LONDON, March 20 (Reuters) - Investment banks must take tough decisions to quit ailing business areas and should reduce their balance sheets by $1 trillion - or almost a tenth - to lift profitability, an industry report said.
European banks face a particularly challenging outlook and are likely to continue losing market share to big U.S. rivals, according to the 2014 Wholesale & Investment banking Outlook by Morgan Stanley and Oliver Wyman, released on Thursday.
The report said investment banks needed to cut their balance sheets by about 8 percent, even after cutting them by a fifth in the last four years, and to redeploy another 5-7 percent to business areas that were more profitable.
Return on equity (RoE) across the industry should recover to 12-14 percent by 2016 if banks implement changes across fixed income, equities and advisory and cut costs by greater efficiency in areas like technology, Morgan Stanley/Oliver Wyman predicted.
Banks have struggled since the financial crisis to lift profitability back above their cost of capital, which is typically 11-13 percent, mainly due to tougher regulations.
RoE averaged 6 percent last year, but was 11 percent for core operations after stripping out the drag from regulatory fines and closing down non-core assets, the report said.
It said regulatory issues could still knock 3 percentage points off the industry's returns by 2016, due to the impact of localised rules and requirements - or "balkanisation" - and caps on leverage imposed by U.S. and European regulators.
"We think these (leverage caps) are likely to settle at 4-5 percent - higher than many European banks have assumed, forcing a 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 about half of investment banks' revenue - would continue to hurt.
Rates income has slumped, hit by low interest rates and the need for banks to hold more capital against their assets . Rates revenues have dropped 60 percent from their peak in 2009, and the industry needs to take out another $15-20 billion of capital that is allocated to the business and cut 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 banking downturn, especially JPMorgan, Citigroup and Bank of America.
Morgan Stanley estimated Deutsche Bank, Barclays , Royal Bank of Scotland, UBS and Credit Suisse lost about 5 percent of FICC market share to U.S. rivals in 2013 and will lose another 3 percent this year, notably from Deutsche and Barclays.
(Reporting by Steve Slater; Editing by Pravin Char)