Senior executives are changing the way their organisations work in an effort to move from merely complying with new regulations to defining how the bank of the future will look.

In 2013, many of the regulatory initiatives launched since the financial crisis were coming to fruition. In Europe, the Capital Requirements Directive was finalised alongside the Bank Resolution and Recovery Directive and the launch of a single supervisor for the 17 eurozone nations that is due to carry out an asset quality review and stress test in 2014. The UK introduced legislation to enforce the Independent Commission on Banking’s recommendations of ringfencing retail banking. In the US, rules on the liquidity coverage ratio, resolution and liquidation, and the separation of proprietary trading – the Volcker rule – were finalised, and a fresh round of stress-testing launched.

In surveys among banking executives carried out at a series of round tables organised by The Banker and EY during the final quarter of 2013, 43% of respondents in Europe, the Middle East, India and Africa and 75% of US respondents said they expected a reduction in business lines or markets by 2016 owing to capital or liquidity constraints. But then, 23% of Europeans and 17% of Americans predicted an increase in appetite for new products and markets. It is easy for senior managers to be overwhelmed by the rising tide of regulation, but clearly vital that they do not lose sight of those opportunities for growth. As post-crisis regulatory initiatives reach final rule-making, banks have a chance to try to move beyond reactive decision-making, and begin planning strategically.

“What we are seeing is that in the planning round for 2014, there is a much bigger focus on how banks frame their plans and budgets so that, as well as addressing regulation, they also position themselves to be the bank of the future. They are asking not just what must we do, but what should we do to direct the strategic future of the bank rather than just implementing the next compliance project,” says Dai Bedford, a partner in the financial services team at EY.

Keeping client focus

Edward Thurman is the head of financial institutions at Lloyds Banking Group, and a member of the team that led the bank’s strategic review that started in 2011 and returned it to profit in 2013. He is keen to avoid being too dramatic about the impact of regulation, arguing that banks will find ways to adapt to measures including structural challenges such as ringfencing, while still serving clients with the appropriate product set.

“The changing regulatory environment is an important factor in the way in which we will develop our business, but it will not be the single defining factor. We have to stay focused on client needs and avoid being overly distracted by theoretical outcomes,” says Mr Thurman.

If the response is right, banks can use the process of complying with new regulations to inform strategy and steer it in the direction of securing sustainable returns for shareholders. “The more forward-looking banks have realised that many of the requirements created by the swing toward more forward-looking supervision based around stress-testing are also good business practices, including much tighter management of risk and much greater capital discipline, which will ultimately lead to more efficient banking,” says Thomas Huertas, a partner in financial services risk management at EY and former member of the executive committee at the UK Financial Services Authority.

However, Mr Huertas adds that the overall effect is to reduce the risk appetite of banking groups, which will want to retain investment-grade ratings even at the bottom of the cycle. Banks will be able to draw down their counter-cyclical buffers, but will want to determine their asset size strategically at all times. “If you draw the analogy with a retail store, their inventory is there to promote turnover and they always monitor closely what is the level of that inventory. More of that thinking will have to come into banking so that a lower level of capital is needed to support the inventory,” he says.

Balance sheet challenge

The leverage ratio intensifies that pressure to hold down balance sheet size. In the EY survey, it is the stand-out factor that respondents believe is likely to change their business model (see chart). Independent investment bank Moelis has advised a number of banks such as France’s Natixis on winding down books of complex derivatives including credit correlation trades. Peter Meijer, a managing director in the European risk advisory team at Moelis, says 2013 has marked a step-change in the type of asset disposals undertaken by banks.

“Before [2013], the financial crisis was often the driver and banks were disposing of illiquid portfolios to avoid the consequences of further bouts of market instability. Since the start of [2013], we are beginning to see more strategic disposals as banks have stabilised and are making decisions about their future core business,” says Mr Meijer.

Basel III is not the only source of pressure for higher capital ratios and lower risk appetite. Pre-crisis, investors wanted to see bank capital highly leveraged. These days shareholders prefer to see their investment strongly capitalised to avoid bail-in and dilution risks, says Patrick Butler, chief executive of contracts-for-difference advisory broker Prime Markets and a former executive board member for treasury and capital markets at Raiffeisen Bank International.

Previously, business lines might be kept as part of the core even if they did not meet the hurdle for return rates but banks need to become more ruthless about applying the test of whether laggard activities can be part of a valid long-term business model.

“There were a lot of banks entering what they perceived as businesses that could generate fees without consuming capital, especially [mergers and acquisitions] advisory. But with competitors crowding into these activities and the European economy static, the reality is that these units often generate negative cash flow, even if they do not require significant capital,” says Mr Butler.

Which of the following external issues are the most important  considerations when looking at changes to your business models

Greater specialisation

There are also viable businesses that banks are departing because capital requirements are high or evolving. Macquarie, Crédit Agricole and Royal Bank of Scotland have all sold equity derivative and structured product businesses over the past 12 to 18 months, often including client-servicing platforms. These are viable businesses that attracted an enthusiastic buyer – France’s BNP Paribas in all three cases.

“Even with good businesses, regulation can begin to bite, whether it is the leverage ratio or the liquidity coverage ratio. There is a cumulative build-up of costs that is undesirable if the unit does not fit into the bank’s long-term plans,” says Mr Meijer.

For the strategic buyer BNP Paribas, by contrast, equity derivatives are very much a part of its core and the French bank has the chance to further entrench its market-leading position. Mr Huertas anticipates more specialised and differentiated business models emerging, as banks will exit certain types of business due to regulatory constraints unless they are a market leader in that field.

Even in relationship-driven corporate banking, the landscape is changing. Challenger banks are pushing into areas that the largest players find too heavy for the balance sheet and cost base. For instance, small business leasing and receivables finance specialists Close Brothers and Aldemore in the UK are making headway. Mr Thurman at Lloyds does not see challenger banks as a threat to the large universal banks. Instead, new players are potential clients for the services they do not operate in-house.

“We can mobilise capital for the real economy, for those who are ready to take on assets that the largest banks now regard as non-core. That could be private equity or alternative investment funds, or the specialised challenger banks. We’ve developed analytical capabilities to handle regulation, and our own treasury has the experience of raising and managing capital. It is right that we should bring this expertise and understanding to smaller banks that do not have the same capacity,” says Mr Thurman.

Non-bank partners

Mr Thurman acknowledges that there are many non-bank investors who now regard the large banks as sources of assets to buy, because banks themselves cannot hold those assets and generate an acceptable return. Lloyds itself sold its social housing loan portfolio to its former subsidiary, pension provider Scottish Widows, combining the origination expertise of Lloyds Bank with the Scottish Widows annuity book.

“Developing partnership models, like we’ve done with Scottish Widows, supports relationship managers across the bank to deliver the full capacity of the group to our clients and ultimately benefit the wider economy. It remains key that we tackle these new approaches in a disciplined way that does not involve diluting our own customer proposition. It’s a question of keeping to a simple business model anchored in the needs of clients, but of course that’s easier to say than it is to deliver,” he says.

Mr Meijer says the gap in price expectations between non-bank buyers and bank sellers has begun to narrow. “There were US hedge funds and private equity funds that raised a lot of money in 2009 and 2010 expecting to make a quick profit buying portfolios from European banks at knock-down prices because of the eurozone crisis. That did not happen. A successful buying strategy involves putting in the due diligence, building the capability to wind down assets faster than the bank, or even using the acquisition as a bolt-in – for instance, by placing a portfolio that comes with a client-servicing platform into an insurance environment,” he says.

Improving efficiency

Mr Butler says Prime Markets is looking at moving into medium-term lending backed by securities collateral, an area neglected by the mainstream banking sector. However, the role of non-banks extends beyond simply taking unwanted assets from bank balance sheets. “There is an exodus of banks from non-core businesses, but even in areas where they remain active, banks can make huge cost savings by using other players for certain activities, for example, by using independent brokers for distribution,” he says.

Here again, regulation is interacting with other trends, especially the rise of electronic platforms in wholesale banking and markets businesses. Mr Meijer says the weaker earnings environment has focused minds on how the rise of electronic trading affects the banks. It did not initially lead to significant staff cuts, but today banks are looking to cut headcount, or transfer more staff to middle and back-office functions to tackle the greater burden of regulation and compliance. “If and when business picks up, banks will look to increase financial market capacity via greater technological efficiency, rather than extra staff,” he says.

Of course, technology projects will also be essential to meeting the challenge of regulation. Mr Bedford expects a much closer alignment between risk, capital and financial management. He says some banks are already looking at creating a specific function, effectively a chief capital officer, to aggregate views of financial and risk data, and supervisory stress tests.

“Financial forecasts now need to integrate stress tests, so it is critical for the two functions of finance and risk to speak the same language, which is a challenge because the two activities have grown up separately,” he says.

He identifies several areas where banks are undertaking core capability projects to make that switch, including intra-day liquidity management, optimising collateral management and some capability for more dynamic capital allocation, both geographically and across flow, cleared and uncleared financial market products.

Cross-border prospects

Capital allocation in international banking groups is one of the more difficult challenges. Regulators still appear torn between the greater efficiency of bank resolution policies that rely on the home supervisor to resolve the bank – so-called single point of entry – and the desire to protect the integrity of bank operations in their own jurisdiction.

“International banks might rather have a branch in a lesser location than be required to open a subsidiary in a larger financial jurisdiction. That sounds bold, but if you step back and look at it from the point of view of a global investment bank that wants to be profitable in a constrained environment for capital, collateral and liquidity, you want to be able to manage those items on a cross-border basis. In that context, the last thing you want is to be forced into a subsidiary. But it also comes back to what clients want in terms of a locally regulated subsidiary versus a well-capitalised group with a branch through which they do business,” says Mr Bedford.

Raiffeisen recapitalised its Russian subsidiary after the 1998 government default and banking crisis, and has since earned considerable profits from the unit. Mr Butler contrasts this with banks today exiting markets such as Greece at the very bottom of the cycle. “The reality of scarce and expensive capital means that banks and their owners are not willing to suffer the pain in order to enjoy the potential upside, and mistimed acquisitions are no longer tolerated – banks just want to cap the losses,” he says.

Nonetheless, Mr Thurman believes cross-border banking is still a strong business model provided banks keep to the acid test of client needs. The payments business in the international arena is an excellent example of serving those needs. “There has been some retreat from international banking, and that means we have to do more with fewer partners, and stay focused on the mutual benefits for ourselves and our correspondent banks. The greater compliance and anti-money laundering requirements are also pushing in that direction, we need to rationalise our networks and ensure a robust process of choosing who we work with and why,” he says.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter