The Financial Times recently opined on the future of equity research, anticipating significant structural changes in the investment banking model. Pressures on investment banks are likely to impact research, potentially forcing a change in the way research is paid for.
The article is an outgrowth of the view that investment banks are being inexorably squeezed by regulatory and market pressures, articulated in an earlier FT article. Deleveraging is reducing profitability; the Volcker rule impacts proprietary trading, which was a huge source of income; derivatives are moving to exchanges; and shrunken balance sheets make capital scarce for bridge loans for M&A transactions, prime brokerage services to hedge funds, or trading capital to counterparties.
The predicted outcome is not amalgamation but more specialized firms, such as merchant banks like Evercore and Greenhill which concentrate on corporate advisory and M&A.
The FT sees equity research as particularly vulnerable to the squeeze: “Here [in equity research] we see the intricacy of the [investment banking] model – and its vulnerability – on full display. The analyst’s function is threefold: to attract corporate clients, to increase deal flow and to come up with market-moving ideas from which the dealers can profit in advance. Remove those, and all that remains is the ostensible purpose of research – to advise the investing institutions. The value of that is evident from the fact that the service is provided free.”
One suggested outcome would be to separate dealers and brokers: “The old system of separate brokers and dealers, which was swept away in the Big Bang reforms of the 1980s, did a better job in some ways. For a start, those dispensing advice did not own the stock they were recommending.”
In the event that investment banks no longer underwrite the equity research function, the FT envisions two potential solutions: “First, the fund management industry agrees to stump up for independent research. Second, the authorities impose standard measures and requirements, as in the credit industry, whereby those seeking capital can be obliged to pay an explicit fee.”
There is another factor impacting equity research unmentioned in the FT articles, which is the secular decline in commission volume over the past three years. One cause of this decline is the deleveraging mentioned by the FT. Declining commissions pose the greatest threat to the current model for equity research.
If it continues, the full service equity research offered by bulge bracket investment banks will be even less profitable than it is now. Although investment banks are used to operating in feast or famine environments, eventually structural pressures will take their toll. At the very least, there would be fewer full service offerings as some bulge bracket firms exit.
However, under the recent provisions of the JOBS act, investment banks have succeeded in loosening the barriers between investment banking and research. If all agree that research is a public good, then perhaps legislators can be persuaded to allow banking to help subsidize research, as in the pre-Settlement days.
The bottom line is that equity research has interesting times ahead. Independent research is more nimble and has a lower expense structure than banking research, so it will continue to be part of the mix under any scenario. However, it is premature to announce the demise of banking research.