Source: www.breakingviews.com is Europe’s leading financial commentary service
Date: July 2003
By Christopher Hughes
For decades, equity analysts at bulge-bracket banks have been paid large salaries to produce more research than anyone ever really needed. But the cross-subsidies that supported them are now facing abolition in the UK. You don’t need to be a top-rated analyst to see what this means. The salaries of an awful lot of number crunchers will be coming down.
The investment management industry hugely appreciates equity research. Sure, some money managers, particularly in hedge funds, do their own homework and actively commission research. Most, though, are accustomed to being spoon-fed ideas by sell-side analysts. According to the latest Thomson Extel survey, fund managers value sell-side analysts’ ideas much more than their purely quantitative modelling work.
Fund managers take all the broker research they are given because they do not pay for it. Their research intake is funded by the trading commissions levied on their clients. But the UK Financial Services Authority is proposing that fund managers pay a refund to clients to cover the cost of research and other services received that are not related to the execution of stock trades.
The regulator is worried that fund managers transact through certain brokers for the perks rather than because of the quality of their execution. But the effect of the clampdown will be to hit overproduction.
Although still in draft form, the FSA’s proposals are already shifting the broking industry towards producing less research. According to Thomson Extel, about 40% of commission charges go towards research. And money managers are so scared by the prospect of rebating clients for these previously undisclosed services that they are asking brokers for an itemized bill for commissions. Armed with this rate card, they can buy research and execution services separately, rather than being forced to buy them as a bundled package.
The arrival of transparent pricing spells less demand for research. Fund managers will probably reward the output of only two or three top-rated analysts. And the separation of research from execution may mean brokers will be less interested in producing research for the sake of attracting order flow per se.
Meanwhile, as research starts being provided on a stand-alone basis, related revenues will come under pressure as competition emerges from boutiques. These boutiques won’t necessarily clean up, although they have a marketing advantage in being independent. But they will probably nibble away at margins in the juiciest sectors.
How will the bulge-bracket banks adapt? A withdrawal from research altogether, to focus on execution, looks unlikely.
For starters, banks can get more value out of an analyst than boutiques can. Their analysts have the benefit of market rumours and information about trading patterns. The proprietary trading desk can use the research too.
Moreover, some big fund managers will still want a one-stop shop covering all sectors in all territories. The junior analysts at Fidelity, for example, are rotated around sectors regularly to give them an overview of the market before they become fund managers. They will value a continuing relationship that adapts to their needs.
Above all, the bulge-bracket houses will need to continue providing equity research across a wide range of sectors for the sake of their corporate business. True, New York state attorney-general Eliot Spitzer has banned direct links between research and investment banking. But companies are loth to employ a bank as an adviser if it does not cover their stock, even if the analyst’s view is negative. Maintaining broad coverage will also help the bulge bracket differentiate itself from boutiques. In this case, the research function may become rather like the economics department – an important part of the bank’s brand, even though it does not generate revenues directly.
The question is whether the bulge bracket has much scope to trim its cost base as commission income falls when the forced sale of research ends. The first step will be to restrict coverage to the sectors that really matter to a bank’s business overall. Within that, resources will have to be more targeted. In some areas, a bank will employ top-rated analysts who write regularly on their industries. In others, coverage will be piecemeal. Modelling and data mining can be outsourced.
But such measures can only go so far. If the bulge bracket really wants to keep up appearances, sooner or later the only place left to make cuts will be analysts’ salaries. Seeing what’s coming, the most experienced number crunchers, already sitting on safe pensions, will take the opportunity to set up on their own either as consultants or in boutiques.
The best of the rest should continue to earn a decent crust in the bulge bracket. But for the vast majority, salaries will probably be cut pretty hard.
breakingviews is Europe’s premier English-language online subscription commentary service, supplying the top investment banks, hedge funds, asset managers and corporations with timely insight into markets, economics, companies and business.
In addition to its online service, breakingviews supplies its market-moving commentary to a handful of prestigious daily newspapers. These print partners include the Wall Street Journal Europe, Gaceta de los Negocios, la Repubblica, NRC Handelsblad, l’Agefi, Kauppalehti and others.
