The Investment Industry Association of Canada (IIAC) is remarkably upbeat about the outlook for the investment industry despite the environment of low commodities prices and heightened market uncertainty, in which dozens of investment dealers face possible closure in the next few years.
In his latest letter to the industry, IIAC President and CEO Ian Russell recounts the various forces buffeting the investment industry in recent months, from the moribund resources sector, to the intensified market volatility and uncertainty that has hit equities around the world, sparking a decline in both underwriting and trading business. At the same time, the investment industry is also facing continually rising regulatory burdens that are driving costs relentlessly higher.
As a result, Russell warns that he expects between 20 and 30 institutional boutique firms, "to seriously consider shuttering operations in the coming year." On the retail side, it's not much better as operating costs "escalate sharply over the next couple of years," he says. "This rapidly rising cost structure may be enough to force the 20 or so struggling, non-profitable dealers into mergers, or more likely to shutter operations."
Yet, Russell's overall view on the investment industry is far from pessimistic. Specifically, he reports that overall industry profit rose by 29% in 2014 and both profits and revenue were back above pre-financial crisis levels. In the first half of 2015, revenue was up by another 3% year over year, although profits were down by 5%.
In this environment, Russell reports that certain segments of the industry are adapting to thrive: "Many boutique firms have taken steps to broaden their business by expanding their retail and corporate client base through recruitment of advisors and acquisition of struggling boutiques, and are realizing efficiencies through the application of technology. These initiatives will mitigate the impact of weaker conditions and eroding profitability. Moreover, the deterioration in business conditions may be less severe than expected — limited to the energy sector — with a chance for a throttling back of the regulatory burden once CRM2 is fully in place."
For the large, integrated firms, the IIAC projects that operating revenue and profit will increase by 6% and 3%, respectively, in 2015, if business conditions in the second half of the year stay roughly in line with the first. "We think the odds favour such an outcome," Russell says.
For institutional firms, the IIAC forecasts an 11% drop in operating revenue and a 20% drop in profits, if business conditions stay the same in the second half. This could, in turn, drive many small firms out of business. Yet, the IIAC also notes that "there are many boutiques with a more broadly based investment banking business, and these firms will continue to participate in non-resource financings offsetting the weakness in the resource sector. Further, some boutiques will benefit from a greater incidence of advisory work."
For the retail sector, the IIAC is projecting that operating revenue will be flat this year, but that profits will drop an estimated 23% due to ongoing increases in operating costs. That outlook could weaken further still if market conditions erode. Yet again, the IIAC notes that a growing reliance on fee income "will mitigate the negative impact on the retail business as the shift to fee-based accounts from traditional commission brokerage continues."
Furthermore, it notes that within the retail space, the self-clearing retail boutiques are expected to suffer much more than the introducing firms. Operating profit at the self-clearing firms is projected to drop by about 30% this year compared with 14% for the introducing firms.
The introducers have not been hit as hard by rising costs, Russell notes, as they rely largely on their carrying brokers to meet most of their increasing compliance requirements. And, even these small shops have successfully shifted their revenue mix away from a reliance on transactions and toward fees. Moreover, they've also been able to make use of technology to expand their businesses and reduce costs. "The smaller firms recognize the opportunities to build out distribution and scale to strengthen profitability. Small firms have added advisors and support staff to seize opportunities," he says.
Yet, he also warns, "If the layering of regulation persists with a fiduciary or formal client best interest standard, the compliance costs will escalate…"
Already, Russell says that, "The self-clearing retail firms will see a substantial increase in operating costs this year and next, severely denting earnings performance. The introducing firms have so far escaped large cost increases, but will be in for a shock over the next few years as these boutiques face an escalation in carrier fees and operating costs as CRM2 rules and FATCA reporting become fully effective."
"The outlook for the investment industry over the next year or so will certainly not be robust, but positive business factors leave room for optimism," Russell concludes. "Moreover, the industry has borne a steadily increasing regulatory burden throughout, leaving the hope that the pace of rule making will slow. A well-diversified industry, with vigorous full-service dealers and specialized retail and institutional firms, remains the order of the day."