The financial markets are evolving at pace and institutions must adapt so they are not left behind.

In about 500 BC, the Greek philosopher Heraclitus wrote “nothing endures but change”. What was true then defines the financial landscape still. In the past few years, the European banking and capital markets have been transformed: the introduction of the euro has kickstarted the European bond markets, and there is a continuing shift from bank lending towards capital markets funding. At the same time, regulatory and accounting changes are driving innovation in product design and portfolio and balance sheet management.

Consolidation trends

Just as the environment and product range evolves, so too must financial institutions reinvent themselves to succeed in the new terrain. This supplement aims to explore some of the themes and issues driving the changes.

Although there have been relatively few bank M&A deals, and some analysts remain sceptical about the financial and strategic benefits of cross-border bank mergers, the deals on the table at the moment suggest that consolidation may soon be playing its role in reshaping the European banking landscape.

UniCredit’s bid for HVB and ABN AMRO’s bid for Italy’s Banco Antonveneta are in progress, for example, and BNP Paribas announced the takeover of Commercial Federal last month. There are further indications of M&A activity: banks have excess capital, strong profitability and low domestic growth, and long-standing political barriers are beginning to be dismantled.

The question of how to fund M&A strategies may be climbing the agendas of some CFOs – and issuance of bank capital could be a solution. Our “Flight from innovation” feature explores how capital structures are being shaped by the need to meet regulatory requirements while trying to preserve equity and minimise the cost of issuance.

Sophisticated financial technology and new types of market players have helped capital and credit markets withstand severe dislocations. In the Asian and Russian crises in the late 1990s, secondary market liquidity dried up and the primary market closed. But severe credit events since 2000 have not had the same long-term impact.

At an operational level, this explosion in the range and complexity of financial products over the past decade – particularly evident in financial institution regulatory capital, securitisation and derivatives – has meant that banks have had to build different skill sets to address these trends, and to reallocate resources and capital to new products and services. These and other changes are discussed in “The evolution of Europe’s markets”.

Impact of regulation

From a regulatory perspective, the continued development of the Basel Accord will change how banks manage their balance sheets, risk and funding strategies. “Basel shifts market focus” looks at how the introduction of Basel II will lead to further developments in securitisation as banks fine-tune their use of these instruments for funding and portfolio management, and consider securitising a broader range of assets. The new accord will differentiate and increase risk weights on higher risk positions and portfolios. Institutions will begin to securitise fewer traditional exposures and turn to portfolios with high loss-given defaults, such as commercial mortgages and leveraged loans.

In Germany, the Basel II-led risk weighting changes will force banks to become more aggressive in dealing with the non-performing assets that are clogging up the country’s banking system. “NPL trading takes off in Germany” reveals that, whether selling assets to a financial investor, restructuring the assets or spinning them out to a special-purpose vehicle, German banks are seeking to reinvigorate their businesses by cleaning up their balance sheets.

Capital requirements

Just as institutions can use quantitative techniques to help measure Basel II’s impact on their capital requirements, so too can they analyse their treasury portfolio from a capital perspective and optimise its structure with respect to regulatory changes. “Treasury taming” shows how such tools will help banks and investors in the new regulatory environment.

While products such as derivatives and asset-backed securities have undergone almost unprecedented innovation, others such as FX have become increasingly commoditised. The pressure this has exerted on the profitability of individual business lines has caused many financial institutions to rethink the way they deliver services. In “Best of breed”, we look at outsourcing and argue that similar cases can be made for investment management, and cash and securities services.

The ability to “white label” another bank’s service as your own, thereby preserving your brand and client franchise, will lead more financial institutions to reshape their business. The traditional model of the bank as both manufacturer and distributor is under siege. It is another example of how banks are evolving along with their markets.

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