30 June 2009
What’s next for the UK financial sector?
In advance of new regulation, Mark Burley, a senior consultant to the Banking and Finance sector at Morgan Clarke, takes a view on what the future may hold for financial services in the UK.
“In the remarkably short period of four weeks, following the collapse of the highly leveraged Lehman Brothers last September, the financial sector suffered a collapse in confidence which led to a global financial meltdown. Rather than expediting the flow of credit through the economy as they were supposed to do, banks have ended up blocking it. The destruction of shareholder wealth has been staggering with total market capitalisation of the global banking industry falling by half in 2008 wiping off all the gains made since 2003[1]. Moreover, the IMF estimates that the total “bill” for the crisis will be $4.1 trillion[2]. It’s not only the credit that has dried up, but also trust in the sector.
Over the past few months there has been growing evidence that, for many banks, the issues have quickly moved from survival to what will be the future banking business model. Banking CEOs are shy of pronouncing confidently about the future, but most think that the chance of another Lehman Brothers has been greatly reduced by the actions taken by Governments so far. It is also worth considering that the nature of any future potential losses is greatly different to the huge unpredictable write-downs on trading-book assets that were the stuff of sensational headlines at the turn of the year. Although many banks remain exposed to significant losses on the loan books they hold, these should be more predictable and can be realised in the banks’ accounts over a longer period of time. Even the biggest victims of the crisis are expecting to return solid profits during 2009.
Given that the very worst may have passed, what might the future of banking in the UK look like?
One sure development in the brave new financial world will be a resurgence in the traditional banking model which relies not on leverage but on sustainable value to generate profits. Profitability is key as banks seek to rebuild their balance sheets and cover the predicted losses from their loan books. It was the threat of continued losses that starved the financial sector of private capital and forced Government intervention; it is the promise of future profits that will herald the return of private capital and allow the Government to “disengage” from its current participation in such institutions as RBS and the Lloyds Banking Group. The resilience offered by sustainable profits is a goal with appeal not only to the banks and Government, but is also of prime interest to the FSA, with seeming alignment between the mooted regulatory reforms and current thinking within the banks about the future.
What is the FSA looking for to support future stability?
The FSA suggest six measures[3] as detailed below, with an overwhelming focus on capital adequacy and leadership responsibility.
1. Higher levels of capital in the banking system and more buffers with which to absorb both unavoidable oscillations in the real economy and unavoidable oscillations in financial market sentiment.
2. Capital buffers which are deliberately built up in good times, so that they are available to be drawn down in bad times.
3. A much stronger focus than in the past on the liquidity of banks: how much of their balance sheet is held in liquid assets? How wide is the mismatch between the maturity of their assets and of their liabilities? And a much deeper suspicion of the argument that long-term assets can be considered as ‘liquid’ since they can be sold rapidly in the marketplace – an assumption which proved dangerously overstated in 2007, when many banks wanted simultaneously to sell risky assets.
4. Very careful attention to the trading risks which commercial banks are running. In the years running up to the crisis, commercial banks became too involved in position-taking as a speculative activity in itself, rather than as an activity sometimes needed to support the provision of services to corporate or household customers. In future, commercial banks must be focused on the core and essential functions of customer service: to achieve this much higher capital requirements are required against the trading activities of banks.
5. A strong determination to regulate financial institutions and activities according to their economic substance not their legal form. In the past, various institutions and off balance sheet structures which performed bank-like functions were allowed without being subject to effective bank regulation - simply because the legal form which they took was not that of a bank. In future, regulators require the power to gather information on all major categories of institution whose activities influence the stability of the banking system – investment banks, mutual funds and hedge funds as well as banks themselves – and to extend regulation to them if they are taking risks which could increase the instability of the system.
6. At both national and global levels, to ensure that the big picture is visible, regulators must identify how risks are building up in the complex and interconnected global system.
In light of these proposed measures, banks are looking to move away from wholesale funding and encourage longer term deposits from customers. Not surprisingly, risk is out of fashion and the focus is on activities and clients that demand less capital. This represents a fundamental reversal from pre-crisis activities, but as one analyst[4] notes “the banking industry got it so wrong and destroyed so much value that it is difficult to sit in front of investors and say we are going to carry on as before.”
The total amount of capital that banks hold will increase on the back of the dual drivers of regulatory demand for buffers against loss and when the increasing risk weightings on assets suffering the impact of the current downturn, take effect. This will encourage the banks to focus on less capital intensive businesses. The pre-crunch banking model of massive returns driven by leverage and asset velocity (i.e. quickly moving assets off the balance sheet through securitisation) will be replaced by a more measured model where the emphasis is on the quality and sustainability of earnings and the predictability of capital requirement and availability. The implication for banks is that they will have to look at increasing profits from their “unleveraged” businesses. Competition for market share and product re-pricing are the obvious signs of these activities.
One ray of light for the remaining banks will be that the FSA will likely be very nervous about allowing new entrants into the financial industry, or allowing foreign banks free rein in the UK market. Moreover, important revenue streams from cash management services and other transactional businesses require significant technology investments and operations which would be difficult for a new entrant to replicate. However, here too there are growing challenges as the fairness of bank fees comes under increasing scrutiny. One can only assume that the current political involvement in the industry will compound this pressure.
What does this all mean?
All this places tremendous pressure on all parts of a bank to perform, whereas in the past it was possible to tolerate a business that only grew revenues, as other highly leveraged parts of the business could create copious returns, this can no longer be the case - one hand in the freezer and the other in the oven does not mean that on average you are OK! Each business unit must demonstrate that they add real value to the bank.
It might be tempting for some to hold the view, that now the poorly managed banks have been exposed, the industry will return to its previous status quo, perhaps with a few token changes demanded by the FSA to increase liquidity. We consider, however, that the banking world has truly changed. The institutions that have failed (and indeed those that have been allowed to fail) are of such a size that every remaining institution will need to understand that everything they do, from the way they manage their balance sheets to the way they price their overdrafts has to change.”
If you have any questions on this article, or would like to discuss our analysis further, please contact Mark Burley on 01306 621600 or at mark.burley@morgan-clarke.co.uk
--------------------------------------------------------------------------------
[1] Boston Consulting Group
[2] Global Financial Stability Report IMF
[3] Speech by Adair Turner, Chairman, FSA 16th June 2009
[4] R. Ramsden Goldman Sachs
More news from Morgan Clarke