Greenwich - Stamford, CT — The decision by some major banks to scale back their role as primary dealers of European government bonds is reducing liquidity for investors and could, over the long-term, be compromising banks’ ability to grow revenues in other fixed-income products.
Heightened regulatory pressures coupled with years of historically low interest rates are stressing banks’ trading businesses, with fixed-income revenues garnering a smaller share of the overall top and bottom lines for most traditional dealers. In response to the deteriorating economics of the business, several banks have reduced their presence as primary dealers in various European government bond markets.
A new Greenwich Report, European Fixed Income: The Importance of Primary Dealerships, draws on the results of interviews with more than 1,200 institutional fixed-income investors in Europe to assess the impact of this shift.
The research finds that for investors, the reduction in the number of active dealers has created real concerns about their ability to source liquidity needed to trade. For banks, there’s a positive correlation between dealers’ trading business in European government bonds and other fixed-income products—a finding that suggests dealers who retreat from government bond markets could have trouble maintaining their market share in other products.
Diminished Liquidity
Institutional investors report that large, directional trades are more difficult and take longer to execute. Some investors say they are forced to reduce trade sizes or even abandon trades altogether due to the lack of liquidity. The investor community also expresses concerns that banks are concentrating resources on top-tier clients and reducing coverage or even cutting ties with non-priority targets. “Investors said the diminished liquidity is complicating their efforts to make important portfolio adjustments like shortening duration,” says Satnam Sohal, a Greenwich Associates consultant and author of the report.
Impact on Bank Trading Revenues
Banks with access to primary markets play a role in increasing secondary trading revenues not only in government bonds, but also in related products such as derivatives. The study results show the strongest positive correlation between government bond trading share allocations and those of covered bonds. Correlations between government bonds and interest-rate derivatives and investment-grade bonds are also positive.
Reducing head count in fixed-income product areas deemed less profitable may, to some degree, lower cost pressures for the bank and free up balance sheet—but bringing fixed costs down would take a lot longer. “Furthermore, as overall revenues in fixed-income trading businesses remain under pressure, it is likely that the de-emphasis will end up burdening other businesses more, hence lowering their profitability as well,” says Satnam Sohal.
For global and regional European banks, it may be necessary to stay the course in order to catch a larger share of the upside when the tide turns. As overall market conditions improve, shareholders will likely find that a focused approach will result in more volatile ROE over the long term, while a more diversified approach may provide more stable returns. “As market cycles favor one business, it will not be so easy for those who have scaled back to resume an active role,” says Satnam Sohal.
