue impact across all. This accounting transparency allows management to reward those areas making client investments even if revenue was realized by a separate business areaa key ele-ment in the transition from a product to a client-centric approach to profitability.

Any model of client profitability produces a variety of signals, highlighting strengths in some areas and weaknesses in others. Accordingly, part of managements role is to emphasize the systems objectivity and its benefits for every part of the business and ensure it is used with proper sensitivity. Examples of potential uses and challenges include:

Clients. A client-focused approach to profitability will usually confirm that most of a banks priority clients do indeed deserve their special treatment, but will also show that a number of them do not. And by highlighting the factors that drive profitability, the client-focused provides new diagnostics into varying profitability among clients, client sectors, regions or products (Exhibit 5).

Quantifying client profitability gives a bank a clear view of where to make adjustments to optimize client business mix and services levels (Exhibit 6, page 10). Clients with potential for high revenues and margins should be granted priority for resources, and conversely, low-potential accounts should have their resources scaled back (Exhibit 7, page 11).

The challenge often comes when the bank must describe service-level changes to the client. Clients may counter that whatever business they bring affords the dealer a profit and are likely to attribute shortfalls to the dealers ability to manage its own costs. These can be difficult, sensitive conversa-tions and work best when banks follow a carefully-developed script.


Sales teams. In FICC, client profitability measures are valuable for managing clients, but tend to be less successful for guiding sales teams, as conveying too much information can lead to unintended consequences. For example, armed with actual revenues, salespeople might emphasize higher-margin products while playing down crucial but lower-profit business such as flow cash securities. In this case, salespeoples efforts to optimize their individual production could create an unhealthy dynamic that favors short-term results at the expense of building deeper, sustainable client revenues.

Additionally, sharing the details of client-level costs may lead sales teams to reduce service in order to raise margins, when the units long-term ob-jective might call for the opposite. And as sales teams have no control over operations and capital costs, offering that information could be a distraction. Rather than furnish sales teams with detailed reports on clients full-loaded profitability, management can instead set target levels of resources for individual accounts, separately determined by profitability and coverage segments. These metrics should illustrate the quality of trading flow, reflect activity levels and rank clients by more neutral percentiles or tiers.

Fund X All hedge funds All clients

Gross credits 100 100 100

Quality adjustment -50 -40 -35

Revenue margin 60% 65% 50%

Sales cost ratio 10% 12% 15%

Trading cost ratio 7% 8% 7%

Research cost ratio 5% 6% 7%

Capital/RWA cost ratio 12% 11% 18%

Trade-processing cost ratio 12% 13% 12%

Total expense ratio 46% 50% 59%

Prot margin 14% 15% -9%


Exhibit 5

A diagnostic can highlight the factors that drive protability


Client profitability metrics must also be used with care when managing equities sales teams. Equities revenues can be measured accurately at the client level, but due to the holistic nature of equities sales and re-search coverage, attributing revenues to an individual salesperson is less exact. Therefore client profitability metrics are valuable to an equities sales manager or account quarterback in evaluating a team, but could provide misleading results on an individual producer.

In prime services, client management is central to the entire business and salespeople play a different role from that in the transaction-driven busi-nesses. Full disclosure of client profitability is necessary and important in the effective management of clients.

Business development. Often a client is assigned a high priority in a cap-ital markets business line without regard to actual profitability, because the account is important to the bank in another segment or to the firm overall, or because it offers substantial potential. Providing a high level of service

Actions

Discuss mix of in-comp business and order business with clientDiscuss internally value of client ow informationWiden marketsMove to e-platform to reduce other costs

Adjusted revenue1

Discuss service level with client to determine proper coverage intensityAdd junior members to coverage teamTransition low-margin ow business to e-trade platforms

Sales expense

Examine hit/miss ratios for client inquiryScale back access to traders

Trading expense

Discuss service levels with client with goal of increasing volumes or decreasing provided service

Research expense

Push cost saving platforms such as Omgeo and TradeExpress for clients withlarge sub-account volumesConsider modifying pricing for smaller trades where processing costs make them unprotable

Processing expense

Discuss mix of ow vs. risk trades and risk reduction strategies with clientPrice incremental risk transactions more aggressively

Capital, RWA, balance-sheet cost

1 Client volume provides less revenue potential than average


Exhibit 6

Dealers can take actions in the areas where client protability lags


can be a sound long-term decision, but a system for assessing client prof-itability can make the true cost of such business development clear. In this way, management can make decisions about service levels with their eyes open. Relationships can be evaluated on their current profit contributions as well as their potential, giving capital markets management ammunition for recommending adjustments to service levels to the clients sponsors.

Management challenges

Imposing a client profitability framework on traditional capital markets busi-nesses may generate resistance from trading and sales managers, due to differences in form, scope and accountability from familiar systems. However, successful application of this framework can demonstrate its value and es-tablish client profitability as an important management tool. Among the more common challenges:

Client profitability versus product profitability. Banks report prod-uct-line income statements to their business units, corporate management and shareholders, and this difference in form is probably the greatest

0

5

10

15

20

25

30

35

40

-10 -5 0 5 10 15 20

Client D

Client C Client B

Client A

Client E

Client F

Mitigate and Prioritize Prioritize

Maintain Deprioritize

Economic marginPercent

Potential wallet $ million

Potential wallet vs. margin for resource allocation


Exhibit 7

Incremental resources should be directed based on potential wallet and economic margin


challenge to the adoption of client profitability management. Although client-level accounting generates more reports, and in greater detail, than the aggregated statements of conventional systems, these reports in fact represent subsets of product-based income statements. Given time, implementation of a client account model is likely to improve managers understanding of cost allocations, and the two reporting systems will complement each other, leading to a stronger and more transparent ac-counting framework for business units overall.

Allocating overhead. A client profitability statement will also allocate a wide range of unfamiliar costs to managers over which they have no control. They are likely to discount these new expense loadings, in the belief that their clients earn a profit except for all the new stuff. But the additional overheads are valid expenses to be charged against clients, and a well-designed implementation will report client profitability both before and after the additional charges, allowing managers to focus on the client-oriented costs within their control. As for senior management, having fully-loaded client profitability metrics at hand, properly segmented, will afford greater insight into the impact of infrastructure and other costs allocated by the parent organization.

Sales versus trading. While senior management will likely embrace client profitability reporting, sales and trading line managers may push back. Many banks allow sales teams to consider themselves the owners of client revenue and attribute all other revenue to trading desks. The dis-tinction is artificial, particularly in an increasingly client-focused market, as banks need both sales teams and trading desks to generate revenues from clients, and client flows are essential to traders in managing the risk profile of their portfolios. The solution goes beyond accounting, however, and addresses dealer culture: client revenue and profitability must be jointly managed by sales and trading teams. Improving client profitability is likely to enhance trading desk profits, and this shared success should make sales and trading managers more amenable to any changes.

* * *Despite regulatory pressures, capital markets will continue to be an important source of revenue for capital markets banks. As the industry adjusts to a more demanding regulatory environment, it will likely operate on a smaller scale, earn lower margins and be more dependent on clients than on risk. While profits


from proprietary trading will effectively disappear, banks have the opportunity to defend their bottom lines through informed management of client relationships.

The transformation starts with data and technology, creating a unique identifier to track each clients revenues and expenses. The hard work begins, however, when management incorporates the new insights into a units culture and day-to-day operationsreserving balance sheet capacity for clients that meet a hurdle rate of return or restricting sales and research coverage for clients without adequate revenues.

Any new performance metric will face challenges. When it confirms a managers beliefs, it will be recognized as valid and relevant, but when it contradicts them, it will be questionedor ignored. To overcome these real-ities, senior management must lead the transformation by incorporating the new measures into performance reviews and compensation frameworks for all parts of the organization, including research and trading teams as well as sales. Equally important, the owners of the profitability model must incorpor-ate critical feedback, adapting to the nuances of the business.

When client profitability is measured fully and accuratelyreflecting revenues instead of volume, with realistic accounting for expensesmanagers may be surprised to find that their largest clients, measured in terms of managed assets or trading flows, may not be their most profitable. Similarly, small ac-counts likely will not pull their weight. In some cases, the bottom 40 percent of a units clients might contribute 10 percent of revenues, while drawing 30 percent of resources. With successful implementation of client-focused sys-tems, dealers will find many opportunities for managing revenues and costs and realize substantial improvements in profitability.


Further insights

McKinseys Corporate & Investment Banking Practice publishes frequently on issues of interest to industry executives. Our recent reports include:

McKinsey Working Papers on Corporate & Investment Banking, No. 4:The Brave New World of SEFs: How Broker-Dealers Can Protect Their FranchisesJune 2014

McKinsey Working Papers on Corporate & Investment Banking, No. 3:Winning in Transaction Banking in AsiaJune 2014

McKinsey Working Papers on Corporate & Investment Banking, No. 2:Sales Transformation in Mid-Market Corporate BankingMarch 2014

McKinsey Working Papers on Corporate & Investment Banking, No. 1:Winning in Western Europes New Corporate Credit LandscapeFebruary 2014

The Return of Strategy: A Roadmap to Sustainable Performance for Capital Markets and Investment BankingNovember 2013

Corporate Bond E-Trading: Same Game, New Playing Field(a joint report from McKinsey and Greenwich Associates)August 2013

Matthieu LemerleDirector [email protected]

Roger RudisuliPrincipal [email protected]

Akash ShahAssociate Principal [email protected]

Ed BergmanSenior Advisor [email protected]

Contact

For more information about this report, please contact:

Global Corporate & Investment Banking Practice July 2014Copyright McKinsey & Company www.McKinsey.com/client_service/financial_services

mckinsey improving capital markets profitability

Documents

capital markets banking

capital markets units

capital markets banks

capital markets businesses

corporate investment

corporate banking

capital markets institutions

capital markets segment