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Bloated Investment Banks Can't Stomach Their Own Medicine

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The worst may be yet to come as regulations on investment banks continue to increase.

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There is nothing investment bankers love more than decrying inefficiency in lesser mortals. For a generation, Wall Street has rejoiced at the sight of people being thrown out of work, and bosses squeezing evermore revenue out of those lucky enough to remain. People not pulling their weight are a favorite object of scorn, as famously crystallized in Mitt Romney's closed-door "47%" speech.

You would expect the Masters of the Universe, being the moral leaders they are, to live by their own rigorous code of perpetual fat-trimming. But alas no, according to a revelatory new report from McKinsey & Co.

The superconsultants make it clear that investment banking around the world is not what it used to be. Global revenue for the industry came to $331 billion last year, a 30% drop from 2009, which actually set a record of $473 billion as markets recovered from their post-Lehman shell shock. McKinsey sees no new boom on the horizon either. It predicts maximum annual-revenue growth of 4% between now and 2017, as deal- and market-making in developing markets stagnates, while Asia and Latin America creep forward.

The slowdown has turned the lords of Wall Street and the City into profit laggards. Average return on equity for the industry -- that McKinsey calls capital markets and investment banking, or CMIB -- came to 10% last year, compared to some 15% for the S&P 500 (INDEXSP:.INX). Big banks are worse off than little banks. The 13 largest CMIB houses, which account for 53% of industry revenue, returned 8% on equity in 2012. More focused regional institutions are performing much better, but still worse than pedestrian non-financial businesses. Asian banks for instance, averaged 13% ROE last year. "As other industry sectors show signs of recovery, capital markets and investment banking remains in the slow lane," McKinsey's big brains conclude.

Worse may well be yet to come, the consultants warn, as governments around the world continue to set loose "an avalanche of new regulation" that forces investment banks to increase capital, rein in leverage, and restructure beloved businesses -- like derivatives trading -- in ways that make them less profitable. Return on equity for the Big 13 may halve to a lamentable 4% by 2019 "without structural changes or mitigation," the report prophesies.

Surely, faced with such stiff headwinds, investment banks must be slashing head counts, biting into bonuses, and forcing brown-bag lunches. Well, not exactly. "Costs remain sticky," McKinsey finds, unleashing a masterpiece of B-school understatement. In fact, while sector revenues have sunk by 10% a year since 2009, costs have subsided by just 1% annually.

The price of abiding by new rules has something to do with this. Legal fees for the Big 13 banks reached a whopping $33 billion last year, McKinsey reports. But "front-office head counts" – i.e. guys in blue suits pulling down fat salaries – have also proved sticky, shrinking by just 4% annually even as the business implodes. Investment banks are getting dramatically less bang for those big bucks. Costs averaged 66% of income in the boom year of 2007. That climbed to 80% in 2011 and 73% last year. "On a per-head basis and including capital costs, the economics of the front office for CMIB look unsustainable," McKinsey intones.

The narrow conclusion from this portrait of a sick industry trying not so hard to cure itself is that investors may be overenthusiastic about the shares of Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), the two pure-play investment banks still out there on the market. Both have been going like gangbusters. Goldman's stock has risen by 42% over the past year and Morgan's by 87%, crushing the mere 28% rise in the S&P 500. Other banks tilted heavily toward CMIB, like Credit Suisse (NYSE:CS), have also outperformed.

The broader conclusion is that the Obama Administration and its still more regulation-loving counterparts in Europe may actually be weakening the capital-markets industry in an historic way. That regulation avalanche may look clumsy and haphazard. Leftos may cry ceaselessly that nothing has changed and the rest of us remain slaves to the evil 1%. But the net effect has been to poison the honeypot and make getting rich on Wall Street more difficult. Banks themselves seem to be in denial of this reality, but if McKinsey is even half right, the truth is catching up with them fast.

For a good 99%, maybe more like 99.9%, or the world's population, that is a good thing. Anecdotally, it seems like the best and the brightest young people these days are dreaming of getting rich quick via killer apps, or even producing objects with emerging 3D-printing technology. Tech nerds are not always angels either. Just take a look at the terrific reporting the New York Times' Nick Bilton has been publishing about the genesis of Twitter (NYSE:TWTR). But we'll take them as masters of our troubled universe over Fabulous Fab and his friends.
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No positions in stocks mentioned.

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