A Morgan Stanley report titled 'Outlook for Global Wholesale and Investment Banking' published in March this year predicts that constructive markets could haul the investment banking divisions (IBDs) of major banks into the black in 2009, despite the analysts' belief that "merchant banking and legacy assets will require further and extensive provisioning measures".

IBD is defined by the report as comprising: equity proprietary business, equity derivatives, cash equities/prime brokerage; FICC (fixed income, commodities and currencies) which includes FX, rates, credit trading/prop, real estate securitisation; and advisory. Thus, the term IBD is somewhat misleading, since it is not the traditional activities of debt and equity underwriting and advisory that are leading the return to profitability. Rather, the driver is doing commoditised business on a vast scale. This is fairly alien to the highly profitable and specialist services offered in the past.

Rates, FX, flow credit and commodities businesses have seen a profit rebound in the first quarter, the report points out. Flow credit has seen the strongest rebound with global debt capital markets revenues up almost 80% from the fourth quarter, the report estimates. In addition, the banks are benefiting from much wider bid-offer spreads, higher underwriting fees and expanding margins on loans.

However, the report is pessimistic on other IBD areas such as proprietary equity trading (which is predicted to be down 118% in 2009 versus 2008), prime brokerage (down 21%) and cash equities (down 20%). Despite this, the report believes things will not return to the catastrophic circumstances in the final quarter of last year. In discussing that quarter, the report makes the striking calculation that the structured equity market lost $10 billion, equivalent to the profits generated by the entire industry in that area in the past two to three years.

The 'flow business' referred to by the report is a throwback to the traditional function of investment banks as intermediaries, rather than entities trading their own account. Flow trading also involves standardised and highly liquid products, as opposed to tailor-made products. The latter may have to be warehoused on the bank's balance sheet for long periods of time, using up capital -- not a good thing in the current environment.

The report forecasts continued losses for the investment bank units at UBS and Citi in 2009, but its base case scenario estimates single digit return-on-equity (ROE) at Credit Suisse, J.P. Morgan, Societe Generale and Deutsche Bank. UBS and Citi are seen as the worst performers in 2009, with ROEs of -10% and -2% respectively. The best performer could be Credit Suisse, with an estimated 9% return, the report says.

The relative strength in IBD leads the analysts to conclude that the wholesale banks will do better than the retail banks.

The top picks in the report are noticeably not the traditional investment banking powerhouses such as Goldman Sachs and Morgan Stanley itself, but banks with a strong brokerage history, such as Credit Suisse in equity, and Deutsche Bank in FX. In Japan, Credit Suisse has let go of most of its investment bankers in order to focus on building out a very sophisticated electronic trading business, involving algorithmic trading. Deutsche is a recognised leader in FX trading.

However, one weakness in this model is that it depends on a trade-off between profit margins and volume. The cost of trading is driven down through electronic means, but the bank theoretically benefits from an increase in volume. This occurs in bull markets, but is not sustainable in bear markets -- at least for equity.

FX trading is different to equity trading because the market is so huge and liquid and market impact (which occurs when a trade materially shifts the market) is less of a factor. Currency volatility has also increased sharply in recent months, which increases participation. FX is thus a more promising asset class than equity.

The elite investment banks, with their highly customised solutions, are much less suited to this model. They currently do not have the technology, corporate culture or infrastructure to capitalise on these markets. This is despite their expedient conversion into bank holding companies.

The report also offers insights into compensation, projecting that compensation-to-revenue will drop to 38%-40% in the future, from 43%-45% in the recent past. In 2010, compensation per head could reach 2003 levels. It might even be lower than the report suggests as the new environment, which requires heavy infrastructure investment, means reducing non-compensation costs is not so easy. And that leaves compensation as an easy target for cost-cuts.

The universal banks have another advantage, which is their retail deposits. This is generally regarded as more stable than wholesale funding, and will enable them to extract greater wallet share in a capital-starved environment.