UBS investment bank president calls for Europe-wide collaboration

In the nine years since Europe saw the first signs of the global financial crisis, the majority of regulatory and equity market attention has been focused on the process of building bank capital and dealing with legacy assets. 

Substantial progress within the industry now sees capital ratios that are unrecognisable when compared with pre-crisis levels, despite the substantial tightening in regulatory rules. European banks have raised more than €600bn in fresh equity capital since December 2007, primarily from private sector sources. Several hundred billion euros in additional capital has been generated by lenders from business disposals and balance sheet deleveraging, radically improving sector resilience and stability.  

But capital stacks that are multiples of historic levels come at the cost of a sharp reduction in the return on bank shareholder capital. This is one of the principal causes of the depressed valuations at which Europe's major banks trade. The equity of the 20 largest listed eurozone banks currently trades at a 40% discount to face value, a haircut worth €150bn. Developed market banks are the second cheapest sector in the world, both when measured by price/earnings multiples and on dividend yield. While the work to build capital continues, this substantial valuation discount should serve as an important reminder that the availability of substantial amounts of additional shareholder capital should not be taken for granted. 

NPL progress

Substantial headway is also being made in resolving non-performing loans (NPLs) and assets with poor risk-reward profiles. Economies such as Ireland and Spain, which embraced broad-based bad bank structures relatively early in the crisis, received widespread credit for taking comprehensive action. Work continues in Greece, Italy and Portugal to free banking systems from the drag of legacy NPLs. 

The Italian banking sector in particular is in the process of taking meaningful steps to build balance sheet resilience, supported by government measures that will accelerate the resolution and removal of NPLs from lender balance sheets. In time this will allow banks to improve returns, support national macroeconomic stability and sustain a structurally higher rate of future credit growth when customer demand for credit increases. All three of these outcomes should be viewed as important objectives for both the public and private sectors. 

Low interest rate threat

But while capital levels continue to build and credit quality issues are easing, building pressure on revenues from the low interest rate environment presents a much larger headwind for financial institutions. Lower debt servicing costs delivered by global monetary policy is supporting borrower profitability, asset prices and economic growth to a greater or lesser extent. In a lower growth environment, all of these are positive, but they come at a mounting cost to the banking and insurance sectors, threatening the medium-term stability of parts of the industry unless market structure and business models evolve significantly.   

It is noticeable that as the European Central Bank's (ECB's) bond purchase programme exceeded the €1200bn mark in July, bank deposits at the ECB – one measure of excess liquidity in the system – moved beyond €1000bn, almost triple the levels observed at the start of the financial crisis. Viewed solely from a banking sector perspective, the injection of additional liquidity in future will likely serve mainly to reduce the market rate for firms taking credit and liquidity risk – the two drivers of returns for lenders – undermining bank profitability further.  

In it together

It is beyond dispute that healthy economies require healthy banks, capable of both sustaining and growing the credit supply as well as absorbing the volatility in profits which come from economic slowdowns when they inevitably occur. The significant and structural reduction in European bank net interest margins brought on by negative rates, flat yield curves and more expensive bank funding rules impairs the banking sector's capacity to perform one of its core functions.  

In addition, enduring uncertainty as to how much capital banks will be required to hold in future under a revised set of Basel Committee regulations unavoidably sees European banks holding capital buffers which they hope not to need. Significant geopolitical risks - upcoming elections in Europe's major economies, the renegotiation of the UK's relationship with the EU, and many others – also contribute to volatility in the environment which industry leaders cannot ignore. Combined, these factors affect to some degree the cost and availability of credit in the economy at a crucial time in Europe's economic history. 

Bank and insurance leaders arguing for higher policy rates and actions to drive steeper world yield curves will grow in number. But until forecast growth and inflation rates rise, it seems likely that such calls will go unheeded, prompting firms to embark on further restructuring. For the good of the broader economy, these steps need to be supported by regulators and the public sector at the right time. 

There is the prospect that banks will reduce capital devoted to lower return activities, pivoting towards those offering a better outlook for capital generation and reward. Inevitably there will be an element of strategic crowding in these moves, with potentially significant parts of the market becoming underserved. Due attention must be paid to the impact that such shifts will have on the users of financial services, with issues such as falling trading liquidity or excessive consolidation in service provision becoming more topical. The extent to which important functions previously provided by banks move into unregulated sectors, the so-called 'shadow banking' space, also warrants due attention. 

Simple thinking 

Over time, bank complexity will also come under sustained attack, reducing cross-border banking linkages and driving a greater focus on a smaller number of markets by international banks. Competition will, therefore, fall in some places. 

Lenders will devote considerable energy and shareholder funds to improving operating efficiency. Take the extraordinary advances in the adoption of digital banking, for example. UBS's research, based on surveying more than 27,000 customers of some 210 banks in 24 countries, showed 64% customer penetration in mobile banking, up from just 42% last year. Changing customer habits and revenue pressures will see a step change in branch reduction plans in developed markets, hastening a material reduction in retail-driven headcount. Some emerging markets will miss out the branch-driven expansion of banking services altogether. Credit provision will become more cost effective, but employment levels will fall, and the provision of good advice will in places become harder to obtain even as Europe's demographic-driven need to save begins to rapidly accelerate. 

Substantial investment in restructuring and overhauling bank technology, often achieved by working with the new generation of fintech companies, will lead to a more resilient sector that serves customers better. Incumbent lenders that are able to rethink, reposition and restructure effectively will be significantly more competitive than those which do not, delivering better returns to shareholders, customers and society at large.   

For their part, regulators need to give banks clarity on future capital requirements as soon as possible. That said, the commitment by the Basel Committee to finalise planned improvements to the Basel III framework by the end of 2016 should not be delivered to the detriment of the quality and appropriateness of the rules themselves. Regulators and the industry alike should not squander this valuable opportunity to devise rules that lead to the efficient and socially effective allocation of scarce capital. 

Equally, with so much structural change needing to be worked through, both regulators and industry incumbents must not waste valuable energy on justifying the very existence of banks, but rather time should be spent focusing on establishing the right framework under which the right model, structure and culture can be developed. Thereby they would be enabling this industry, in all its shapes and forms, to fill a role that is not only important for economic growth, but central to societal advancement. 

For all industry participants, now is the time for clear thinking and an eye to the medium term.

Andrea Orcel is the president of UBS's investment bank.