Investment banks should cut balance sheets by $1 trillion -report

LONDON, March 20 (Reuters) - Investment banks must taketough decisions to quit ailing business areas and should reducetheir balance sheets by $1 trillion - or almost a tenth - tolift profitability, an industry report said.

European banks face a particularly challenging outlook andare likely to continue losing market share to big U.S. rivals,according to the 2014 Wholesale & Investment banking Outlook byMorgan Stanley and Oliver Wyman, released on Thursday.

The report said investment banks needed to cut their balancesheets by about 8 percent, even after cutting them by a fifth inthe last four years, and to redeploy another 5-7 percent tobusiness areas that were more profitable.

Return on equity (RoE) across the industry should recover to12-14 percent by 2016 if banks implement changes across fixedincome, equities and advisory and cut costs by greaterefficiency in areas like technology, Morgan Stanley/Oliver Wymanpredicted.

Banks have struggled since the financial crisis to liftprofitability back above their cost of capital, which istypically 11-13 percent, mainly due to tougher regulations.

RoE averaged 6 percent last year, but was 11 percent forcore operations after stripping out the drag from regulatoryfines and closing down non-core assets, the report said.

It said regulatory issues could still knock 3 percentagepoints off the industry's returns by 2016, due to the impact oflocalised rules and requirements - or "balkanisation" - and capson leverage imposed by U.S. and European regulators.

"We think these (leverage caps) are likely to settle at 4-5percent - higher than many European banks have assumed, forcinga tougher re-evaluation of where the balance sheet is deployed,"the report said.

Tougher rules on leverage would hit Deutsche Bank and Barclays hard.

The report said continued weakness in fixed income,currencies and commodities (FICC) - which accounts for abouthalf of investment banks' revenue - would continue to hurt.

Rates income has slumped, hit by low interest rates and theneed for banks to hold more capital against their assets. Rates revenues have dropped 60 percent fromtheir peak in 2009, and the industry needs to take out another$15-20 billion of capital that is allocated to the business andcut costs faster, the report said.

Banks across the world continue to reshape, and the big U.S.banks are taking market share during the investment bankingdownturn, especially JPMorgan, Citigroup and Bankof America.

Morgan Stanley estimated Deutsche Bank, Barclays, Royal Bank of Scotland, UBS andCredit Suisse lost about 5 percent of FICC marketshare to U.S. rivals in 2013 and will lose another 3 percentthis year, notably from Deutsche and Barclays. (Reporting by Steve Slater; Editing by Pravin Char)