Ben Saunders

3 February 2017

Challenges in Investment Banking and Why Software-Driven Innovation Is the New Source of Competitive Advantage

As the financial services industry continues its long recovery from the global economic crisis, investment banks in the US are still struggling regain former levels of profitability. In JPMorgan’s own words in 2016: “This is not a growth sector” [1].

Donald Trump's promises of increased growth, reduced taxes and lighter regulation has helped spur investment (helping FICC divisions to their first annual rises since 2012) but Coalition Research Group has warned that "the environment is still quite challenging and a lot of the negative factors that have played against the banks are still there”, with Head of Research George Kuznetsov citing the burden of regulation and pressures on margins [2]. Return on equity for the top 12 investment banks was only 7.7% last year and this is not likely to change soon.

The costs of regulation and IT have a large part to play here in keeping margins down. In this regard, investment banks face a unique set of challenges. Their need for sophisticated in-house applications, innovative customer-facing portals, and high levels of transparency and security across the board mean that they are faced with substantial pressure on all fronts. These challenges touch on not only technology, but also the people and processes that work with that technology.

That’s why we recently launched our own Investment Banking Practice: to help banks to get out of the vicious circle of higher regulatory spend and falling profits by driving software-driven innovation using cloud platforms and DevOps practices.

In this blog, I’ll be examining the major challenges that investment banks face that point to a need for a fresh approach to technology in the sector.

I’ll cover five major areas: post-crisis uncertainty, doing more with less, legacy technology, internal barriers to change, and market threats.

1. Post-crisis uncertainty and ambiguity

The financial crisis of 2008 inaugurated an era of uncertainty for investment banking.

In the wake of rising regulation they have lost some of their autonomy: 80% of banking respondents state that they are changing their business strategy in response to regulatory changes [3].

In the aftermath of the crisis, the banking sector has been struck by waves of regulatory changes that have fundamentally transformed the way in which it operates. Stringent new rules have put almost all the major functions of investment banking, namely capital, liquidity, risk management, compliance, traded markets and governance, under far greater scrutiny.

Banks must themselves interpret the hefty volumes of regulations, assess their own situation and then decide what must be amended to guarantee compliance. This creates a tendency for banks to overcompensate, investing excessive funds in compliance to be safe, rather than sorry.

Exacerbating these trends is the rate of publication of new regulations. MiFID II regulation builds on the provisions of MiDID I, and Basel III on Basel II & I and so on. It is not necessarily the case that stipulations from one version carry over onto the next, and organisations can find that the changes they have previously made to comply proved to be a waste of time and money!

This is to say nothing of the uncertainty created by the position of the impulsive figure of Donald Trump at the helm!

2. Innovating more with less

The cost of complying with regulatory demands means that 72% of profits are put back into compliance (much of which involves IT systems). As a result, the average Return on Equity across the industry has fallen from over 20% to over 7%, barely enough to cover the cost of capital [3].

As JPMorgan state: “[t]he real issue ... is the dramatic increase in infrastructure costs, driven by regulatory and IT spend. Unless banks can get this under control, they will never achieve the sort of return on equity investors are looking for".

With the majority of IT budgets, therefore, going into “keeping the lights on”, there are limited transformational budgets for investing in the kind of innovation that would either raise profits, increase efficiency or reduce costs.

This creates problems in a number of areas.

Risk management and analytics

One important effect of increased regulation is a reduced appetite for riskier - higher margin - trades. This pushes banks towards a volume- rather than margin-driven model. Additionally, gaining a competitive advantage with these more “vanilla” trades relies more and more heavily on the real-time analytics and risk management capability of investment banks, which often places huge strain on their outdated antiquated infrastructure, which, in turn, limits their competitiveness.

Transparency

A further strain on banks’ people, process and technology is the requirement for total transparency across all digital activities. There must be end-to-end coverage, with every step of all trades fully accounted for: who did what, how and when?

But accounting for such transparency across many discrete IT systems is complex and requires special expertise, not to mention financial support.

The downward spiral

Banks struggle to comply in time with regulatory deadlines, are constrained by their own technological limits and find themselves in a downward spiral: due to regulation there is simply less money to invest in IT solutions that would increase innovation and efficiency, whilst making regulatory compliance simpler.

3. Renovating technology

The necessity for ever-more sophisticated risk management, real-time analytics, automated testing, proliferating customer-facing portals and burgeoning security requirements is putting ever greater pressure on banks’ technological capabilities.

A major hurdle to innovation is banks’ reliance on monolithic legacy applications and inflexible, outdated infrastructure.

Below are some of the major hurdles.

Grid compute

As noted above, in the current climate, effective risk management and real-time analytics are gaining in importance. These are highly resource-intensive activities that fluctuate hugely in usage, as trade volumes increase and decrease, and markets open and close throughout the day.

Consequently, during busy times queues form amongst different asset classes and time zones, which cuts into competitive advantage as trade analyses are delayed and opportunities missed.

Banks’ reliance on fixed-quantity distributed grid compute conflicts with their inability to know in advance how much compute they will need at certain times of the day, week or year. They face either being constrained by their limits, or paying for compute that they aren’t using.

Client portals/new platforms

Every company is becoming a software company. How often do you visit your local retail bank branch compared to how often you pop open their app?

The same goes for investment banks, who need to constantly innovate to be able to provide customers with best-practice digital access to their products and services across a range of devices and platforms.

Doing this effectively requires a software delivery pipeline that is optimised for fast, small releases and well-oiled DevOps teams to support. Legacy systems and processes, combined with siloed development and operations teams means that software deployments can take many months, or even years.

Cyber-security

Cyber-threats are ever on the increase and legacy technology has become a risk factor. They are more prone to unpatched vulnerabilities and create compatibility issues in M&A situations.

According to the FDIC, post-crisis ideas like ‘too big too fail’ encouraged a flurry of mergers and acquisitions as banks sought to consolidate their protection under the law. But often the legacy infrastructure acquired by a bank through M&A activity is not up-to-date and features extensive vulnerabilities that create additional fire-fighting headaches for IT teams.

Blockchain technology

According to a report by Accenture, blockchain technology could help the world’s largest investment banks cut their infrastructure costs by between $8 and $12 billion a year by 2025 [4].

A blockchain is a distributed record of transactions that is maintained by a network of computer and does not need to be approved by a central authority. This creates a “golden record” that doesn’t require data reconciliation (a massively expensive process) and that would be very useful for auditing.

The report stated that blockchain technology could reduce compliance costs by up to 50%.

But this is a novel technology, which will require significant investment - and expertise - upfront. Banks will have to free up the human and financial capital necessary to reap the benefits of this innovative technology.

Central banks are moving already, with the Singaporean central bank investing in a blockchain-based record-keeping system as part of a five-year $225m transformation. The Bank of England similarly plans to use Blockchain and a digital central bank currency.

Big data for business value

Investment banks can use technology to turn data into business value.

But developing the rights tools and technologies is a major challenge that, ideally, requires a highly-efficient software-delivery pipeline so that banks can iterate rapidly on their software to stay maximally competitive, whilst also ensuring security and regulatory compliance.

However, if executed well they stand to to provide organisations with a much more granular view of the marketplace and their customers and will, ultimately, boost profitability and enhance competitiveness.

Firstly, they can increase their knowledge of their customers and their behaviours in order to more effectively up- and cross-sell products and services.

Secondly, data analysts are able to provide more effective risk-profiling to assess the impact of world events on portfolios and exposure to particular markets and asset classes.

Thirdly, increasingly sophisticated predictive analytics can be used to turn previously useless data into business value. Vast amounts of data can be processed automatically, reducing risk and allowing companies to make improved predictions.

4. Internal barriers to change

Beyond technology, banks are ill-equipped to deal internally with the vicious circle of rising demands and falling capability.

Siloed and divided systems

There are a huge number of different IT systems across the different regions, branches and departments of investment banks, which multiplies the complexity and difficulty of introducing innovative changes to how IT is implemented across the business.

For example, front-, mid- and back-office IT systems are siloed and often incentivised in conflicting ways. Operations teams running back-office systems want to maintain stability and keep the lights on, whilst front-office teams feel the pressure to innovate frequently on customer-facing applications.

Also, banks also often use multiple trading platforms across their various asset classes, which adds further complexity to the digital ecosystem.

Lack of skills

Post-crisis lay-offs often hit the resident experts in legacy applications, leaving limited expertise in-house, and with declining expertise outside as market demand for newer skills sends expertise elsewhere.

Equally, their reputation for bureaucracy and inagility means that the fresh digital talent that they need to spark innovation go to smaller, faster FinTech companies where they can get more done and make a bigger impact.

These trends force banks into a reliance on outsourcing. Across siloed departments and business units - not to mention countries and continents - this results in inconsistency, reduced quality and substantial duplication of effort.

Handbrakes due to reg/risk fears

The above issues, combined with the general atmosphere of uncertainty and risk aversion means that initiatives that threaten to spark some innovation by working in new ways or with new tools are often shut down before they have a chance to prove their value.

There can be an atmosphere of cultural inertia that stifles innovation and perpetuates the vicious circle.

5. Market threats

The banks aren’t just playing against themselves. The rest of the world is changing incredibly quickly around them and, if they don’t keep up, they’ll continue to struggle.

Fintech disruption

Global investment in FinTech has grown by a factor of 6.5 over the past five years, in a clear signal of the health of the sector and of the growing threat it poses to more traditional organisations [5].

Smaller, born-in-the-cloud companies face a much lower regulatory threshold than much larger organisations and face none of the challenges that come with a decades-old tangle of legacy technology. This massively increases their ability to innovate, disrupt the marketplace and compete with much larger banks on the basis of agility.

For investment banks, the threat is one of basic economics: as competition grows, margins will decline and only the fittest and most adaptable organisations will survive.

Embracing digital ecosystem

Business Insider recently declared Goldman Sachs a ‘tech’ company, as it has 9,000 more engineers and programmers than Facebook, Twitter or LinkedIn.

Technology that allows for software-driven innovation - whether in terms of real-time analytics, cyber-security, or customer engagement - is the new source of competitive advantage for investment banks.

Organisations that fail to embrace the new digital ecosystem in which they find themselves will struggle.

The imperative of software-driven innovation

The fundamental challenge is one of doing more with less: using smaller budgets with inflexible and outdated legacy technology to deliver almost total transparency across increasingly sophisticated data-driven digital activities and rapid innovation of customer-facing solutions, whilst meeting ambiguous and constantly shifting regulatory expectations.

This challenge cannot be met by continuing with existing paradigms, but simply trying to magically get more done. A shift in paradigm is necessary: don’t go harder, shift gears.

As with any crisis, however, from the ashes of the old arises the new!

Uncertainty around regulation and market disruption means that banks’ best bet is to facilitate software-driven innovation - to rapidly iterate on software that can meet banks’ needs for analytics, data and customer-facing applications, with security and compliance baked into the software-delivery pipeline, and hosted in a flexible, scalable environment: the cloud.

To give you an example of what we mean watch the recording of our webinar to see how we use our lightweight framework for DevOps on AWS (Continuum) to move a trading app and all dev and test data from on-premises into AWS in under ten minutes.