Say goodbye to global banking behemoths?

The end result may well be a banking sector made up of smaller, stronger, more focused and less systemically connected entities.

"Margin compression… represents both a structural shift and a cyclical aberration."
Sally Reid, Global head of IIB Portfolio Management, ANZ

In the face of margin compression, there is an immutable law across all industry segments – consolidation.

But for the banking sector, the legacy of the financial crisis and a fear of “too big to fail" has rendered this key adjustment mechanism significantly impaired, if not defunct. Not only is large scale consolidation unlikely, some level of breakup or paring back of the Global Systemically Important Banks (G-SIBs) seems feasible.

For example, Antony Jenkins, CEO Barclays, said “the universal banking model is dead" in the face of more stringent regulatory and capital requirements coupled with the significant cost of a technology agenda in a digitised world.

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Across the broader landscape, questions over whether some of the larger banks have become “too big to control" have been raised, as deficiencies come to light related to sanctions breaches, money laundering breaches, accounting irregularities, LIBOR and other pricing scandals.

MARGIN PRESSURE

Margin compression in the banking sector is multifaceted and represents a structural shift and a cyclical aberration.

Pressures include:

• Cyclical lows in asset spreads - exacerbated by the sustained loose monetary policy stance of central banks across the world. In general, the balance sheets of corporate and institutional customers are stronger than they were pre-crisis and good-quality corporates have access to bank funding and, in some cases, the bond market.
  
  
• Pressure on cost of funding - driven by new regulation that has increased capital and liquidity requirements for the global banking sector, as well as the risks inherent in the banking sector being better understood by investors.
  
  
• Increased regulatory costs – a key feature of cost pressures with regulatory costs (staffing, systems and additional capital requirements) rising both to meet changing regulatory standards and objectives and to pay for fines for breaches of regulatory standards.
  
  
• Increasing competition - faced by the banking sector from non-traditional competitors (much of this competition has only ramped up in the last decade).
  
  
• Competition is driven by:
  i.technology companies (payments, money markets, deposits);
  ii.funds management companies (wealth management, savings, direct investment in corporate and institutional loans and bond markets);
  iii.non-banks (mortgages, deposits); and
  iv.retailers (credit cards, transaction accounts).
  
  
• Increased cost of technology – technology solutions are a core business requirement in a global, interconnected world. Customers want solutions which require more investment in technology while investment is also required to drive down the unit cost of transactions. Technology costs come about from higher depreciation and amortisation charges, as well as increased upfront costs of the implementation and maintenance of technological solutions (internal and customer facing).
  
  
• Global talent pool – the cost of where you perform activities is significantly different from one country to another and technology is rendering issues of time and distance less relevant for staff location. Offshoring and outsourcing are increasingly adopted to constrain cost rises and maintain a competitive cost base. Banks with significant staffing complements (for real or historical reasons) in the main centres of the banking industry (US, Europe – Germany and France in particular - UK, Australia) face urgent pressures to limit wage expenses to maintain competitiveness with emerging financial sectors (which have a natural competitive advantage being located in lower wage jurisdictions).
  
  

Bearing these moving parts in mind, banks could act as they would in the downward part of a 'normal' cycle (with standard cost cutting initiatives, such as reducing headcount and cutting travel budgets) or they could acknowledge the industry and their businesses are going through a significant structural adjustment - which requires a much more active repositioning to arrest margin compression and improve profitability.

More drastic strategic repositioning could include:

• Partnerships (telcos, money services companies, tech giants, retailers etc) – the past decade has witnessed a significant change in the competitive landscape for banks. Not only are they facing competition within the sector but increasingly from non-bank newcomers. A bank with strong, exclusive partnerships will improve its channels and build additional revenue sources. Ultimately partnerships may lead to mergers between banks and other companies that provide core infrastructure, customer channels or access to liquidity.
  
  
• Technological transformation – liquidity is no longer the competitive advantage for banks it once was (companies like Apple and Alipay have substantial cash balances). Banks have to find their unique selling point taking into account that consumer behaviour is changing and evolving as technology becomes an ever more important aspect of decision making. Ultimately this will require banks to have strong technological solutions which allow them to be the aggregator of product in a neutral 'commission based' world.
  
  
• Investment bank / retail bank split – while consolidation of banks leading to ever bigger global, universal banks is clearly unlikely, European banks are exploring models where banks split retail and investment assets (either by spinning off into two separate companies or via asset swaps between two banks rendering one an investment banks and one a retail bank).
  
  Working out how to scale core assets/ businesses and to optimise divestments from non-core assets/ businesses will be a major focus for banks that are serious about competing in the new operating environment.
  
  
• Shrink to greatness – changing regulatory approaches, competition and globalisation have resulted in many banks having an unfavourable (from return on equity perspective) collection of legacy businesses. Banks cannot tinker at the edges if they want to emerge as strong, profitable businesses. 
  
  Those banks that are prepared to radically reshape (when the world is not in crisis mode) will be the long term winners (obviously with short term earnings impact). Those banks which adopt a leaner model will find themselves more fleet footed and more capable of taking advantage of suitable opportunities when they arise.
  
  

Notwithstanding the challenging environment, there is enough stability (currently) for banks to make considered decisions and reposition themselves in a significantly changed and challenging landscape. There are however, some clouds on the horizon that will complicate the landscape for ditherers and potentially result in a more volatile shift to a new paradigm.

These events/ themes could include:

• Credit quality – as well as being the low-point of the asset price cycle, it is also the low point of the credit risk cycle. Any deterioration in credit quality will serve as a further drag on profitability and, if severe, on capital and funding requirements.
  
  
• Liquidity event – liquidity has been propped up by a variety of central bank initiatives across the globe. This has served to provide a more stable liquidity environment in the aftermath of the global financial crisis.
  
  However, sovereign balance sheets are not as strong as they were entering the crisis and their capacity to continue to absorb liquidity risks will reduce over time (and could be materially impacted by events such as the exit of Greece from the Euro or a crisis in Spain or Portugal). This is a key reason why regulators have to continue to put pressure on the banking sector to emerge as a collection of smaller, strong and less “systemically connected" entities.
  
  
• Regulatory differentials – different regulators will impose different requirements which could materially impact where the optimal place to manage certain businesses is. For regional or global banks some choice may exist as to where they base certain businesses to gain a 'home advantage' and this will impact how they stack up relative to where other competitors reside.
  
  

The great challenge for banks is to clearly determine what their long term value proposition is, taking into account the industry is facing significant structural changes. Banks need to communicate to their shareholders who in turn need to accept that there are some short term costs to building a long term sustainable sector.

Banks choosing to 'wait it out' are likely to be confronted by more nimble competitors who more promptly repositioned themselves to adjust to the changing industry dynamics. Smaller, stronger, more focused and less 'systemically connected' banks will be the ones to watch, while the Universal Behemoths of Banking are likely to be the sector laggards of future profitability, if they do not actively look at ways to reposition and adjust.

Sally Reid is ANZ's global head of IIB Portfolio Management.

Photo caption:WASHINGTON, DC - DECEMBER 18: U.S. Secretary of the Treasury Jacob Lew (R) listens to Federal Reserve Board Chairwoman Janet Yellen during an open session of a Financial Stability Oversight Council meeting December 18, 2014 at the Treasury Department in Washington, DC. The FSOC received updates on financial stability during the open session. (Photo by Alex Wong/Getty Images).