Investment banks must shrink or die. WILL there be fewer investment banks at the end of the year?

Last year, brutal market conditions forced almost all wholesale banks to cut costs and jobs. (Margaret Doyle, Jan 05, 2012, Reuters)

Last year, brutal market conditions forced almost all wholesale banks to cut costs and jobs. New regulations will force further shrinkage simply to generate acceptable returns. Unless the market picks up soon, smaller players may conclude that they are better off out of the game altogether.

Banks cut thousands of jobs from their wholesale divisions last year, as revenues collapsed amid the euro-zone crisis. Meanwhile, new regulations will halve average expected return on equity (ROE) across global investment banks this year to 8.3 per cent, said analysts at JPMorgan, well below the 13 per cent needed to cover their cost of equity. To reach that required return, banks have to shrink further. Even factoring in further headcount reductions of up to 20 per cent and a 5 per cent cut in non-compensation costs, returns would still be too low. To reach a 13 per cent ROE, banks will have to slash pay too - by a hefty 23 per cent per head on average, JPMorgan reckons.

Those cuts will remove not just fat, but will undermine revenue as well. The most vulnerable banks are those that are already sub-scale. JPMorgan analysts estimate that last year's revenue at Royal Bank of Scotland (RBS), Societe Generale (SocGen) and UBS will be barely half that of industry leaders Goldman Sachs and Deutsche Bank. Nomura, too, faces a tough call - its investment bank is losing money in Europe, while the threat of a ratings downgrade could undermine its counter- party status. No one is yet contemplating quitting - publicly, at least.

Nomura reckons that its capital strength and liquidity position will allow it to gain from euro-zone turmoil. UBS insists that its smaller investment bank is essential to its private bank. However, there are signs of retreat. The British government, RBS' major shareholder, made clear last month that it wants to shrink the investment bank faster. And SocGen has installed its chief financial officer at the head of its investment bank, suggesting a tighter focus on costs. However, closing investment banks is easier said than done. One banker likens them to nuclear plants - the toxic waste has to be managed by expensive staff.

So, while few banks will kill off their wholesale arms, this may be the year they decide to starve them to death.