The global banking system has been shaken to its core and only by understanding what lies behind the turmoil can banks take advantage of emerging opportunities.

With the banking system undergoing profound change and the market left thoroughly disorientated, it is the ideal time to explore the dynamics behind these changes and try to piece together some of the fundamental trends we are witnessing.

The economic crisis has shaken the banking system and has greatly affected several key areas. First, its reputation has been dented and there has been little so far in the way of plans to repair it. Second, it has had a real influence on client behaviour. Clients are more discerning, more demanding in terms of the quality of service, less inclined to take risks, and more debt-averse.

On the one hand, we find ourselves facing a macroeconomic outlook characterised by weak growth and low interest rates. This means sluggish returns for banks (particularly retail banks) and a higher level of risk. On the other hand, the crisis has affected the stance of the regulators who are, justifiably, reviewing the legislation. So far they have had very little dialogue with the banking industry, partly due to its poor reputation.

This has created a sense of uncertainty and a fear of potential negative consequences on the horizon. Employees of these financial institutions are feeling insecure due to the criticism their employers have received and are finding it difficult to motivate themselves. Moreover, it will be harder and harder to attract talented workers to manage the new challenges that will inevitably present themselves.

Finally, advances in technology mean there are new players on the scene - PayPal or Bling Nation in the online money transfer sector, or the personal finance companies Mint, BillShrink and Kapitall - that will continue to gain market share from the incumbents.

The golden rules
Having examined some of the key factors driving the changes in the system, we should take a moment to look at some of the principles we would do well to keep. The banking industry should be (or should return to being) private. Politics should not play any part in credit allocation. Private banks can always make mistakes but, for the most part, they protect the interests of their clientele.

Being private implies a coherent shareholder remuneration policy. That is not to say private banks are being greedy, it is about safeguarding the interests of shareholders who, in the majority of cases are the asset-owners rather than the banks themselves. They have many investment alternatives and their decision to invest in banks is dependent upon the return they will receive. Today, we know they are reluctant to make this investment. Western banks quote below book-value and the market doubts their ability to repay the cost of capital.

This situation is especially dangerous because, long-term, it could lead either towards a nationalisation of the industry or a significant reduction in the production capacity of the banks. In other words, it will cause a large reduction in credit portfolios.
To analyse the impact these conditions will have on the banks, it would be useful to understand what will happen to the two major banking sectors: retail banking and corporate and investment banking (CIB).

Retail banking is certainly the area that will be worst hit. Lower interest rates will greatly reduce profitability. Weak loan growth means a reduction in mortgage contributions and consumer credit, and a high rate of unemployment implies a greater level of risk. Finally, clients become much more conservative in their investments, and profits generated from portfolio management will grow at a lower rate.

In response, it is essential to carry out an in-depth review of costs and a serious overhaul of the distribution model. We must reduce the network of branches, transferring as many transactions as possible away from manned into unmanned distribution channels, and focus on the quality of client service.

Smaller banks should prioritise client relationships above all else, distributing third-party products. I am referring to asset management and insurance products but this also applies to loans and consumer credit businesses. A high-quality production structure is expensive and it is difficult for small and medium-sized banks to excel in this area as their core value is in the franchise. I believe medium-sized banks can survive provided they have a clear strategy that focuses on commercial investments and they undertake drastic cost reductions in all areas not linked to their client relationships. The alternative is a strong domestic concentration of the industry driven by the need to create cost synergies.

Window of opportunity: traditional banks must not be caught napping as technological advances allow new players such as PayPal to grab market share Window of opportunity: traditional banks must not be caught napping as technological advances allow new players such as PayPal to grab market share

Economies of scale
CIB has been hit by the crisis in its market-linked component but has benefitted in its lending component. In market activities, there have been significant legislative changes that require a need for much higher volumes of capital than before, and investors are giving valuations at lower multiples. It is therefore less convenient to operate in this sector but, at the same time, there is less competition. Consequently, it should be possible to find a decent rate of return on capital fairly easily. Regarding the more commercial side, typically linked to lending, spreads have widened thanks to a greater ability to evaluate risk and to less capital being available. This has caused a reduced production capacity and therefore profitability is slightly increased.

With the simple act of lending, it is impossible to give an adequate return on capital without applying a spread that no company with an investment-grade rating would accept. It is therefore necessary to cross-sell with other products, typically investment banking products such as cash management, debt and equity capital markets, risk management, derivatives and advisory. This enables an economy of scale that is capable of attracting talent which will enable a CIB to compete with other strong players and have first-class risk management.

Overall, it will be crucial for CIBs to be large enough to have economies of scale and to be in a position to cross-sell. This will make life difficult for medium-sized banks. They must concentrate on the strength of their relationships with small and medium-sized clients, to whom larger investment banking firms do not have access. However, corporate client relationships will be more and more geared towards the large banks, who operate not only as lenders but also offer the other services mentioned.

This would lead to fewer large banks, many of them multinationals, operating in CIB. I believe this area will be less volatile than it was during the economic crisis. The market component will be reduced and therefore the multiples related to CIB (when its structure is effectively linked to the customers) will tend to rise.

As long as regulatory authorities are still too nationally oriented, particularly in Europe, for a certain period there will be some aversion to cross-border mergers and acquisitions (M&A), even if economies of scale are crucial to CIB. The financial markets are also aware that banks with larger international exposure are more complex and harder to comprehend, although this point of view can change rapidly. Privatisations will play an important role in cross-border M&A. In fact, for governments who want to get out of the banks they have saved, it will not be easy for them to find domestic buyers.

There will likely be some consolidation in national markets due to the fact that the profitability of small and medium-sized banks will be under pressure in the corporate sector, and they will not be able to turn to the traditional profitability of retail banking to compensate.

This process needs to be watched closely by regulators if consolidation is necessary to maintain the stability of the banking system. If systemically important financial institution regulation is excessively penalising, larger banks will be less willing to take over others.
This will be a difficult time for the banking system to endure, given the challenging macroeconomic situation, the uncertainty surrounding regulation and the extra demands from clients. But there are also opportunities to be found. Investor expectations are (sensibly) lower than in the past and bank valuations have fallen significantly. We should therefore try to imagine a future with less strict regulation, considering that if client satisfaction is prioritised, market shares will be less rigid and it will be possible to break new ground and generate income that would have been unthinkable before.

Alessandro Profumo was CEO of UniCredit from 1997 to 2010, during which time the bank underwent expansion across Italy, Austria, Germany and much of Central and Eastern Europe


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