The UK financial watchdog’s proposal to block investment banks from contractually forcing their clients to award them more business has been met with a shrug by rainmakers in the City of London.
“Internally, we are not even discussing it,” said a senior London-based equity capital market executive. “We don’t think it will make much difference. Maybe you just don’t formalise it any more, but the principle stays the same.”
The problem, according to the Financial Conduct Authority, is that bulge bracket investment banks rely on cross-selling more valuable transactional services — such as equity or debt issuance — alongside less profitable lending or broking services.
The FCA said in its interim report on capital markets competition this week that it found 27 out of 60 financial companies were inserting “contractual clauses” into engagement letters to constrain clients from choosing other providers for future business.
“To a large extent this ‘quid pro quo’ is a commercial expectation, but we also found that the majority of the larger banks use or seek to use contractual clauses that restrict a client’s choice in future transactions,” the FCA said.
Calling for this practice to end, the regulator said the most common example of it was in “right of first refusal or right to act clauses” giving a bank priority on future deals. “We were told that these clauses have the intention of morally or legally obliging the client to award future business to the given bank,” it said. “We received no clear evidence that clients were able to negotiate a benefit (such as lower fees) when committing to such clauses.”
A senior City-based banker said these “quid pro quo” clauses were most common in corporate broking, “which we basically give away for free, so that may need to change”.
Given big banks’ heavy reliance on cross-selling, the FCA’s recommendation — which is still subject to consultation — may appear to threaten the dominant position of the bulge bracket banks in the City’s equity, debt and M&A markets.
In the UK, these markets produced $17bn of gross fees from nearly 6,000 debt, equity and M&A transactions in 2014, accounting for a quarter of all revenues for universal banks. This is one of the last sources of strong profits for investment banks, which have been hit by a sharp fall in fixed income and derivative trading revenues.
If the FCA succeeds in freeing up competition, many bankers think the winners would be smaller boutiques and specialist corporate brokers, but they warn that smaller corporate clients could suffer.
“Companies want these clauses — they actually like them,” said the UK equity capital markets executive. “If you unbundle everything, it will become much harder for them to get revolving credit facilities, which they really value but we only provide as a loss-leader.”
“If the client relationship isn’t profitable overall, we won’t renew the corporate brokerage or the revolving credit facility,” the executive said.
Brokers said that a clampdown on restrictive contracts could lead to smaller syndicates on initial public offerings, which they tend to favour because it makes individual banks more accountable.
Steven Fine, managing partner at small and mid-cap broker Peel Hunt, said: “Companies allowing lenders on to IPO syndicates may have caused larger than necessary syndicates, which doesn’t always achieve the best outcome.”
However, many City bankers appear unworried by the proposal. If anything, they seem to be relieved that the FCA has not gone further imposing outright restrictions on cross-selling.
Banning such “quid pro quo” clauses would bring the UK in line with the US, which has long had “anti-tying provisions” preventing banks in many cases from providing products or services on the condition that clients give them future business.
The FCA said its main concern about cross-selling related to its impact on competition between banks for smaller corporate clients, as most large companies have big panels of banking advisers all competing for mandates.
“Overall, although many clients are in a strong position to secure good outcomes across services as a whole, the bargaining position of many medium-sized and small corporate clients is likely to be less strong than that of large corporate clients.”
Another senior banker said cases would occur when a bank would only lend to a company that badly needed the money on condition of being promised future mandates. “But this will probably continue in an informal way,” he said.
The FCA is also examining how the shares in IPOs are distributed amid claims from some investors that bulge-bracket banks reward their best hedge fund clients with preferential allocations.
Tom Hinton, head of capital markets at SyndicateRoom, an equity crowdfunding platform, said: “If the net in the IPO allocation process falls wider to capture smaller institutions and retail investors then that’s a positive for us and the capital-raising process will be a winner.”
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