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This is no cycle: European investment banks must cut pay

Climate change, or a passing storm? Some investment bankers believe the downturn marks a structural change in their world. Others still believe in the cycle. The risk, following strong third-quarter fixed income trading at U.S. investment banks, is that those in the latter camp go easy on cost cutting and chase earnings instead.

Citicorp's fixed income currencies and commodities revenue was up almost two-thirds year on year; trading at JPMorgan and Morgan Stanley was up one third. Investors can expect the same as Europe's investment banks start reporting this week. But it would be wrong to think that things are looking up: trading still relies on highly artificial and temporary stimulus measures.

That is because client activity remains downcast and the bright spot in U.S. trading was driven by QE3. The European Central Bank's announcement of "outright market transactions" to buy government bonds has also perked up debt capital markets (DCM) activity among the Europeans.

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Deutsche Bank, for example, reported brisk business in DCM over the summer, and Credit Suisse, HSBC and UBS should have good third quarters in DCM. Some analysts reckon that DCM revenues at the biggest banks could rise by almost 50 per cent from the second quarter. Deutsche, Barclays, Credit Suisse and, to a lesser extent, BNP Paribas, should do well in Ficc and, while deleveraging hard, RBS too. But the outlook for cash equities and equity derivatives at Société Générale – is grim.

Better to watch the likes of HSBC and UBS, which have acknowledged the inconvenient truth that markets have changed. All banks need to cut pay. JPMorgan's investment banking compensation ratio of 33 per cent makes Credit Suisse's end-June 50 per cent stick out. Banks that do not cut may have to raise capital as the stimulus wears off. Low book value multiples capture their hesitation.

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