Cross-border universal banks will have to decide not only which countries and product segments to operate in, but also how to build the management structures to deliver the best return on capital under increased regulatory constraints.

While banks are still waiting for some of the dust to settle on the details of new global regulations, most are already undertaking strategic reviews to decide the future shape of their business. Major changes include withdrawing from certain countries or business lines, as well as reorganising structures and management systems to extract value from capital that is more costly, with higher regulatory capital requirements now imposed on most assets.

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“The problem is not just individual bits of regulation, but where do the banks want their business to be in a few years’ time? Large banks are not always as joined up across their different functions as they need to be, so it is important to take a comprehensive view to avoid spending a huge amount of money just achieving compliance, without creating a business model that works,” says John Liver, head of global regulatory reform at Ernst & Young.

Even the model of funding and capitalising a cross-border bank entirely at headquarters level is being undermined as national regulators tighten local capital and liquidity rules on subsidiaries to prevent a repetition of episodes such as the collapse of Icelandic banks, which hit savers in the EU. Local subsidiaries now seem more likely to raise capital and liquidity in their own markets, as the initial public offerings of Santander Brasil and Mexico demonstrated, together with UniCredit’s use of its Polish subsidiary Pekao to raise some of the group’s capital needs via the Warsaw Stock Exchange.

“With more robust legal ring-fencing of entities within a banking group, there could in theory be greater ratings differentiation of same-country legal entities within a banking group than is the case now. We are already seeing differences in ratings cross-border, in part driven by the restrictions placed by local supervisors on the subsidiaries in their jurisdiction,” says James Longsdon, co-head of Europe, the Middle East and Africa (EMEA) financial institutions at Fitch Ratings.

Going local

One of the clearest examples of cross-border rating differentials is Finansbank in Turkey, which Fitch currently rates at BBB-. National Bank of Greece (NBG), which owns 95% of Finansbank, is rated just CCC. The agency reiterated this stance in November 2012 on the grounds that Turkish supervisors “would be very unlikely to authorise significant transfers of capital or liquidity from Finansbank to NBG and would seek to ensure that Finansbank is ring-fenced from any of its parent's problems”.

There is still a strong case for retaining the cross-border model, especially in western Europe where home markets look set to be slow growing for some time. In an economic downturn, flows through the retail banking, wealth management and investment banking activities in one country all tend to fall together, says Hubert Bastide, global head of the financial institutions group at Nomura in London.

“Valuations show that entering new geographies in retail or corporate banking is the only diversification that is consistently successful, delivering benefits from non-aligned economic cycles between different countries for more than 20 years,” he says.

Clearly, buying at the bottom of the cycle when valuations are cheaper would make sense for European banks. But many potential targets are trading at higher multiples than the European banks themselves, and investors may be wary of allowing bank executives to take the risk when the cost of bank capital is so high.

“Santander’s acquisition of Bank Zachodni in Poland was the exception that proves the rule. Santander has a track record of successfully integrating acquisitions, it had a plan for bolt-ons to take market share above the 10% threshold needed for sustainable profitability, and there was an obvious need for the bank to diversify further away from its home market,” says Mr Bastide.

Looking forward to 2016, how do you expect your business to change materially as a result of regulation

Tough time for securities

The most challenged aspect of the industry appears to be the securities business, which faces not only the higher Basel capital and liquidity requirements, but also the clearing requirements of the US Dodd-Frank Act and European Market Infrastructure Regulation. And potentially, trading operations will need to fund themselves separately if full EU structural reform plans are introduced.

Interestingly, those members of the Liikanen Committee who had the deepest experience of investment banking were also apparently among the most radical in advocating trading separation. Former RBS global banking and markets deputy head Marco Mazzucchelli says the experience of shedding some $1000bn in assets at RBS made it clear to him that a substantial part of trading books had little to do with client business.

“RBS was not by any means the most egregious example. If FICC [fixed income, currencies and commodities] divisions broke their revenues down between profit from trading versus net margin over the cost of funds, then we would see that many so-called trading assets are purely being held for the carry trade. The bonus pool for traders and managers should be used to reward successful trading strategies, not just growing the balance sheet and sitting on the interest margin,” he says.

This pressure will force banks to focus on how much balance sheet they can commit to trading activities while still breaking even, especially as the cost of capital for banks with significant trading can be as high as 15% or more. For both equity and fixed-income trading, add-ons such as derivatives structuring and the provision of prime brokerage financing look to be increasingly important to ensure the divisions remain profitable.

“If the margins in flow trading are eroded by more transparent electronic trading, then the non-flow business will be vital. But most banks still group staff by asset class, so there are pockets of non-flow expertise in different locations around the banks. Bringing that expertise together will be vital,” says William Fall, global head of financial institutions group at RBS.

Lending rethink

Even in conventional lending activities, new liquidity rules make it challenging for banks to manage business segments with longer-term asset profiles. Affected sectors include leasing and infrastructure, both of which are vital activities for the real economy. Alternative asset manager Pemberton Capital Advisors, co-founded by former Royal Bank of Scotland head of debt capital markets Symon Drake-Brockman in 2011, has already invested in a non-bank leasing company.

“In the auto leasing sector, car manufacturers will naturally dominate, and they can fund themselves more cheaply than financial institutions right now. But for manufacturing equipment leasing, there is still a question market over who will step in, and pricing has not yet adjusted,” says Mr Drake-Brockman.

In infrastructure finance, it is clear that pension and insurance companies will need to play a more active role to find a better match for their long-term liabilities, with banks switching from lenders to intermediaries. But at present, fund investors prefer financing completed projects with known cash-flows and fewer construction risks.

“There is currently surplus funding available for existing projects, with few of them changing hands, but not enough capital committed to new projects, which are just having to wait to start work. To make the transition to a fully fledged alternative lending community will require support from the regulators, but it is not clear that the Solvency II insurance regulations are really encouraging that,” says Mr Drake-Brockman.

Retail squeeze

Scandinavian banks have been held up as examples of institutions that stayed focused on a narrow set of business lines, relationship-driven banking, and a few geographies that they knew best. This, together with the comparative resilience of home markets (Denmark aside), has left them with some of the best returns on equity and lowest costs of capital in Europe.

Christian Clausen, chief executive of Nordea, says the bank’s strategy has proved its readiness to meet the new regulatory environment. But even so, processes need large-scale re-engineering to handle those regulations adequately.

“The whole equation of capital, funding and returns needs recalculating for each transaction. We have given all our customer advisers granular tools to make those calculations for each customer and product, but it also requires a very high degree of discipline to avoid any drift into unprofitable transactions across a banking network of 32,000 staff,” says Mr Clausen.

The search for cost efficiency could also lead to greater sharing or outsourcing of infrastructure and technology platforms, according to Mr Liver of Ernst & Young. “The infrastructure costs of anything other than the simplest banking products are so high that scale is essential. This is something we already see in the automobile industry, for instance with common chassis manufacturing, but banking is still some way behind,” he says.

Matthew Lindsey-Clark, senior managing director of European financial institutions at boutique investment bank Evercore, says banks will look to generate more from non-balance sheet activities as the Basel requirements bite. But Mr Lindsey-Clark, who has extensive experience advising the UK building society sector, warns that retail banks are set to face fresh competition for fee and commission income.

“The search engine giants and telcos are looking to suck out the non-lending profits from the payments business without needing a balance sheet. This is the next battle, but as yet these non-bank companies’ organisation models are not quite ready for the large-scale provision of financial services,” he says.

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