Big banks have been warning their investors about the competition they face from private credit, electronic market makers and others for some time. Now we have a number to put on it and it’s not pretty — even with an incoming US President Donald Trump promising deregulation.
Banks are set to lose as much as $50 billion from annual revenue by 2027, mostly in the US and mostly in corporate and investment banking, according to research from Oliver Wyman LLC and Morgan Stanley. The industry can replace up to $15 billion of this, mainly through lending more to illiquid private markets, which is already an area of concern for policymakers focused on the risks of shadow banking. The Bank of England warned that non-banks, particularly those that used borrowed money, were likely to amplify market shocks in its annual financial stability report published Friday.
This evolution of finance is well in train and isn’t likely to reverse. It’s the result of advances in technology, the electronification of markets and regulatory changes designed to make banks safer. But the process continues to favor the biggest Wall Street banks, such as JPMorgan Chase & Co. or Goldman Sachs Group Inc., that can spend the most on tech and have tight relationships with the biggest private-market asset managers. And that threatens more concentration of financial leverage — and increased risks in the years ahead.
There are forces that could slow the process down, but they aren’t likely to stop it. In the US, many regional banks have pulled back from asset-backed and commercial real estate lending due to the pressure of sharply higher interest rates on their own funding costs and the prospect of tighter capital rules. With borrowing costs declining and Trump raising hopes for lighter regulation, some of that pressure could ease.
“Will the opportunity to feed on the ground ceded by US regional banks be smaller given a Trump bump? Possibly, if they end up with fewer capital constraints,” Huw van Steenis, vice-chair of Oliver Wyman, told me. “But pressures remain and these banks still want to rebalance their businesses and diversify their books, or engage in M&A.”
The threat to bank revenue has grown dramatically in just the last few years as investors have poured cash into private credit and the lockdowns of the Covid-19 pandemic accelerated the move to electronic trading in bond markets.
Corporate bonds were still mostly traded by people via phone calls and rooms full of traditional brokers and dealers well after stocks went electronic. Part of the reason was that companies can have multiple kinds of debt in different currencies and with different maturities, making bonds more complicated to list and price than stocks. But liquid, investment grade debt is typically now traded electronically, especially in Europe, while the growing popularity of exchange traded funds and portfolio trading has helped improve liquidity for all kinds of bonds.
These developments have made pricing tighter, reduced barriers to entry and favored the quantitative and algorithmic trading capabilities of electronic market makers and other non-banks that are stealing business from the incumbents. Banks can combat this by selling more financing and other services to market makers and hedge funds, adopting the strategy employed when stock markets went increasingly electronic in the decade before.
Back in 2008, banks’ revenue from prime services, the division of investment banking that lends to hedge funds, was only half the level of traditional equity trading revenue, according to Oliver Wyman and Morgan Stanley. Prime grew and cash equities trading shrank; the former is now two-and-a-half times the size of the latter.
Private credit, meanwhile, has been eating away at banks’ business from multiple angles. Direct lending to private equity-backed companies has been the biggest growth area and erodes the opportunities for banks’ leveraged finance desks to earn fees and interest income from underwriting loans and selling them on to investors.
Non-bank lenders are increasingly targeting other areas in the US and Europe where banks have long dominated, including trade finance and asset-based lending (providing funds for industrial equipment or ships, for example). These are projected to be the next big growth areas of private credit in coming years by analysts and fund managers like Apollo Global Management.
The lost revenue for banks will be mostly corporate lending income worth $10 billion to $12 billion, with a similar amount disappearing from investment banking and markets and a further $4 billion to $5 billion from transactions and securities services. Added together, this equates to as much as 14% of total 2023 industry credit-business revenue, according to the research. Commercial banking, meanwhile, could lose $10 billion to $20 billion in interest and fees, the report calculates.
Investment banking and markets are the main areas where big lenders can make some of this money back, with about $8 billion available from the growing range of financing demanded by hedge funds and private asset managers and another $7 billion in fees available from trading, structuring, distribution and other services.
The losses will likely hit all banks to some degree. But the replacement business is mostly going to be done by the leading Wall Street players. With shadow banks competing ever harder, big lenders will be financing them as much as possible stay in the game, keeping the risks and fates of banks and non-banks closely tied together. Prudential regulators need to keep track of these flows — and their potential to feed instability.
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