Big banks are facing competitive pressures from two forces in recent years: regulators and new (fintech) competitors. Regulators have cracked down on many of the traditional activities that fueled growth in the financial sector during the pre-crisis boom. To compensate, many big banks have migrated towards more retail-like activities such as wealth management that face less regulation.
As they attempt this pivot, the banks have also found that new technology-driven entrants are putting pressure on their traditional advisory model. “Robo Advisor†startups such as SigFig, Betterment, and Wealthfront offer cheap, automated investing services that threaten to disrupt the wealth management business.
The big banks still have significant advantages though. Their brand names, financial capital, advisor networks, and large client bases give them the opportunity to leverage the innovations of these startups and become the biggest winners in this new wealth management model.
“Digital advice will become a multi-trillion dollar market over the next decade,â€Â says NextCapital CEO John Patterson. “Trusted brands with large installed client bases that rapidly adapt to digital advice will win this opportunity.â€
Morgan Stanley (MS) has that large installed client base. In 2009, it became one of the biggest wealth managers in the world with the acquisition of Smith Barney. As Figure 1 shows, its wealth management business has always been more profitable than its investment banking activities.
Figure 1: Segment ROIC: Wealth Management Is the Leader
Sources:Â New Constructs, LLC and company filings.
What’s more, the company has already taken the first steps towards adapting digital advice. At its current valuation of ~$29/share, Morgan Stanley has the potential to create almost $28 billion in value for shareholders if it successfully completes this digital transformation.
Regulatory Squeeze On Margins
What used to be a profitable and growing business is now plagued by ever tightening margins as banks spend more and more money on compliance. The six biggest U.S. banks—J.P. Morgan (JPM), Bank of America (BAC), Citigroup (C), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley—spent over $70 billion on regulatory compliance in 2013, more than double what they spent in 2007.
Those numbers come from a recent article in the Wall Street Journal. That same article described a town-hall meeting at Barclays (BCS) where bankers described compliance officers as “nuns with guns,†indicating the extent to which regulation has become a constant squeeze on investment banking activities.
Return on invested capital (ROIC) has dramatically declined since the financial crisis for the big banks. In 2006, they earned an average ROIC of almost 15%. Last year, their profitability had been cut in half, at ~7.5%.
Wealth Management Is The Way Forward For Margin Expansion
Before the financial crisis, Morgan Stanley’s small Wealth Management division was highly profitable, while the much larger Institutional Securities division was not as profitable due, in no small part, to massive bonuses for its many investment bankers.
After the financial crisis—and the Smith Barney acquisition—the Wealth Management division’s ROIC fell, but it remained in the double digits. Institutional Securities, on the other hand, has failed to achieve an ROIC above the company’s WACC every year since 2006.
