That will reduce market liquidity and could raise trading costs for asset managers, forcing them to invest more in trading capabilities, according to the study by Morgan Stanley (>> Morgan Stanley) and consultancy Oliver Wyman.

New rules introduced since the 2007/09 financial crisis require banks to hold more capital for trading activities, making these areas less profitable and prompting cuts to trading desks.

Investment banks' balance sheets supporting trading markets have decreased by 20 percent since 2010, and by 40 percent in risk-weighted asset terms, the report said.

European investment banks will shrink by another 14 percent on aggregate in the next two years, Morgan Stanley analyst Huw van Steenis estimated in the report.

That would include a 43 percent reduction at Royal Bank of Scotland (>> Royal Bank of Scotland Group plc), 25 percent at Credit Suisse (>> Credit Suisse Group AG), 19 percent at UBS (>> UBS Group AG), 18 percent at Barclays (>> Barclays PLC) and 10 percent at Deutsche Bank (>> Deutsche Bank AG).

"For banks, the diminishing returns on capital from market-making call for more and faster structural change," the report said, estimating that for banks to improve their return on equity (RoE) to above 10 percent they need to deliver 2 to 3 percentage points of RoE improvement from restructuring.

"More strategic selection is required, particularly in FICC (fixed income, currencies and commodities) and overseas markets," it said, adding they also needed to shift to a more technology-driven model.

The report said asset managers were increasingly concerned about the reduction in market liquidity and estimated the need for them to invest in trading and execution, collateral management and risk management could add between 1 and 5 percentage points to their costs.

(Reporting by Steve Slater; Editing by David Holmes)