The banking model is broken and needs to change now
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The banking model is broken and needs to change now

Euromoney takes a look at how banks need to fundamentally change the way they do business

The current banking model is broken and needs to urgently change, especially with various key issues – such as yet-to-be-clarified regulatory changes and consequential costs on banks – exacerbating poor returnsand diminishing trading conditions.

“What we’re starting to see now, which we didn’t back in 2008, is for the first time banks starting to exit businesses,” says Richard Ramsden, financial analyst at Goldman Sachs. “What we hear from investors is that some business lines do not make sense in the current environment. Banks can’t carry on with the same number of competitors chasing lower revenues against higher capital and funding costs.”

These pivotal issues remain unclear: what final rules will regulators in the US and around the rest of the world eventually draw up and enact into law, including on capital; at what cost will banks fund in future; what long-term patterns of customer demand will emerge when the prevailing risk aversion and deal drought comes to an end for banks’ trading and capital markets services; what volumes and margins can banks sensibly plan for?

 “What we hear from investors is that the bank model
 is broken. Banks can’t carry on with the same number
 of competitors chasing lower revenues against higher
 capital and funding costs”
 Richard Ramsden, financial analyst at Goldman

As a poignant example, on January 17, Citigroup chief executive Vikram Panditmanaged to surprise investors. He unveiled an even worse set of results for the fourth quarter of 2011 than the more pessimistic banking sector analysts had predicted after what was a dire three months for capital formation, sales and trading, M&A and deal activity of any kind.

The bank managed operating earnings per share of just 0.38, when the Wall Street consensus expectation had been for 0.48. The chief culprit was the securities and banking division, where revenues fell by 33% even while expenses ticked up 4%.

“Market activity was down significantly and our clients reduced their risk,” said Pandit. “Any of our businesses geared to the capital markets, such as sales and trading, securities and fund services and GTS, and even investment sales and consumer banking, were impacted.”

Analysts in Europe looked on nervously.

They all expect the earnings collapse in the final quarter of last year for European investment banks to have been even worse. Announcements get under way early in February. Are the consensus estimates of 40% earnings declines pessimistic enough?

Excluding all the nonsensical accounting adjustments for changes in its own credit spreads, Citigroup’s securities and banking division recorded a $139 million loss for the final quarter of last year, down sharply both from the third quarter of 2011, when the division recorded net income of $2.1 billion, and the fourth quarter of 2010, when it managed a $281 million profit.

The Basel III regime will transform the economicsof the FICC business through charges against counterparty credit risk on inventory and new positions in rates. It is not clear that the industry has worked out how to price the cost for credit valuation adjustments back to customers.

Meanwhile, US regulators have taken the lead in pushing more and more rates derivativeson to central clearing counterparties, so potentially reducing the profitabilityof derivatives for stronger-rated banks. But if these businesses are core to banks’ identity, they won’t simply abandon them. And it remains to be seen what new businesses and revenue opportunities crop up in, for example, outsourced provision of collateral management services to customers that lack the infrastructure for regularly evaluating and posting collateral, as many will be now required to do for the first time.

Several banks initially seem to be withdrawing from less-capital-intensive businesses, such as equity and M&A. Scale and market position has been as much a consideration in these decisions as capital consumption and the full allocation of the costs of non-deposit funding.

“Don’t assume that the big banks will necesarily get smaller,” says Adrian Docherty, head of financial institutions advisory at BNP Paribas. “The small banks may get smaller and the stronger banks will pick up business from thranem. This looks like a time for those that are subscale in corporate and investment banking to rein in their remaining ambitions or define their niche. And while in the run-up to the credit crunch of 2007 and 2008, investment banking was all about sales and production – it will be more about risk management.” 

There are no easy answers as to which businesses banks are likely to quit.

“I am suspicious of studies from consultants claiming to know future business line profitability that equities, for example, should be a 17% return on equity business,” says Docherty. “They give a false sense of precision. Running a successful equities or any other business is about getting a hundred things right, including customer account management, risk management, compliance, culture, compensation and scale. In many areas, investment banking is a winner-takes-all game. The surprise over some of the announcements to withdraw from equity is only that it has taken bank managements so long to realize their businesses were subscale or undifferentiated.”

Cutting back continuously in FICC businesses looks like a tougher call. Commercial and investment banking divisions typically start from unprofitable lending relationships with corporate customers, many now higher rated than their bank lenders.

If a bank doesn’t also offer treasury management, FX and rates hedging, then it doesn’t have much of a raison d’être. These businesses are harder to wind down than cash equity trades, which, once done, are pretty much done.

Much of banks’ FICC infrastructure was built to distribute their own proprietary risk through what looked like customer distribution businesses. Even now, as banks wind down their proprietary risk-taking in FICC and concentrate on genuine customer flows, that often involves putting on linked trades sometimes of several years duration.

For the full story, don’t forget to check out the February edition of Euromoney magazine.

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