Two categories of reform initiative, working in tandem, are set to have a particularly profound impact on banks’ business models and operating structures. We look at both below, considering some of the challenges, business model implications and opportunities that might arise as a result of the interplay between the two.
Capital and liquidity
The globally-agreed Basel 3 capital and liquidity reforms were formulated to make banks safer, and thus better able to support the real economy. Although it was clear the measures would add to banks’ costs, the gradual phase-in was supposed to give firms time to adapt while continuing to support the economy.
In practice, that has not happened. Market realities and regulatory impatience – as evidenced by the European Banking Authority’s short notice demand that firms achieve a 9 percent Core Tier 1 capital ratio by this coming June – have forced banks to take immediate action to strengthen their capital and funding positions.
Few banks have accessed investors for new capital over the last year or so, especially in light of diminishing returns. Instead, to meet their capital requirements, banks are progressively moving their balance sheets away from capital intensive products.
The impact of tougher liquidity standards, which are forcing banks to scramble to raise more expensive longer-term funding, could be even greater. As a result, banks’ capacity to provide the credit needed to fuel growth in the economy is being severely squeezed.
The recent Long Term Refinancing Operations (LTRO) funding of nearly a trillion Euros has created a dependency that might prove too addictive to the banks. However, at the point when it is hoped to wean them off this life-line new tougher liquidity standards will start to impact.
The recovery and resolution plans (RRP) process is designed to ensure banks can fail without taxpayers once again having to pick up the tab.
As a first step, it requires banks to have a viable recovery plan that goes way beyond coping with ‘business as usual’ stresses. Under the UK version, banks’ plans will need to:
- Address a wider and tougher set of stresses, covering both firm-specific and market-wide events
- Identify credible recovery options, including possible asset and business sales, capital raising and liability management, and a potential sale to a third party
- Establish a clear set of predetermined triggers that would initiate the recovery actions.
Resolution plans will be prepared by the authorities, but require banks to provide a large amount of information and detailed analysis of:
- The economic functions undertaken by the firm, and their importance to the financial system and wider economy
- How any ‘critical’ economic functions could be separated from non-critical activities
- Key structural and operational issues relevant to the separation of significant entities during a resolution – with a particular emphasis on interbank and trading book exposures
- How any barriers to a rapid resolution could be removed – including through the upfront restructuring of legal entities, service agreements and intra-group transactions.
Where barriers to resolution exist, the authorities can insist banks change their structure, or their business activities, to remove those obstacles. As yet there is no indication how far the authorities want to push banks in this direction.
The RRP agenda is advancing both globally and locally. The Financial Standards Board (FSB) has issued a set of high level resolution principles, which the UK has adopted. Other countries – including the US, Japan, Australia and Switzerland – are forging ahead with their versions of resolution plans as well.
However, there are still significant hurdles to clear. In particular:
- What thresholds will a firm have to reach for their plan to be deemed credible?
- How will resolution be consistently applied across countries? For example, how far will individual regulators use RRPs as a lever to push for ex ante structural change?
- Can cross-border conflicts within the resolution process be overcome?
Should the European Central Bank (ECB) or International Monetary Fund (IMF) act as the oversight body in resolving a Global Systemically Important Financial Institution (G-SIFI) to prevent local vested interests from disrupting an agreed RRP plan?
There is universal acceptance that weaknesses in the global banking sector exposed by the financial crisis needed to be addressed. To this end, some sensible reforms have been initiated.
However, in the rush to regulate there is a growing danger that the multitude of reforms are failing to pursue a complementary global approach that takes proper account of the trade-off between safety and cost. Instead, legislators and supervisors should consider whether their actions strike the right balance between making banks safer and ensuring they do not retreat from their vital role in supporting the real economy, and especially the crucial commercial banking sector.
In response to the medley of regulatory changes being introduced, there is clear evidence that banks are being forced to undertake fundamental business model reforms.
For example, the stringent capital and liquidity requirements under Basel 3 – which in Europe are being implemented via CRD 4 – will make certain markets and products less profitable, and thus less attractive. As a result, in many cases firms have already begun scaling back or pulling out of some businesses, especially capital-intensive ones. Meanwhile, the UK’s ICB proposals (which are also being considered in various guises by authorities in Europe and Asia), Dodd-Frank in the US, and efforts globally to introduce RRP programmes will act as explicit drivers of structural change.
Global supervisory perspectives are playing a part too. For instance, some supervisors are pushing for booking practices to be simplified, so that trades are booked in-country for local clients in a legal entity they can see. In this way, supervisors can ensure firms retain sufficient capital and liquidity to keep their local business safe. In the US, there have been recent examples of the Federal Reserve pushing firms to establish a virtual bank holding company that has many of the same governance and reporting requirements as a full holding company.
All of these developments point to a growing trend towards the localisation of banks that function as legal subsidiaries with standalone capital and funding, and potentially operational capacity. This might not be the overt agenda, and it might not happen overnight. Nevertheless, the implications for global banking business models – and the impact fragmentation of global wholesale markets would have on the provision of trade finance and financial products to international corporate – are profound.
If the move towards localisation does continue the number of truly global banks is likely to shrink further, and the gap between regional and national banks and these global institutions will become increasingly stark.
For banks with the flexibility and capabilities to address these regulatory and business model developments, plentiful opportunities do exist. In particular, those institutions that start from a stronger position – with robust balance sheets and capital structures, and fewer inherent risks in their business model – will be well-positioned to leverage their comparative advantage to win market share from weaker rivals.
Furthermore, there are growth prospects in a range of markets. Private banking is one area that continues to offer high growth potential, especially in booming emerging economies. Markets in Asia, and a potentially rebounding United States, may offer attractive opportunities as well.
To maximise opportunity, therefore, banks will have to choose carefully where they invest their scarce capital and resources, in order to target areas with the best growth potential and where they can be truly competitive. Being a weak number four or five in a market will no longer be enough. Operational and governance models must adapt to a more ‘modular’ organisational structure. Technology and infrastructure must be optimised to increase efficiency, reduce duplication and complexity. Finally, flexibility and transparency must sit at the core of any new model – enabling banks to identify and adapt to a landscape which will move faster and farther than ever before.