Challenges in the Capital Markets Industry

Industry challenges

The challenges faced by companies in the capital markets industry can be divided into four categories:

• new regulations during the global financial crisis in 2008
• increased competition from globalization and consolidation
• cost pressures
• slowdown in developed market economic growth

New regulations during the global financial crisis in 2008

During the global financial crisis, governments adopted new regulations that have impacted all companies within the capital markets industry. Although critics disagree as to whether the new regulations are beneficial or not, almost all agree that regulations are challenging in the face of financial innovation. Because some regulations prevent companies from realizing their full potential when it comes to revenue, companies frequently create new products and technologies to get around these regulations. Regulatory agencies are often under-funded, which also makes it difficult to stay on top of all these new innovations.

Despite critics' opinions about the usefulness of regulations, they were created with several goals in mind. First, the new government guarantees of debt and bank deposits were created to improve investor confidence. Second, government purchases of private-sector securities were meant to restore liquidity to capital markets. Finally, the creation of short-selling bans was meant to prevent destabilizing speculation and reduce risk.

Increased competition from globalization and consolidation

While globalization is beneficial to the capital markets industry in many regards, it can also lead to increased competition. When more foreign competitors enter the market, the supply of credit tends to decrease and financial instability tends to increase. Nevertheless, many banks still go global for two reasons. First, multinational banks set up shop where their clients are. So if a multinational bank's client opens a new location in another country, the bank will tend to follow suit. The second reason is that it's very profitable. Most multinational banks focus on a small number of large clients, which, combined with advanced technology and knowledge, makes operating in foreign countries a sure way to increase earnings.

Globalization also poses a challenge for many companies in the industry, since they're increasingly facing larger, vertically integrated competitors. When banks consolidate, they often increase their global reach significantly.

Cost pressures

Many firms in the capital markets industry are facing cost pressures as a result of technological advancements. The Internet is ubiquitous, and small investors now have many tools at their fingertips that give them instant information. In the past, these services were strictly the domain of large institutional traders. But as information becomes even cheaper and faster to access, research and advice will continue to lose value, and brokers will have to search for other avenues to deliver value.

Another example of the impact technological advancements have had on the capital markets industry is in the area of profit margins. For instance, equity trading and market making margins have decreased because innovations in technology have decreased trading costs for clients. Buyers and sellers are increasingly able to interact directly without going through a broker, and this has had a significant impact on revenues.

Slowdown in developed market economic growth

The global financial crisis had a significant impact on economic growth in developed markets; in fact, the economic recession affected all the major players in the global economy. Prior to the crisis, investment banking firms took big risks and engaged in highly leveraged transactions. But these banks couldn't gather enough capital to support all these risky investments, so when the recession hit, most of them suffered immense losses. Many investment banking firms had to cut jobs.

The financial crisis had the biggest impact on the capital markets companies that were unable to keep their businesses solvent. Companies that remained in business had to face the reality of operating in an economy that had slowed significantly, which, for many, meant accepting much smaller revenues, or even losses.

Strategies for overcoming challenges

There are several strategies companies in the capital markets industry can employ to deal with these challenges:

• corporate reorganization of securities firms into bank holding companies
• greater focus on risk management
• specialization
• vertical integration and acquisitions
• developing business relationships
• adoption of latest technologies
• cost cutting measures
• look toward growth in emerging economies

Corporate reorganization of securities firms into bank holding companies

Following the global financial crisis of 2008, governments adopted new regulations that had an impact on companies within the industry. One strategy securities firms can use to overcome this challenge is to reorganize into bank holding companies. This allows them to have greater access to liquidity and funding.

A bank holding company is a firm that controls one or more banks, and can raise capital much more easily than traditional banks. When a securities firm assumes the status of a bank holding company, it can take on the bank's shareholders' debt on a tax-free basis. It's also easier for a bank holding company to borrow money and acquire other banks. And bank holding companies have more leeway in issuing stock, as well as making share repurchases of their own stock. There is a downside to becoming a bank holding company, however – companies with this status are bound by stricter regulatory standards.

Greater focus on risk management

Another way companies in the capital markets industry can overcome the challenge of new regulations is to place a greater focus on risk management. Many banks engage in proprietary trading, but new regulations limit this activity. Shutting down proprietary trading desks is one way companies can comply with the law and limit risk.

Specialization

Many investment banks are feeling the pressure of increased competition. Specialization is one way they can overcome this challenge. There are several benefits for companies that specialize:

• reductions in costs – Companies that turn to specialization often enjoy reductions in costs from operational scale efficiencies. When a company increases its product volume, the average unit cost decreases. Specialized companies also see reductions in cost associated with specialized lending expertise. This expertise can encompass many types of knowledge. Whatever their area of expertise, specialized firms are often at a competitive advantage, since their costs associated with loan write-offs or poor credit risks are greatly reduced.
• reductions in credit risk – Specialization often reduces a company's exposure to credit risk and credit losses. As the magnitude of unplanned losses decreases, an investment bank requires less equity capital. Thus, even if the level of earnings remains static, shareholders will enjoy a higher rate of return on equity. The result of a reduction in credit risk is a higher stock price.
• increased marketing efficacy – Specialization may help investment banking firms increase their marketing efficacy and achieve faster growth. Often, a bank that has specialized lending knowledge is willing to issue bonds loans that other banks are not. This bank will likely attract more new business than a bank that doesn't have specialized knowledge. In addition, smaller specialized banks often have access to a distribution network that's wider and more specialized than they would otherwise have. This allows them to attract customers outside their geographic area, and achieve higher growth rates than their diversified competitors.

Vertical integration and acquisitions

One reason for the increase in competition facing investment banks is consolidation, or banks acquiring other banks to become larger companies. But firms in the capital markets industry can use this strategy themselves to overcome the challenge posed by the increase in competition. Acquisitions such as this typically lead to vertical integration, meaning the company is able to provide not only its own products and services, but those of the acquired company as well.

Developing business relationships

Another way companies in the capital markets industry can overcome the challenge of increased competition is to work on developing business relationships. After the financial crisis that began in 2008, the relationships investment banks had built with shareholders, boards, and executive management were damaged. In order for these connections to be restored, banks must work to reestablish business relationships.

One way investment banks can foster good business relationships is by improving communication among their research teams, sales and trading divisions, and clients. Software to manage customer relationships can be particularly useful, especially when it's used to keep track of client and business information.

Adoption of latest technologies

More and more firms in the capital markets industry are facing the challenge of increasing cost pressures. One way companies can overcome this challenge is through the adoption of the latest technologies. E-trading is putting financial pressure on investment banks, and firms must increase the volume of transactions if they hope to earn revenue. This high volume of transactions can only be accommodated through the use of a cutting-edge telecommunications infrastructure.

Because sales and trading margins are much higher on new, innovative financial solutions than they are on typical bonds or equities, the engineered financial products segment is growing substantially. These are known as derivatives, and include several different products such as options, swaps, and credit default swaps, or CDS.

Cost cutting measures

The challenge of an economic slowdown in developed markets can be overcome, in part, by using cost cutting measures. Many of the largest investment banking companies have laid off hundreds of employees. Although layoffs are often painful for affected employees, reducing staff remains one of the most effective cost cutting measures, and it also allows companies to review performance and weed out unproductive employees. In addition to layoffs, many companies also cut costs through divestment. This means they reduce their assets, usually by selling them.

Look toward growth in emerging economies

Another strategy investment banking firms can use to overcome the challenge of an economic slowdown in developed markets is to look toward growth in emerging economies. Emerging markets, such as Asia and Latin America, are spurring opportunities for economic growth. In fact, emerging markets accounted for nearly all economic growth in 2010. Banks that want to remain competitive are expanding at a rapid pace into high-growth markets. In particular, many banks turn to mergers and acquisitions in emerging economies to bolster their revenues.

But it's not only companies in developed economies that are taking over those in emerging economies. In 2010, mergers and acquisitions on the part of companies in emerging markets accounted for 15% more mergers and acquisitions activity than in the first quarter of 2009. This growth represents significant revenue potential for banks in developed economies.