McKinsey Improving Capital Markets Profitability

Improving Capital Markets
Proftability: From a Product

To a Client Focus
McKinsey Working Papers on Corporate & Investment Banking | No. 5
July 2014
McKinsey Working Papers on Corporate & Investment Banking
are a series of publications presenting McKinseys latest research
and insights on corporate and investment banking. Incorporating
a broad range of views from McKinsey partners and experts
globally, the papers provide a leadership-level perspective on the
opportunities and challenges facing corporate banking, investment
banking and capital markets businesses worldwide. Their purpose
is to encourage discussion about the future of the industry.
* * *
Kevin Buehler
Director, New York
kevin_buehler@mckinsey.com
Daniele Chiarella
Director, Frankfurt
daniele_chiarella@mckinsey.com
Helmut Heidegger
Director, Vienna
helmut_heidegger@mckinsey.com
Matthieu Lemerle
Director, London
matthieu_lemerle@mckinsey.com
Akash Lal
Principal, Mumbai
akash_lal@mckinsey.com
Jared Moon
Principal, London
jared_moon@mckinsey.com
Editorial Board
Improving Capital Markets
Proftability: From a Product
To a Client Focus
1
The proftability of global corporate and investment banks is settling to a lower
baseline, due in part to regulations that followed the 2008 fnancial crisis. In a recent
white paper,
1
McKinsey suggested that without signifcant revisions to business
structures, return on equity for the top 13 capital markets and investment banking
(CMIB) units could slip to as low as 4 percent. Banks profts are also hobbled by
the market regime prevailing since the fnancial crisis: monetary policy has induced
very low volatility, and severely limited proftable trading opportunities. In this
challenging environment, capital markets institutions can unlock signifcant value in
their businesses by changing their approach to gauging proftability, from one that
focuses on products to one that also centers on clients. By applying the resulting
insights to the allocation of resources for all of their businesses, banks can expand
the bottom line of their capital markets units by 10 to 30 percent.
Capital markets banking units recognize the need to develop a better under-
standing of the drivers of client profitability in a contracting marketplace. At
least seven of the top 10 capital markets banks have undertaken initiatives to
better understand client revenues and expenses in order to drive cost savings
initiatives and balance sheet reduction. One sales head McKinsey interviewed
observed: We need to know how much extra revenue we get from providing
an extra touch point or an incremental amount of balance sheet. From their
side, clients recognize the value of the approach as well and have increased
the scrutiny of services they receive from brokers. In some respects, an in-
formation arms race is underway in capital markets, where a strong grasp of
client profitability will be crucial to sizing and pricing business opportunities.
Each capital markets segment faces unique pressures. In the U.S., fixed in-
come, currencies and commodities (FICC) units face serious challenges as a
result of both the Volcker rule and the increasing amount and cost of capital
they must retain. European banks are facing separate capital and process
requirements for OTC derivatives from European Market Infrastructure Regu-
lation rules, and European regulators may yet impose a financial transactions
tax. Prime services are dealing with increased capital requirements, as well
as a reduction in the leverage carried by clients. The equities business may
be less impacted, but must still address regulatory changes to derivatives
operations and better manage the cost of services provided to a client base
that increasingly executes through lower-paying electronic channels. In all
cases, a new framework for measuring profitability will provide the perspec-
tive and transparency needed in the new client-centric environment.

1
The Return of Strategy: A Roadmap to Sustainable Performance for Capital Markets and Investment Banking, McKinsey,
November 2013.
Improving Capital Markets Profitability: From a Product to a Client Focus
2
A disciplined approach to client management
Despite major investments in information technology for their capital markets
units, few banks have a clear view of revenues and expenses at the client
level. The task is a challenging one. In FICC and other over-the-counter
(OTC) trading businesses, revenues are not based on commission schedules
but on variables such as the clients ability to influence pricing and the trad-
ers discretion in hedging and holding positions. Cost attribution is no easier,
as most accounting systems allocate expenses, often subjectively, to trading
desks or business units rather than to client accounts. Charges for capital
and risk are typically aggregated across portfolios as well. Moreover, com-
pensation is typically based on the bottom line of trading desks rather than
the contribution to profits of the clients that traders and sales people serve.
However, useful systems for tracking profitability can be developed within
reasonable cost and time to market constraints. Depending on a banks
expense allocation methods, systems can be extended to report at the client
level by monitoring a few key variables. Additionally, the past few years have
brought improved methods for capital measurement and management.
Among the major capital markets business lines, equities has a head start
in adopting a client profitability orientation. Commission rates have been in
decline for years, and the dual nature of the equities business modelsplit
between advisory and execution, often without a clear relationship between
services and revenueshas pushed managers toward a client focus. FICC
and other OTC business lines have more work ahead of them in attempting
to shift from a product-centric business model to one focused on clients.
Measuring client profitability
Most banks develop at least simple estimates of client revenues, and some
banks go further on client profitability, with basic models that incorporate a
few specific estimates of costs. In McKinseys view, a holistic view of clients
depends on a framework that loads all client costswhether financial (capital
dedicated to customer trades) or organizational (sales, research, trading and
operations)against an accounts actual revenues (Exhibit 1).
Revenues. The starting point for a client profitability framework is revenue.
As noted, equity units already track commissions by client, but OTC busi-
nesses have typically relied on the metric of sales credits, usually derived
from volumes traded. The challenge is that due to varying product margins,
revenues earned from a client can be very different from the sales credits
3
generated. Even so, dealers find sales credits to be a familiar and effective
tool for managing sales teams. This argues for tracking both estimated rev-
enues and sales credits. Many managers are already aware that sales credits
are an imperfect measure of productivity, but also realize how difficult it is to
upend the existing sales culture. Some banks use sales credits as a basis for
estimating revenues by adjusting them for trade quality or observed mark-up.
Other banks have started automatically calculating captured spread by using
live price quotes to determine real-time distance to mid-market from the
executed client price.
Direct and indirect costs. The direct costs of sales, research and trading
primarily salaries and bonusesare the easiest for managers to understand.
Allocating them, however, can be more complex. If a salesperson speaks
with a client twice a day and meets with him once a week, she likely spends
more time serving that client than just one observed hour. On the other
hand, while a trader might never meet a particular client face-to-face, it is
Client proftability
Expenses
Revenue Income
Best estimate of client
revenue based on
actual outcome
Sales
Actual cost to provide
sales coverage for
each client
Research
Actual cost to provide
research services to
each client
Trading
Actual cost of trading
and trading support
Ops and trade
processing
Actual cost of capturing,
processing and
settling trades
Capital, balance sheet,
risk-weighted assets
Comprehensive
cost of capital and
balance sheet
Should refect:
Not all clients are
created equal
A client economic
model should
refect differences
in clients:
Trading styles
Pricing power
Levels of
resource
allocation/
consumption
Volume of
accounts
managed
Source: McKinsey Global Corporate & Investment Banking Practice
Exhibit 1
A client proftability model must refect all revenue and cost
elements of serving a client
4
unlikely that he has provided no service whatsoever. A client cost allocation
approach must be flexible enough to use all interactions, including execu-
tions and quotes, and intelligent enough to load these direct observations
with those less tangible ones not directly observed. Many banks start
with timesheets that capture aggregate time spent with clients as often as
monthly. Even more powerful is the use of real time activity metrics from
phone, email and trade logs and a centralized meeting calendar used
together with travel and entertainment expense ledgers.
Behind every direct service role are equal or greater indirect resources, and
determining a rational and fair process for loading their costs to client ac-
counts is essential. Such costs include compensation for sales and trading
support, compliance, finance and senior management, as well as the costs of
technology. Indirect costs can be allocated to client accounts based on the
revenues they generate, the direct expenses they incur, or other economic
grounds, but those costs must be a part of the calculation to avoid overstat-
ing client profitability. Because these indirect costs are so often subjectively
assigned to businesses, the best framework will show account profits both
with and without these internal allocations, giving managers one view of the
business based on what they directly control and another that is consistent
with the broader business P&L.
Operations costs. Trading desks seldom pay sufficient attention to the cost
of their middle- and back-office operations, in part because banks often
do a poor job of allocation. As with revenues and capital charges, the cost
of operations varies greatly by client and can have a surprising impact on
profitability. With a given product, revenues tend to rise with trade size, while
operations costs are more correlated to trade count. Small trades, therefore,
can incur the same processing cost as larger ones and thus quickly outstrip
revenues (Exhibit 2).
Meanwhile, trades of the same size and revenue can have very different oper-
ations costs, depending on simple factors such as the number of subaccount
allocations and other special handling requested by clients. Operations costs
can be greatly reduced, however, by trading through electronic channels and
increasing the proportion of straight-through trades.
Capital costs. Most dealers have improved their capital accounting frame-
work, making allocations to individual business lines more efficient. However,
the new environment demands a more precise understanding of trades at the
client level. Traditional capital accounting tends to view the portfolio of a desk
5
or unit in the aggregate, netting all positions, whereas a client-focused view
takes into account the stories of securities in inventory, rather than viewing
them as generic end-of-day positions to be financed.
Cash bond inventory positions can be grouped in three categories. The frst
is those the frm wants to holdsecurities that a desk believes clients will fnd
attractive or that will appreciate in value. In such cases the frm should bear
the cost of capital, rather than charge it to the client that sold the position.
Second are securities that the frm may not want to own, but takes into inventory
nonetheless to support the selling client. In this instance, capital costs arising
from a given position should be attributed to the client for as long as the bond is
held. Third are liquid, frequently-traded fow positions. These can be viewed as a
conventional pool of securities, with capital charges attributed to all buyers and
sellers to price their share of the working capital.
In the case of OTC derivatives, capital treatment is dependent on the nature
of the transaction. Liquid swaps that are cleared by a central counterparty
can be treated like flow cash securities, where the cost of working capital
is allocated across all positions. As transactions become more complex,
Hypothetical 5-year interest rate swap with 5 allocations
Swap Notional
Estimated revenue
Middle offce
Back offce
External third-parties
Processing IT
Total processing
Cost ratio
$1,000,000
$119
$196
$420
$314
$97
$1,026
862%
$10,000,000
$1,190
$196
$420
$314
$97
$1,026
86%
$50,000,000
$5,590
$196
$420
$314
$97
$1,026
17%
$100,000,000
$11,900
$196
$420
$314
$97
$1,026
9%
Source: McKinsey Cost Per Trade Study 2012; McKinsey analysis
Exhibit 2
Operations and trade processing expenses have a signifcant impact
on client proftability
6
however, revenues booked on a particular swap may already take into ac-
count capital charges and hedging costs, and systems should avoid charging
clients twice for the same cost.
Client profitability profiles
The results of a comprehensive client measurement system can run counter to
management intuition on client proftability. An analysis of one banks 2013 results
revealed a large number of unproftable FICC accountsvalue destroyersin-
cluding some that also generated high levels of sales credits (Exhibit 3).
A comparison of revenues earned versus capital provided to FICC clients for
the same bank yielded similar resultsshowing a similar cluster of accounts
near the intercept, where capital is provided but little revenue is delivered in
return (Exhibit 4).
Managing from a client proftability framework
Most dealers have processes that identify priority clients and the actions
needed to maintain and grow their business. Within an organization, these
Sales credits vs. client proftability for U.S. rates
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
-2,000 -1,000 0 1,000 2,000 3,000 4,000 5,000 6,000
Gross sales credits ($000)
Client proftability ($000)
Value
destroyers
Exhibit 3
Traditional sales credits often provide weak signals on
client proftability
7
processes often exist both at the firm level and on several product-focused
levels. Their effectiveness is, however, uneven. Those areas with greater
insight into client profitability generally have a more disciplined approach. In
cash equities, for example, most dealers have at least a basic understanding
of client-level spending on research and sales costs relative to commission
revenues, and thus can incorporate proftability metrics into client management.
In FICC and other OTC business lines, client account management is more
art than science. Sales and trading must agree on priorities, while often
fundamentally disagreeing on sales credit-based revenues. Resources
are apportioned to clients based on these estimated revenues, which can
reward clients with lower real revenue with higher levels of service. The
reverse can also happen; clients that generate significant real revenues,
but low sales credits, might not receive the resources they deserve. When
properly designed and implemented, client profitability frameworks can
reveal such misallocations, and deliver compelling results. One top 10 global
fixed-income firm found that over $200 million was being lost annually to
value-destroying clients, so they recalibrated their pricing and resources
provided. A second top 10 dealers client profitability system showed that
Capital cost ratio distribution
Client revenue
$ thousands
Cost of capital deployed
$ thousands
0
1,000
2,000
3,000
4,000
5,000
6,000
7,000
0 100 200 300 400 500 600 700 800
Exhibit 4
A comparison of revenues earned and capital provided reveals an
ineffcient cluster of clients
8
sales credits were overstating the revenues of certain large clients by nearly
50 percent. The firm reacted by directing these clients low-margin flow
trading to lower-cost electronic channels, and leveraging senior sales efforts
with additional junior staff. In a third instance, a regional European bank used
client profitability to help guide the transformation of several of its capital
markets product lines. The bank shifted sales coverage resources away from
lower-margin client segments and better focused its capital commitments to
more deserving clients.
A client-proftability approach puts all products on an even playing feld and
helps drive standardization of client management. Any resource deployed, in any
product area, can be assessed with a defensible return-on-investment metric.
A holistic coverage approach can be managed fairly by tracking the real cost
invested by one product area versus the real revenue impact across all. This
accounting transparency allows management to reward those areas making client
investments even if revenue was realized by a separate business areaa key ele-
ment in the transition from a product to a client-centric approach to proftability.
Any model of client profitability produces a variety of signals, highlighting
strengths in some areas and weaknesses in others. Accordingly, part of
managements role is to emphasize the systems objectivity and its benefits
for every part of the business and ensure it is used with proper sensitivity.
Examples of potential uses and challenges include:
Clients. A client-focused approach to profitability will usually confirm that
most of a banks priority clients do indeed deserve their special treatment,
but will also show that a number of them do not. And by highlighting the
factors that drive profitability, the client-focused provides new diagnostics
into varying profitability among clients, client sectors, regions or products
(Exhibit 5).
Quantifying client profitability gives a bank a clear view of where to make
adjustments to optimize client business mix and services levels (Exhibit
6, page 10). Clients with potential for high revenues and margins should
be granted priority for resources, and conversely, low-potential accounts
should have their resources scaled back (Exhibit 7, page 11).
The challenge often comes when the bank must describe service-level
changes to the client. Clients may counter that whatever business they bring
affords the dealer a proft and are likely to attribute shortfalls to the dealers
ability to manage its own costs. These can be diffcult, sensitive conversa-
tions and work best when banks follow a carefully-developed script.
9
Sales teams. In FICC, client proftability measures are valuable for managing
clients, but tend to be less successful for guiding sales teams, as conveying
too much information can lead to unintended consequences. For example,
armed with actual revenues, salespeople might emphasize higher-margin
products while playing down crucial but lower-proft business such as fow
cash securities. In this case, salespeoples efforts to optimize their individual
production could create an unhealthy dynamic that favors short-term results at
the expense of building deeper, sustainable client revenues.
Additionally, sharing the details of client-level costs may lead sales teams
to reduce service in order to raise margins, when the units long-term ob-
jective might call for the opposite. And as sales teams have no control over
operations and capital costs, offering that information could be a distraction.
Rather than furnish sales teams with detailed reports on clients full-loaded
proftability, management can instead set target levels of resources for
individual accounts, separately determined by proftability and coverage
segments. These metrics should illustrate the quality of trading fow, refect
activity levels and rank clients by more neutral percentiles or tiers.
Fund X All hedge funds All clients
Gross credits 100 100 100
Quality adjustment -50 -40 -35
Revenue margin 60% 65% 50%
Sales cost ratio 10% 12% 15%
Trading cost ratio 7% 8% 7%
Research cost ratio 5% 6% 7%
Capital/RWA cost ratio 12% 11% 18%
Trade-processing cost ratio 12% 13% 12%
Total expense ratio 46% 50% 59%
Proft margin 14% 15% -9%
Exhibit 5
A diagnostic can highlight the factors that drive proftability
10
Client profitability metrics must also be used with care when managing
equities sales teams. Equities revenues can be measured accurately at
the client level, but due to the holistic nature of equities sales and re-
search coverage, attributing revenues to an individual salesperson is less
exact. Therefore client profitability metrics are valuable to an equities sales
manager or account quarterback in evaluating a team, but could provide
misleading results on an individual producer.
In prime services, client management is central to the entire business and
salespeople play a different role from that in the transaction-driven busi-
nesses. Full disclosure of client profitability is necessary and important in
the effective management of clients.
Business development. Often a client is assigned a high priority in a cap-
ital markets business line without regard to actual proftability, because the
account is important to the bank in another segment or to the frm overall,
or because it offers substantial potential. Providing a high level of service
Actions
Discuss mix of in-comp business and order business with client
Discuss internally value of client fow information
Widen markets
Move to e-platform to reduce other costs
Adjusted revenue
1
Discuss service level with client to determine proper coverage intensity
Add junior members to coverage team
Transition low-margin fow business to e-trade platforms
Sales expense
Examine hit/miss ratios for client inquiry
Scale back access to traders
Trading expense
Discuss service levels with client with goal of increasing volumes or decreasing
provided service
Research expense
Push cost saving platforms such as Omgeo and TradeExpress for clients with
large sub-account volumes
Consider modifying pricing for smaller trades where processing costs make
them unproftable
Processing
expense
Discuss mix of fow vs. risk trades and risk reduction strategies with client
Price incremental risk transactions more aggressively
Capital, RWA,
balance-sheet cost
1
Client volume provides less revenue potential than average
Exhibit 6
Dealers can take actions in the areas where client proftability lags
11
can be a sound long-term decision, but a system for assessing client prof-
itability can make the true cost of such business development clear. In this
way, management can make decisions about service levels with their eyes
open. Relationships can be evaluated on their current proft contributions
as well as their potential, giving capital markets management ammunition
for recommending adjustments to service levels to the clients sponsors.
Management challenges
Imposing a client profitability framework on traditional capital markets busi-
nesses may generate resistance from trading and sales managers, due to
differences in form, scope and accountability from familiar systems. However,
successful application of this framework can demonstrate its value and es-
tablish client profitability as an important management tool. Among the more
common challenges:
Client profitability versus product profitability. Banks report prod-
uct-line income statements to their business units, corporate management
and shareholders, and this difference in form is probably the greatest
0
5
10
15
20
25
30
35
40
-10 -5 0 5 10 15 20
Client D
Client C Client B
Client A
Client E
Client F
Mitigate and Prioritize Prioritize
Maintain Deprioritize
Economic margin
Percent
Potential wallet
$ million
Potential wallet vs. margin for resource allocation
Exhibit 7
Incremental resources should be directed based on potential wallet
and economic margin
12
challenge to the adoption of client profitability management. Although
client-level accounting generates more reports, and in greater detail, than
the aggregated statements of conventional systems, these reports in
fact represent subsets of product-based income statements. Given time,
implementation of a client account model is likely to improve managers
understanding of cost allocations, and the two reporting systems will
complement each other, leading to a stronger and more transparent ac-
counting framework for business units overall.
Allocating overhead. A client profitability statement will also allocate
a wide range of unfamiliar costs to managers over which they have no
control. They are likely to discount these new expense loadings, in the
belief that their clients earn a profit except for all the new stuff. But the
additional overheads are valid expenses to be charged against clients,
and a well-designed implementation will report client profitability both
before and after the additional charges, allowing managers to focus on
the client-oriented costs within their control. As for senior management,
having fully-loaded client profitability metrics at hand, properly segmented,
will afford greater insight into the impact of infrastructure and other costs
allocated by the parent organization.
Sales versus trading. While senior management will likely embrace client
profitability reporting, sales and trading line managers may push back.
Many banks allow sales teams to consider themselves the owners of
client revenue and attribute all other revenue to trading desks. The dis-
tinction is artificial, particularly in an increasingly client-focused market,
as banks need both sales teams and trading desks to generate revenues
from clients, and client flows are essential to traders in managing the risk
profile of their portfolios. The solution goes beyond accounting, however,
and addresses dealer culture: client revenue and profitability must be
jointly managed by sales and trading teams. Improving client profitability
is likely to enhance trading desk profits, and this shared success should
make sales and trading managers more amenable to any changes.
* * *
Despite regulatory pressures, capital markets will continue to be an important
source of revenue for capital markets banks. As the industry adjusts to a more
demanding regulatory environment, it will likely operate on a smaller scale, earn
lower margins and be more dependent on clients than on risk. While profts
13
from proprietary trading will effectively disappear, banks have the opportunity to
defend their bottom lines through informed management of client relationships.
The transformation starts with data and technology, creating a unique identifer
to track each clients revenues and expenses. The hard work begins, however,
when management incorporates the new insights into a units culture and
day-to-day operationsreserving balance sheet capacity for clients that meet
a hurdle rate of return or restricting sales and research coverage for clients
without adequate revenues.
Any new performance metric will face challenges. When it confirms a
managers beliefs, it will be recognized as valid and relevant, but when it
contradicts them, it will be questionedor ignored. To overcome these real-
ities, senior management must lead the transformation by incorporating the
new measures into performance reviews and compensation frameworks for
all parts of the organization, including research and trading teams as well as
sales. Equally important, the owners of the profitability model must incorpor-
ate critical feedback, adapting to the nuances of the business.
When client profitability is measured fully and accuratelyreflecting revenues
instead of volume, with realistic accounting for expensesmanagers may
be surprised to find that their largest clients, measured in terms of managed
assets or trading flows, may not be their most profitable. Similarly, small ac-
counts likely will not pull their weight. In some cases, the bottom 40 percent
of a units clients might contribute 10 percent of revenues, while drawing 30
percent of resources. With successful implementation of client-focused sys-
tems, dealers will find many opportunities for managing revenues and costs
and realize substantial improvements in profitability.
14
Further insights
McKinseys Corporate & Investment Banking Practice publishes frequently
on issues of interest to industry executives. Our recent reports include:
McKinsey Working Papers on Corporate & Investment Banking, No. 4:
The Brave New World of SEFs: How Broker-Dealers Can Protect
Their Franchises
June 2014
Winning in Transaction Banking in Asia
June 2014
Sales Transformation in Mid-Market Corporate Banking
March 2014
Winning in Western Europes New Corporate Credit Landscape
February 2014
The Return of Strategy: A Roadmap to Sustainable Performance for
Capital Markets and Investment Banking
November 2013
Corporate Bond E-Trading: Same Game, New Playing Field
(a joint report from McKinsey and Greenwich Associates)
August 2013
Matthieu Lemerle
Director
matthieu_lemerle@mckinsey.com
Roger Rudisuli
Principal
roger_rudisuli@mckinsey.com
Akash Shah
Associate Principal
akash_shah@mckinsey.com
Ed Bergman
Senior Advisor
ed_bergman@external.mckinsey.com
Contact
For more information about this report,
please contact:
Global Corporate & Investment Banking Practice
July 2014
Copyright McKinsey & Company
www.McKinsey.com/client_service/financial_services

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