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by ModuleQ on Jul 2024
- The confluence of regulatory and technological cycles create investment banking eras.
- We are at the cusp of Investment Banking 3.0, an era catalyzed by strict capital requirements (Basel Endgame) and artificial intelligence.
- Studying the prior changes in IB 2.0 (late 1990s), we expect banks will need to quickly step into AI enablement.
- While ModuleQ cannot predict exactly how AI and regulatory change will shape the industry going forward, history shows us that these periods accelerate disruption, allowing challengers to compete against incumbents.'
Investment banking is undergoing a generational shift, forging a new era. We are calling this change Investment Banking 3.0. New eras in banking are rare, even with the industry perched at the fast-paced vanguard of capital markets. These shifts are caused when two ebbing forces periodically meet: technology & regulation. When the two enter a period of rapid change simultaneously, there has historically been an industry-level shift. We believe we are now entering such a period:
Why regulation and technology versus, say, economic policy or globalization? Are these really the two catalysts driving industry-level change? The answer starts with the true drivers of change in the business of intermediating capital formation. Stepping back to the earliest era of modern financial services (19th century), regulation has shaped the means and process by which financial information is controlled and disseminated. This is crucial to investment banking. We saw the impact of regulation clearly in the first third of the 20th century.
In the wake of the great depression, the public demanded severe regulation of financial services to ensure capital markets would never again plunge the country into a depression. This led to the Securities Acts of 1933 (fair dissemination of information), 1934 (securities enforcement), and 1940 (registration framework for investment companies). Similarly, with Glass-Steagall, investment banks had their commercial banking activities cleaved, unbundling banking and changing the competitive landscape. This unbundling through regulation dramatically changed the industry.
Meanwhile, technology is a force for continuous progress and its impact on banking has gone through relative peaks and troughs. This period (1930s – 1940s), which we characterize as Investment Banking 1.0, did not undergo a step-function change in technological impact. It predated the revolution of computation that would hit the industry slowly beginning in the 1950s, and accelerating into the 1980s. Think of the adoption of workhorse tools like spreadsheets, the introduction of the Quotron, odd-lot trading, and increasingly smaller fractional pricing. The post-depression regulation and the introduction of computers were two asynchronous megatrends. And so, we witnessed more of a gradual evolution to the business.
Investment Banking 2.0
If we fast forward to the 1990s, we see a synchronization pattern. This period saw the internet and telecommunications revolutions take hold, coinciding with major regulatory changes. We had Graham-Leachy (allowing bank holding company consolidation or rebundling) and Sarbanes-Oxley (improvement of corporate financial disclosure) come into law. These changes fundamentally altered the structure of banks. Consolidation means more corporate complexity, more need to integrate (for synergies), and the necessity of technology to actualize that opportunity. And so, the early 2000s was not a gradual multi-decade shift, but a rapid, step-function change, which we call Investment Banking 2.0.
In this phase, the confluence of greater economies of scale through consolidation (megabanks), improved emphasis on accounting oversight (renewed faith in capital markets), decimalization (greater liquidity & trading volume), and the application of modern technological tooling (for things as wide as coordinating travel to advanced risk modeling) reduced the cost of capital formation through increasingly efficient intermediation and better liquidity. This led to a rapidly expanding growth and profit pool for the industry. The scale of activity broadened across asset classes, banks’ footprint went global, and the need for technical expertise fundamentally changed the talent equation.
Banks expanded their reach to the developing world, technological investment exploded, and PhD talent was brought in to complement the traditional relationship builder. Bankers had to adapt to an increasingly connected world: delivering efficiency while competing against giants. We witnessed the rise of innovations like the Blackberry, VaR modeling, decimalization, and CRM. These now seem antiquated but were crucial in driving this change.
Why We Are At Investment Banking 3.0
Twenty-five years later, we are on the cusp of Investment Banking 3.0. This change did not occur in 2008 with the global financial crisis or the introduction of Dodd-Frank. In 2008, the technological landscape was a continuation of Investment Banking 2.0. Yes, Dodd-Frank began the gradual dismantling of hyper-scale investment banking, as proprietary trading and risk warehousing shifted to the buy-side. It began a stricter capital requirement regime that has only ratcheted up in the ensuing years. However, the adoption of new technologies post-GFC was largely a continuation of the hyperconnectivity and increased compute revolution of the early 2000s. Without a new paradigm, the pace of change did not accelerate quite as dramatically as the early 2000s. Technological change meant more mobile and continued migration to the cloud. Think of it as Blackberries to iPhones instead of an entirely new form factor. Another way to analogize is the workflows given to first-year analysts. They remained largely the same.
In 2024, we are about to gain access to that “new device.” Its spread will be accelerated by another serious regulatory change. The culmination of capital ratio requirement regulation is settling into the form of Basel Endgame, and the shiny new technological tool will be Artificial Intelligence. The productivity-enabled technologies brought on by AI will permeate every bit of existing technology that banks have been investing in for the last twenty-five years: from risk modeling to CRMs, to office productivity suites and market data. The confluence of a regulatory-induced business model shift and a technological shift will mean rapid adoption and a reconfiguration of Investment Banking.
Investment Banking 3.0 – Signs of Separation
Step back and think about what has happened to financial services in the last 25 years. Commercial banking has seen mega consolidation around technology: better mobile apps, better payments, better data, and more opportunities to cross-sell consumers. Meanwhile, investment banking has been less quick across this dimension. Yes, we have seen the rise of tweaked boutique models. They have entered the marketplace with focused areas of practice and somewhat novel economic compensation arrangements. These boutiques have carved out interesting practices that compete globally against foes small and large. On the other end, the larger banks have made meaningful inroads into regulatory-friendly adjacencies such as wealth management. The synergies were apparent given their economies of scope and technological prowess. However, the business model of investment banking has been relatively the same. This status quo seems ripe for disruption.
What disruption will ultimately be for investment banking is hard to gauge, especially from the surface. It’s impossible to project how the industry will look in 5-10 years, or who will be the winners, especially on the cusp of a transformative technology’s adoption. Of course, there is a degree of apprehension towards excessive hype in AI; a reticence to retool in a regulated industry for what some fear may be a flash in the pan.
History tells us that this reticence is unwise. Looking back to the early 2000s, there too was less of an understanding of mobile connectivity, exotic derivatives, or the need to push into emerging markets. The firms that were first to model and better understand cross-border risk and to empower a global workforce with technology were the ones that succeeded: not only in the run-up to the global financial crisis but in its turbulence and ultimate aftermath. The clear winners were those who embraced change first instead of hastily fast-following to keep up with the Joneses.
The same likely goes today. First-movers will be able to attack incumbents who were optimally positioned to win in the prior era. Incumbents that are willing to disrupt parts of their own success may maintain that incumbency from a position of technological and business-structure advantage. Both require courage amid uncertainty. That uncertainty is driven by an inability to discreetly model future return-on-investment with a novel technology.
And so, the degree of dispersion in digital infrastructure adoption across investment banks is glaring but not necessarily apparent. This may call to question the need for an acceleration of investment. Regulatory limitations in financial services always make rapid adoption nigh impossible. The last few years in investment banking have not made apparent a “killer feature” like mobile in commercial banking. But history tells us it would be foolish to expect the same to happen with the advent of AI.
With AI, the chasm will widen, and we’ll begin to see truer signs of technologically induced separation across firms. This is the lesson from prior era shifts. So, it is imperative for those who are behind to lean in before it is too late. For those in an advanced technological position, it is time to hit the pedal to the metal and reap the rewards.
With Investment Banking 3.0, investment banking will go back to its roots. It will be abundantly clear that banks are in the business of information intermediation. As Dan Schulman recently said when musing about the fungibility of investment bankers, “It’s the people who can challenge me on how I think about the world who are unique.” In this business, informational advantage is the key advantage. And so, enhanced productivity and a smarter workforce with better/faster/smarter decision-making will be key. How this can be facilitated by AI isn’t readily apparent today on a quarterly report, but it will be when Investment Banking 3.0 takes off; just as the companies that neglected to adopt digital spreadsheets or the advanced modeling of derivatives were left in the dust.
Investment Banking 3.0 – Ingredients for Success
While we can’t tell you exactly what will happen, we can identify a few ingredients for success that will improve the chances of successful evolution. It starts with the structural change brought on by regulation: a requirement to be more capital-efficient. Banks will have to be more exacting on how they compete (often against motivated niche specialists). To do so, they must invest in the types of technology that provide operational leverage.
There must be a willingness to experiment with new technology and to gather feedback: to learn by doing. By jumping in, firms can develop the crystallized knowledge that only comes with experience. You learn what you don’t know and adjust your plans with greater precision. Of course, it must be approached carefully under compliance, but gathering tacit knowledge is the benefit of learning by doing. It is key when tectonic plates are shifting underneath one’s feet.
Next, because of the increasingly strict regulatory requirements brought on by Endgame, balance sheets are changing, and so are business models. Capital market activity is already adapting. Embracing that change with a technological catalyst is a smart decision. We see this clearly in the direct lending landscape. Banks are augmenting their businesses, shedding former risk pools while working in a symbiotic fashion with an expanding buy-side landscape. One banker has called this state “unnatural partnerships.” These new modes of work will continue to develop as regulation casts the die for which banks are reshaped. Managing these new partnerships and their new workflows through AI-enabled technology will be key to maintaining the front foot.
Finally, in a world where talent is increasingly mobile, creating the right ecosystem for bankers to thrive is crucial for navigating change. Are you empowering your bankers with the right tools, infrastructure, and data to succeed? Can you unleash the productivity and business-generation potential of motivated talent through the infusion of AI tooling? If, as Schulman noted, capital is increasingly fungible and firms are limited in their ability to take exotic risks, the right platform that attracts the right talent will generate the best return on assets.
The Byline Through it All
If we step back and return to what investment banking truly is, we arrive at the job of intermediating information in the pursuit of capital formation. If intermediation wasn’t required, private companies would contract directly with public shareholders, public companies would fund and pursue acquisitions, sponsors wouldn’t need debt syndication, and institutions would offload large blocks of stock without market impact.
Intermediation is key in making global capital markets function harmoniously, and that function is driven by the informational advantage of intermediaries. Informational advantage accumulates partly from the repeat action of an intermediary versus the one-time action of a transactor. That is table stakes. Today, it is reinforced virtuously when organizations become learning entities that continuously improve. This entire process is dependent on talent enabled through technology.
In the era of Investment Banking 3.0, the technological arrow in a bank’s talent quiver is AI, and the rate of change will make this apparent in the coming months and years. It is ModuleQ’s goal to deliver the tooling that does just that. ModuleQ delivers the right information to the right banker at the right time by leveraging our patented Personal-Data Fusion technologies. It is built with the banker in mind, making the transition into AI-enhanced work as smooth and efficient as possible. In a period where catalyzing change is vital, we allow banks to be on the front foot without having a compliance footfall.
This is our singular focus, and we recognize the importance of the moment. Achieving this type of transformation has been mission-critical for banks in each of the prior historical era changes. By delivering on this overarching goal, we hope to usher in a new era of banker workflows and efficiency that will rapidly become the norm. As William Gibson wrote: the future is already here, it just isn’t evenly distributed. With ModuleQ, step up and embrace the challenge of Investment Banking 3.0.
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