Banks under regulatory pressure need to transform business

BOSTON: Five years after the onset of the financial crisis, banks are still struggling to create sustainable value and must revise their business and operating models, taking a centralised, comprehensive approach at all organisational levels to make transformation happen, according to a new report by The Boston Consulting Group (BCG). The report, titled ‘An Inflection Point in Global Banking: Risk Report 2012’, was released last week.

At 89 billion euros in 2011, the economic profit of the global banking industry remained negative for the fourth consecutive year. The primary causes of the poor performance were risk costs—still 75 per cent above pre-crisis levels, despite a slight decline due to lower capital charges. Banks’ ability to create value has also been hampered by falling income levels, refinancing costs that are again increasing, and still-rising operating costs.

The pressure on economic profit will not ease in the foreseeable future, according to the report, which covers 145 banks that account for nearly 75 per cent of banking assets in Europe, the US and Asia-Pacific. In addressing the implications that structural industry changes have for bank income and costs, the report concludes that banks must take action now on multiple fronts in order to put value creation on a more positive trajectory.

The equity investor perspective

During the crisis, the cost of equity rose from its stable pre-crisis level of nine per cent for all banks to 12 per cent for commercial banks and 16 per cent for investment banks. Investor expectations in the future will continue to differentiate between investment banks on the high end and commercial banks on the low end.

“These shifts in the cost of equity (COE) have sparked a debate on what constitutes an adequate level for banks going forward,” said Gerold Grasshoff, a senior BCG partner and co-author of the report. “In today’s environment, with risk-free rates hovering around zero per cent, the real question seems to be whether COE and return-on-equity levels above 10 per cent are realistic.”

Banks will need to adopt a segment-specific approach to setting target returns in order to create incentives aligned with equity investors’ interests. This is common for companies in many other industries, the report says.

The debt investor perspective

The perspective of debt investors is also undergoing a structural change, reflected in particular by limited market access and higher credit-risk premiums for banks. As a consequence, banks have reverted to other sources of funding—primarily central-bank liquidity but also deposits and secured funding.

Many of the trends appear to be long-term, so capital market funding will be more selective and more costly on a sustained basis. “In the future, banks will need to give strong consideration to the availability, sources, and cost of funding in their business models and steering mechanisms,” said Peter Neu, a BCG partner and co-author of the report.

The regulator perspective: An overhaul by the end of 2012

G-20 reforms such as the new Basel III framework—despite discussions in the US and EU on postponing implementation—as well as central clearing and margining for over-the-counter derivatives, will form the new global regulatory foundation. While some regulations have already been introduced, virtually all remaining major reforms will be phased in by the end of 2012 or in early 2013.

In addition to the G-20 reforms, banks must contend with a number of domestic reforms—for example, bank levies and the Liikanen proposal in the EU, the Volcker Rule in the US, and the Vickers report in the UK. Market pressures are speeding the implementation of reforms, ultimately requiring banks to comply with the major elements by the end of 2012 or at least to present a credible plan for fulfilling the requirements.

Implications of the ‘New New Normal’ will affect economic profit at the group, business, and product levels. Although the banking industry has reacted to changing market perspectives, major hurdles remain. For example, 50 per cent of the banks in our survey are still short of the funds required to reach minimum capital ratios.

“As an inflection point is foreseeable for the industry, banks must ensure that they account sufficiently for all aspects of the ‘new new normal’ when they adapt their businesses,” said Grasshoff. “Each operating model will need to be reviewed separately according to business line and region.”