The banking sector has been incredibly strong but this could be as good as it gets. The healthy balance sheets, the low-interest rate environment and the benign economic cycle have prompted many market commentators to talk about a wall of liquidity. Banks have been willing to lend cheaply but as the economic environment becomes more uncertain and growth slows down, this pricing may start to look increasingly out of line.
In the past few months we have seen increasing signs of such stretches in the corporate market, particularly in leveraged finance and private equity. We feel the market is getting increasingly nervous, prompting the question: which deal will be one too many and who will be left holding the pieces?
Despite this, we have yet to see banks tightening up their credit standards. Indeed, we have heard much anecdotal evidence to the contrary as banks compete over relatively few transactions. There are signs of higher leverage, looser covenants and weakening collateral requirements in banks’ dealings with corporates and with hedge funds.
In the personal sector, there are signs of the high debt burdens biting on consumption as retail spending slows down. The housing market is also fairly flat and, although the predicted meltdown has not quite materialised, we have seen some banks scaling down their market share.
In the global economy, we continue to see signs of instability and potential vulnerability, with the euro area remaining sluggish, the US increasingly suffering from high oil prices (exacerbated by the disaster in New Orleans) and China still the unknown in the equation. So, while the central forecast for the next 12 months is still positive overall, the downside risks have definitely increased.
Three warnings
I would sound a note of caution on three fronts. First, in the next two to three years there could be a recession. This could make this spring’s tougher trading environment look benign.
Second, structural elements in the way some banks operate may be under threat and perhaps there is a lack of business realism. Banks have had a very good run. In particular, investment banks have benefited from what I might call the ‘create your own customer’ programme. I refer to the tendency of banks to spin out traders from their proprietary trading desks into the market as hedge funds. These funds have attracted considerable amounts of third-party money and now account for a good portion of equity and fixed income trading, along with a growing share of loan participations. Revenues from hedge fund clients in the form of trading commissions and prime brokerage fees have been an important bulwark for major investment banks. But it is unlikely that hedge funds can keep growing at the same pace as in the past few years and banks need to be realistic about how much more growth they can get. There are signs that hedge fund returns are, on average, declining and that inflows to hedge funds are slowing, at least in percentage terms.
Third, there is a threat of business discontinuity. The events in London this summer highlight once again the need for robust business continuity arrangements.
Growth challenge
The critical challenge facing most of you here is: where are banks to find future top-line growth? When I talk with leading firms, they say that they plan to increase their market share significantly in key markets. The same firms tell me they expect a wave of consolidation. Each of them has a story about how they will be the senior partner in any mergers that take place. I predict that not all of these stories will turn out to be true.
Allowing competitive forces to operate more freely is the best way to ensure banks become and remain efficient and can carry out their strategy without constraint. This means accepting that domestic banks will be subject to the market discipline of knowing that they are possible takeover targets, just as they themselves may seek takeover opportunities abroad.
John Tiner is CEO of the Financial Services Authority. These are excerpts from a speech he gave at The Banker Awards ceremony.
