LONDON (Reuters) - Investment banks need to make bold decisions to choose to invest in areas where they have a comparative advantage to win business or choose to exit them as the industry prepares for a big upheaval in the next year or two, a report said on Monday.
Analysts at Morgan Stanley (JPM.N) said wholesale banks could bounce back to deliver returns on equity (RoE) of 12-14 percent in the next two years following structural changes.
That is seen as the level needed to match the cost of equity and deliver profitable returns for investors, but many analysts and investors think they may struggle for some time to get there.
"The gap in returns will widen sharply between banks that manage to scale significantly where they compete and those that do not," Morgan Stanley analyst Huw van Steenis and his team said in a report by the bank and Oliver Wyman.
"Pressure on returns is now critical and marginal change is no longer a viable strategy," the report said.
"Higher fixed costs and more allocated capital mean banks cannot just shrink at the margin to reach adequate returns on capital. Firms now have to choose where they may have comparative advantage and then invest in scale to win in these markets, or exit."
The market is seen underestimating the scale of likely upheaval in the industry as banks adapt to regulatory changes.
Some 15-20 percent of market share could change hands during this industry reshuffle as investment banks reshape their portfolios around three or four winning business models and race to get adequate scale to deliver good returns, it said.
"A confluence of factors now seems likely to trigger significant structural change over the next 12-24 months," the report said.
It also said it expects to see some banks and markets become less global, driven by financial protectionism and a regulatory push for capital and funding in subsidiaries.
"Home market advantages will be reinforced, pushing many firms to focus more domestically," it said.
The analysts lifted their earnings forecast for investment banks by 5-10 percent for 2012-13, based on a stronger outlook for the industry.
Its top picks in Europe are: Barclays (BARC.L), a beneficiary of stronger fixed-income, currency and commodities markets; BNP Paribas (BNPP.PA), based on higher cost efficiency and Fortis deal benefits and strong capital ratios, and UBS UBSN.VX, as it can benefit from faster deleveraging and a stronger capital position.
A rebound in revenues from 2011 could drive RoE up by 4-5 percentage points, Morgan Stanley estimated, predicting that revenues will return to 2006 levels by 2013-14.
Management action and streamlining business portfolios could deliver another 4-5 percentage points improvement in RoE.
"This requires management to act decisively, rather than each player waiting for someone else to fold their hand," the research note said.
A thinner field should improve returns for the best banks in each business line - winners could enjoy RoE 3-4 percentage points higher than the average and 8 points above the losers, it estimated.
Management also need to get to grips with executive pay.
"Deeper thought on incentive structures will be needed to get costs down while re-invigorating innovation," the report said.
Reporting by Steve Slater, Editing by Gary Crosse