Universal banking: not dead yet

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As European regulators renew their focus on the legal ring-fence between retail and wholesale activities, the universal-banking model needs to adapt to new regulatory and market pressures.

The Bank of Finland governor Erkki Liikanen’s recommendations on the detachment of trading from banks’ deposit-taking activities has held the door open for the universal model by allowing both sides to exist within the same banking group, but the radical strategy changes announced by some of the world’s largest banks in anticipation of Basel III and Dodd-Frank already suggest what tomorrow’s universal banks might look like.

According to Jim Eckenrode, executive director with the Deloitte Centre for Financial Services in Boston, banks which operate both retail deposit-taking business and wholesale global markets trading under the same roof are looking at ways to modify their business models to improve the return on capital.

“Across the universal banking landscape, banks are taking a capital-centric look at their business model and asking what activities will be profitable,” he says. “For some institutions, this is much more an issue of stakeholder requirements and demands as it is a regulatory imperative. We are seeing evidence of new approaches as banks exit businesses which are no longer economic to concentrate on areas where they can win.”

New regulations dramatically reduce the incentive to commit capital to the asset class, as seen with the planned closure of a previously dominant fixed-income division.

“Banks are already shutting down proprietary trading desks and withdrawing from market making in some instruments in a broad move toward much lower balance-sheet consumption,” says Brad Wood, partner with GreySpark, a dedicated financial services consulting firm based in London. “Banks are either making or getting ready to make the move to an agency-based model, with revenue flowing more from commission fees than from asset exposure.”

 
 Erkki Liikanen; source: Reuters
Evidence of reduced wholesale trading activity, particularly in fixed income, currencies and commodities, will continue to emerge as regulation is phased in and shareholders increase scrutiny around capital usage, but there is little proof that universal banks are ready to abandon the overall goal of serving both retail and wholesale markets.

Indeed, it is the largest universal banks that dominate the most liquid markets that are most likely to benefit from the reduced risk appetite and trading activities of smaller players.

“What we are seeing is a strategic rethink among universal banks about where best to deploy scarce capital for the benefit of their clients and shareholders,” says Eckenrode. “Although entire businesses are being repositioned, and will continue to be for some time, we haven’t seen the demise of universal banking by any stretch.”

Indeed, several of the largest universal banks have extended their corporate lending activities and maintained their retail networks, while modifying their capital markets operations to optimize balance-sheet consumption. As recent Euromoney coverage highlights, the systemically significant banks below the tier one players are also continuing with wholesale trading activities but on a much reduced basis, with a refocus on asset classes where banks can add value to core clients.

Stu Taylor, CEO and co-founder of Algomi, a London-based technology and consulting firm, concurs. “The withdrawals from business sectors, although well-publicized, do not represent a complete pull back from universal banking,” he says. “We are a few years into a major deleveraging event, and incoming regulations are driving a sectoral focus on balance-sheet optimizing and balance-sheet velocity.

“Balance sheet is now scarce, particularly in OTC products. While we see some scaling back, many banks are trying to provide a wide range of market making capabilities across all assets by adopting aggregation strategies that combine own balance sheet with liquidity from external sources. To do this, banks need to be a lot smarter in how they organise themselves.”

Capital conservation

Taylor notes that fixed-income inventory has declined by 75% to 90% among European investment banks, as trading desks slash their holdings to reduce balance sheet and capital consumption. Clearly, the ability to get out of positions quickly has become a key priority for banks seeking to remain active in fixed-income markets.

“Banks are still prepared to put capital to work, and a little capital is still much better than none when it comes to market making and best execution - this is their competitive edge in the new environment,” he says.

However, with clients now holding the vast majority of assets, market fragmentation is an important market issue with serious implications for clients to connect to liquidity providers.

“Under these thinner, fragmented market conditions its essential to use the information and natural client franchises that banks have built up over time and leverage their existing market positioning to optimize the way that sales operates," he says.

Wholesale banking, and its viability within the universal banking model, is now more a question of distribute to originate rather than the other way round.

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