Transaction banking takes on a new lustre as liquidity dries up

The reputation of banks across the world has taken a hammering of late. Towering financial institutions, once seen as bastions of stability, have crumbled in the face of the most severe liquidity crisis in living memory. Bear Stearns’ collapse and subsequent US Federal Reserve-backed rescue proved, once and for all, that the ‘too big to fail’ school of thinking was flawed.

It is not only Bear Stearns. The reputations of some of world’s oldest and most respected financial institutions have been left in tatters with a series of executive casualties in their wake. First went Merrill Lynch’s CEO and chairman, Stan O’Neal, followed shortly afterwards by Citi’s CEO and chairman, Chuck Prince. Most recently UBS’s chairman, Marcel Ospel, bit the bullet and stepped down in April. Elsewhere such respected names as Lehman Brothers and Deutsche Bank have admitted spectacular write-downs on their subprime-tainted assets.

Francesco Vanni d’Archirafi, global head of treasury and trade solutions at Citi, has not seen the like of it for a quarter of a century. “It has been rapid and very unexpected, and there has been a huge liquidity crunch against some specific asset classes and industry segments,” he says. “The crisis has been very tough on several industries and continues to pose challenges for the financial services industry, mostly in North America, but also in western Europe where Libor spreads are at record highs.”

The most immediate effects of the subprime crisis are clear for all to see: plummeting profits, widespread redundancies and a determination by regulators to make sure that nothing on this scale ever happens again. Under the surface, however, there are more profound impacts on the global banking industry.

Traditional avenues of profit for banks are drying up and short-term liquidity is non-existent. The three-month inter-bank lending rate was stuck at 6% when this article was written, which has stymied profits from loans and financing. Without this critical revenue, banks are being forced to look internally at how they are going to continue to generate revenue in an environment where debt has become a dirty word and equity markets are volatile. The answer for many banks is transaction banking.

Countercyclical business

Traditionally seen as the carthorse that stood next to the more thoroughbred equities, fixed income and mergers and acquisitions businesses within the bank, transaction banking units have taken on a new vitality.

For Alan Verschoyle-King, managing director and head of European payments and trade services at the Bank of New York Mellon, it is a countercyclical business. “Transaction banking is very much a headline focus at the moment, in a way that I don’t think it would have been a year ago,” he says.

“When the going is good, and there is a lot of liquidity in the market and revenues are flowing, most bankers and corporate treasurers don’t wake up in the morning and say: ‘What is it I can do to drive greater value out of my working capital infrastructure.’ But they most certainly do when the going gets tough.”

For Mr Verschoyle-King transaction banking represents a balance sheet friendly, steady income stream at a time when other income streams are challenged.

Chris Geldard, senior executive of consultant Accenture’s banking practice, agrees. “The beauty of transaction banking is that it is fee based and even though there is a trend towards commoditisation of those fees, this drives surety in terms of revenue and cash flow,” he says. “Many banks are in the process of cleansing their balance sheets and reducing their exposure to low-quality loan portfolios. Even though credit will be re-priced to reflect the heightened market risk, banks will be focused on closing the revenue gap through other means.”

Cost reduction drive

The problem banks now face is how to generate more revenues from a highly competitive, traditionally low-margin business, at the same time as driving down costs. According to Mr Geldard, up to 30% of a bank’s cost base can be made up of transaction services, making it a prime candidate for cost reduction.

He says: “There is a sharp lens coming onto transaction services as an alternative source of revenue, but at the same time there is also a sharp lens coming on transaction banking services as a prime candidate for cost reduction.”

Cost reduction is easier said than done. In the past two years, a swathe of regulation designed to make the banking market more efficient has been introduced across Europe. The Single European Payments Area (Sepa) and the Payment Services Directive were introduced this year and are designed to drive down the cost of banking for individuals and companies in Europe. This has two effects. First, it cuts traditional sources of cross-border payments revenue for banks and, second, it requires banks to spend vast amounts on internal infrastructure.

Add to this mix a market in which both corporate and financial institution clients are increasingly discerning about which banks they do business with, and the situation arises where the importance of providing services that go beyond traditional payments processing becomes paramount.

The key to profiting from the transaction banking business in the future will be to drive volumes through value-added services. This strategy, however, requires enormous scale, both geographically and financially.

Smaller players squeezed

Citi’s Mr d’Archirafi believes that this will have consequences for the smaller providers. “Industry consolidation is being led not only by the credit crisis but by regulations such as Sepa, MiFID [Markets in Financial Instrument Directive], Target 2 and Basel II, which require significant technology investments to be ready,” he says.

Transaction banking has become a far more relevant part of banks’ businesses. In the case of Citi, it now makes up almost 10% of total profit. Last year’s headline-grabbing purchase of ABN AMRO by Royal Bank of Scotland (RBS) was in great part fuelled by RBS’s desire to get hold of ABN AMRO’s transaction banking business.

“One of the really interesting elements of the acquisition was how transaction banking came through,” says Mr Verschoyle-King. “It was a major part of the mix. If you go back three or four years, I don’t think transaction banking would ever have been considered as one of the drivers of an acquisition.”

By purchasing ABN AMRO, RBS increased its global footprint in transaction banking to more than 50 countries and took on a world-class infrastructure. If €71bn is not available to buy another bank, the only other options are to build an in-house capability, which is a costly exercise, or to outsource. What Mr d’Archirafi calls “collaboration for success” means that smaller providers can continue to service their clients, while saving on costly technology investment and compliance with new legislation.

The drive towards cost reduction is a key theme, not only for the service providers, but also for their clients. For Accenture’s Mr Geldard, the smarter transaction banks will be those that can provide a more holistic range of services to their clients. The key differentiator for banks in the future will no longer just be price, but service quality.

Mr Geldard says: “Core payments revenues are declining in terms of profit, but volumes are increasing. A lot of management time and effort will be spent building new value-add services for corporate clients.”

Online push

Value-added services will increasingly involve taking traditionally paper-based activities, such as invoicing and direct debit mandates, online.

In 2007, more than 70 billion payments were made electronically in Europe, according to Mr Geldard, and that figure is predicted to increase to anything up to 140 billion by 2012. Banks are increasingly turning to technology providers, such as VocaLink, to provide these services for their clients and drive down costs. According to VocaLink’s head of international market development, Paul Taylor, an effective payments capture service could save an average bank in Europe about €20m a year.

“At a time when banks are looking for certainty and security, having a platform that is flexible and scaleable in terms of volume is very important,” says Mr Taylor. “You’re taking the cost and risk out of that [payments] process engineering. It wipes out a massive slug of costs for the banks that are currently trying to introduce this on a pan-European level.”

In a world starved of liquidity, it is clear that banks will have to find other means of generating revenue, and their transaction banking units will be instrumental in doing that. However, huge challenges remain. It is a costly business unit to operate and those costs will only go up against a background of new legislation and demands for better technology. Added to that, margins are likely to remain low.

Mr Verschoyle-King regards one of the biggest challenges to be simplifying the transaction banking structure. “Despite all the fine words and great initiatives, such as the euro and Sepa, the infrastructure that goes with transaction banking is still hugely complex, hugely expensive and, quite frankly, a nightmare for buyer and seller to navigate. This has to be on everyone’s agenda,” he says.