31 March 2016
The existential crisis in banking
by Frank O’Nomics
Financial institutions exist to make money. Or at least they used to. The financial crisis of 2008, the seemingly endless series of scandals (Libor, FX, interest rates swaps, etc,etc) have all served to lead these entities, which are the life blood of a service economy like the UK, to question the very nature of their existence. Having previously spent their time trying to maximise their growth potential (a growth that was historically very profitable) they now focus on business model sustainability. This means a great deal of focus on the risk-reward of the businesses that they engage in, in particular whether the rewards are worth the risks, both in terms of capital and reputation.
This growing focus on the correct business model has so far resulted in a great many redundancies, closures of business areas and a scaling back of balance sheets. All of this has a significant impact on the long-term potential growth of our economy and it would seem that the process has a lot further to run; there is a great deal of regulation still to come into force which businesses need to rapidly adjust for. It is worth looking at the range of regulations that are still to come to get an idea of the restrictive headwinds that the industry faces, but first an illustration of the dangerous risk-reward balance that banks are coming to terms with.
It used to be the case that you wanted your revenue producers to do just that, generate as much profitable business as possible. However, not all business is necessarily good business in the longer-term and this was well illustrated by the write-downs announced by Credit Suisse last week. The bank uncovered a portfolio of illiquid assets that had been hidden from senior management, resulting in a $633 million write down for Q4 last year and a further $346 million in Q1 of this year. The CEO, Tidjane Thiam, has said that the business changes that they have enacted as a result (including cutting an additional 2000 jobs on top of 4000 announced previously) will leave the bank with more reliable and predictable profits. This will inevitably mean that the upside for profits will be constrained, but the combination of an acceptable risk-reward balance and reduction in reputational risk will be happily accepted by most shareholders. The problem is that banks like Credit Suisse and UBS are now becoming more and more focused on steady businesses such as wealth management, rather than being the agents for capital raising and investment that they were traditionally involved in. The decline of institutions that can be both the architects and engines of economic growth raise the prospect of an extended period of economic stagnation.
The issue becomes important when regulation, rather than rational business assessment, becomes over restrictive in terms of dictating the new business model for financial institutions. It was refreshing, but quite surprising, to see this highlighted in a speech to the Harvard Law School by the acting Executive Director for International Banking at the Bank of England, Sarah Breeden, last week. She argued that regulators should look at the costs of their actions to rein in banks, not just the benefits, and talked of the “stability of the graveyard”, where international banking is unable to support international trade and growth, or where it does so at too high a cost. The Bank of England has been leading the push for banks to hold ever higher financial buffers against a potential downturn and to separate investment banking from high street banking. Ms Breeden sees the Bank’s role as lion tamers but does not want to see the lions being “completely sedated”. We should not underestimate the importance of the Bank’s role here, given that the UK hosts 170 international banks from 50 jurisdictions. A significant proportion of international banking activity is booked in the UK (twice that of anywhere else) where the largest investment banks and global capital markets are situated.
We should then consider the further sedatives that financial institutions have to face. The Independent Commission On Banking has said that banks should ring fence their high street banking from their investment banking arms and requires those that lend to businesses and individuals to “retain a systematic risk buffer” to protect against a significant economic downturn.
Most of the other elements of legislation are usually very dull and dry,too complicated for anyone other than those who have to ensure that they are compliant and face a curtailment of their activities. A very good example is the Markets in Financial Instruments Directive II. I’m sure that Mifid I passed most people by, but this was intended to make financial markets more efficient, resilient and transparent, while strengthening protection for investors. Mifid II will involve a significant change in the detail and nature of trade reporting, driven by the EU, which will prove both onerous and expensive for banks. In addition, there are new regulations for the certification of senior managers and anti-money laundering that will need to be complied with, all of which may seem laudable, but will leave some questioning the ongoing benefits of the underlying businesses, which could become perceived as more trouble than they are worth.
What many of the regulations appear to ignore is the extent to which banks will self-regulate. They are not interested in receiving continual fines, the loss of business commensurate with a hit to their reputation, and the huge losses that they have suffered from not monitoring their business lines properly. JP Morgan is a very good example here, having spent some $1billion on internal safeguards and processes to ensure that the losses generated by the “London Whale” (in excess of $6 billion) are not repeated.
The momentum behind the official initiatives is such that there is no sense in stopping the process now, but there may be some scope to moderate the severity so that the lion is not overly sedated. Mark Carney has commented that “trust arrives on foot, but leaves by Ferrari”, and he is correct in suggesting that reputational risk should be a key factor in driving business models, but the very nature of banking is to take risks and the current scenario points to a dangerous future of economic stagnation. For now we will continue to see financial institutions reviewing their business models and, while they do, scores of revenue producers are likely to want to keep their heads down, avoid taking any risk and hopefully miss the axe of restructuring.
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