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Equity research under pressure #research #bankculture

Equity research under pressure #research #bankculture

William Vincent, Senior Consultant, william.vincent@skadilimited.co

UBS has been caught up in a political row in Australia after it produced a research report on the privatisation of a New South Wales electricity utility, a deal in which it is acting for the seller. What happened is that UBS put a report entitled “Bad for the budget, good for the State”, then changed the title to, simply, “Good for the State”. The opposition Labor (sic) party is claiming that this was the result of direct interference from the ruling Liberals.

To which a rational first response is “so what?” After all, Australia is a long way away, and Australian politicians are renowned for fighting like starved rats in a barrel, so why should anyone bother about this? In fact, while the details are not terribly important, this case, coming on top of several others, illustrates equity research is still vulnerable as it tries to square the various circles of adding value to its users, not offending the investment bankers and their clients, satisfying ever-more intrusive regulators, all the time while facing a crippling squeeze on revenues.

Two instances over the past year or so indicate the scale of the problem. First, last summer UBS (again) came under fire, this time in the UK. A UBS analyst had produced a report on Saga, which UBS had helped to float a few months earlier, with an Underperform recommendation and a target price some 4% lower than the sale price. The result was a chorus of criticism, notably from the UK Shareholders’ Association, which was quoted in the Financial Times as saying, “It’s all wrong for them to value the company at a high level and then drop it,” while an unnamed but — according to the FT — influential fund manager described the incident as “very, very strange.”

So, this argument goes, it’s wrong for an analyst to set a price target (which, incidentally, has proved to be accurate) independently of the bankers, rather than try to ramp up a price simply because his house had a role in the flotation? Clearly, no-one has told the regulators, who have spent much of the past fifteen years setting and enforcing rules that give analysts no choice but to act in a way that the UK Shareholders’ Association believe is “all wrong”. In short, UBS’ analysts were attacked for doing exactly the right thing – a classic case of damned if you do, damned if you don’t.

Second, there was the case in the USA last November when Citibank was fined a cool $15m for inadequately supervising equity analysts. The specific issue was that an analyst told people at a dinner that he’d short a stock on which he had an official Hold rating. It is possible to think of reasons why analysts might feel there is little wrong with this position, for example a share that is expected to perform in line with the market over a twelve month timeframe might well be over-bought in the short-term, nonetheless the regulator took tough action.

These cases, and others, illustrate how difficult it can be for research to operate today. What should banks now do – send a compliance person to every analyst dinner, lunch or post-work beer with a client? The only answer is for research to have absolutely clear, transparent and detailed policies for every regulatory contingency. Banks must be able to convince the regulators that every analyst is aware of the rules, receives regular training in them, and understands the consequences of not following them. Research management and the analysts under them must understand that compliance is not optional, and that the penalties for even what seem like minor breaches will be severe. Needless to say, this will not go down well with the notoriously egotistical and touchy research community, but the price of being caught in financial and reputational terms is so high that no alternative exists.

The problem is that heads of research aren’t necessarily experts on the regulations, and in any case are likely to be caught up in the day to day cat-herding exercise that is managing analysts. The compliance and other professionals who do understand the regulations are not analysts, and thus don’t necessarily know the pressures inherent in the job, and they run the risk of being seen as “the enemy” by the people at the coalface, with all that that implies.

Meanwhile, Frost Consulting has estimated that total spending on equity research fell to about $4.8 billion in 2013 from $8.2 billion in 2008, with a further cut, to around $3.4 billion, expected by 2017. London is likely to be hit especially hard, because new rules will effectively prevent payment by the buy side for research that is not “substantive.”

Many banks will almost certainly have to axe much, if not most, of their current output, and with it the people responsible for it. The whole ethos of research will have to change, from churning out yet another quarterly results analysis or big, bland sector review to doing radical stuff, like producing readable, original, tightly argued research that produces recommendations that actually make money.

All in all, therefore, research is facing a period of fundamental change. Those that get it right have the opportunity to clean up in a market where much of the competition will be squeezed out. Those that do not will be the squeezed.

Issuance Issues #bankculture #issuance

Issuance Issues #bankculture #issuance

Nicolas Corry, Managing Director, nicolas.corry@skadilimited.co

Last week Bloomberg writer Zeke Faux’s piece on Death Spiral Financing allowed a small chink of light to shine on the Private Issuance market. Death spiral structures are not new, and generally appear to be above board, but it is hard not to recognise the risk and damage they pose to investors in a company that chooses to source finance in such a manner. Private transactions tend to be by their nature private. They tend to be structured between (one hopes) sophisticated parties that are able to shoulder the burden of reduced disclosure and consequent increased risk. One wonders though what consideration is given to other stakeholders? Smaller shareholders, employees, customers, suppliers to mention a few.

In the Public Issuance market recent reporting by the Financial Times offers insight into the activities which may occur during the book building process. While activities such as order inflation may be known, the allegations made regarding fake order creation to win more paper, will shock many.

It seems clear that Control Functions should review their organisations’ issuance procedures, with careful attention given to where business lines meet, such as at Syndicate and in the Private market, where transactions are handled together between banking and markets. These areas represent gap risk, as consideration may have been given to each business individually, but not together as a whole.

 

Ammunition for the regulation industry

Ammunition for the regulation industry

William Vincent, Senior Consultant, william.vincent@skadilimited.co

The December BIS Quarterly review contains an interesting piece which analyses the performance since 2007 of the three main classes of banks – retail funded, wholesale funded and trading led.

 

Its broad conclusions are:

 

  1. There has been a marked shift away from wholesale funding to retail funding, while the number of trading-led banks has remained constant.

 

  1. Profitability of all three models has fallen sharply, but trading-led banks have suffered the most.

 

  1. Trading-led banks have gone from the most profitable sector, with ROE approaching 20%, in 2007, to the least, with ROE of 5%, in 2013.

 

  1. Trading-led banks have consistently had the highest cost-income ratios, at approximately 70% versus 60% for retail banks and 50% for those which fund mainly in the wholesale markets.

 

  1. Trading-led banks carry significantly more capital, with a capital adequacy ratio of 17.3% versus 14.6% for retail banks and 12.2% for wholesale.

 

So, trading-led banks demand more capital, have significantly higher costs in relation to income, have suffered the most severe fall in profitability, are the least profitable and worst performing of the three groups. However, their numbers have not shrunk to reflect these factors, whereas the number of wholesale-funded banks – which have not performed as badly – has shrunk substantially.

 

The authors of the report surmise that the reason for this is that investment bankers pay themselves so well that they are loath to change their business model – they organise their banks for themselves, in other words, rather than their clients or shareholders. This may or may not be true – after all, past busts have been followed by booms, and banks which closed down or cut too deeply missed out – but the BIS’s view is undoubtedly the one that will gain traction.

 

This will inevitably provide more ammunition for the UK’s politicians and regulators to squeeze the investment banks. Already, they have taken powers for themselves to control what and how bankers are paid, and are imposing limitations on risk that will make it harder than ever for investment banks to produce worthwhile levels of profitability even if and when the good times return.

 

All this means that it is more vital than ever before that banks understand and control their risks (and risk takers), that costs are kept under control and that management is kept fully aware of any business or reputational threat before it blows up into yet another scandal. All in all, therefore, the role of internal audit has never been more important.