Global capital markets: stronger, but still challenging

The investment banking industry has rallied strongly since the 2007-08 financial crisis that rocked its foundations. Banks are leaner and fitter; due largely to regulatory pressure and the entire system is in much better shape, helped by the crackdown on high-risk and speculative activity. This has left the sector less vulnerable to the next financial downturn.

Those are the more positive conclusions in the newly-published report entitled ‘Restructuring for Profitability’ from Broadridge Financial Solutions. The US investor communications and analytics group canvassed opinion from nearly 150 buy-side and sell-side equity analysts across major world financial centres last autumn, collecting their predictions on the opportunities and challenges for global capital market institutions between now and 2020.

The less welcome news is that the tougher regulatory environment and more demanding requirements for levels of capital mean that industry players will continue to struggle to earn adequate returns on equity (RoE). Analysts also believe that meeting shareholder expectations will require banks to adopt a much more aggressive approach to restructuring and cost cutting.

Broadridge notes that banks have already used up the easier savings from their existing business models, having reduced front-office headcount by about 22% since 2010. The industry will therefore need to take more fundamental measures to squeeze further cost reductions.

The biggest opportunities for savings now lie in the bank and middle offices. Banks can here introduce new technology, automate procedures, re-engineer processes and mutualise many duplicated costs.

“Hard times are not over for capital markets institutions” the report warns, with the period to 2020 set to be challenging as banks deal with regulatory pressures and meeting their cost of capital. However, the process of restructuring and finding greater efficiencies should also produce long-term benefits.

The regulatory Big Six

Among the survey findings is a greater level of pessimism among analysts in Asia, with 75% expecting regulatory pressures on global securities firms to intensify, against 67% of European analysts and only 39% of analysts in the US, where 43% think they are more likely to have stabilised. Asian analysts’ views reflect a weaker performance in the region’s emerging markets and slowing growth in China and Japan, but also the belief that greater regulatory pressure in other parts of the world has yet to impact on Asia.

Respondents in the US, Europe and Asia singled out a ‘Big Six’ of regulatory initiatives that they expect to have a major impact on banks over the next five years. These are as follows:

• ‘Basel IV’: While Basel III is still in the process of implementation, another series of changes is underway – known informally as ‘Basel IV’. The aim is to impose standardisation of risk-weightings on banks’ assets globally, while limiting banks’ use of internal models to set the risk-weightings.
Assigning higher-risk categories to assets and increasing risk-weightings pushes banks’ capital ratios lower, forcing them to compensate by shrinking their balance sheets or raising more equity.
The changes are expected to impact most heavily on European banks. The region’s 35 biggest will have to increase risk-weighted assets by about 10%, or €1 trillion, requiring €136bn of additional equity, JP Morgan estimates.
• Stress testing: This emerged as the main concern of US analysts (77%), but a lesser worry for their European peers (34%). The tests, simulating a bank’s ability to weather a crisis, were introduced under Basel III and in the US by the Federal Reserve in 2009 and have caused friction between banks and US regulators. Some of Wall Street’s biggest banks have been surprised by the disparity between their own expectations of how they perform in the tests and those of the Fed.
• Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR): The NSFR is a Basel III measure that becomes effective in 2018. Its aim is to make banks safer by matching the funding of long-term liabilities with suitable long-term assets-rather than more volatile sources of funding that could dry up in a crisis. Basel III’s LCR, requiring banks to hold a higher ratio of easy-to-sell assets in the event of a 30-day liquidity drought, is being phased in over the period 2015 to 2019. Banks fell short of LCR targets by US$341bn in March 2015.
• Dodd-Frank Title IV: Reforms that will transform a major portion of the over-the-counter (OTC) derivatives market into standardised contracts, traded on exchanges and cleared through central clearing platforms (CCPs). The aim is to improve liquidity and eliminate bilateral counterparty risk as all exposures must be collateralised with government bonds, but at the same time returns on both equities and fixed income will be reduced.
• The Volcker Rule: A US prohibition on banks from engaging from proprietary trading – yet of lesser concern to US analysts than their European peers, who may fear that the EU and Switzerland will follow with similar regulation.
• Ring-fencing: European regulators are curbing proprietary trading by banks by ring-fencing retail banking and payments systems from riskier investment banking activities. UK banks must separate retail banking activities into separate businesses, so they can be resolve more easily in a crisis. Within the EU, banks must ring-fence trading and investment bank activities. The added cost to banks of the rules is estimated at upwards of US$30bn annually.

Safer – up to a point

Panellists at a breakfast briefing held by Broadridge to launch the report agreed that the banking system was safer than in 2008, albeit with caveats. Lord Davies of Abersoch, a former chairman and chief executive of Standard Chartered and who oversaw UK Trade and Investment as a government minister until 2010, warned that banks still faced a “perfect storm” as good returns became harder to achieve while financial technology firms (fintechs) stepped up their competition.

“Regulators and governments must realise that if you continue to pressure the industry ultimately you’re going to destroy it,” he said.

Banking commentator and former investment banker Philip Augar suggested that financial institutions needed to engage differently with regulators, as it was pointless to regard them as the enemy. While the regulatory process to reform the industry had largely been completed in the US, Europe and the UK were “still playing catch up”. Augar also suggested that banks’ current return on equity (RoE) had merely returned to the more realistic levels of the Eighties and Nineties rather than the “crazy” heights hit in the period preceding the 2008 crisis.

While not specifically mentioning this week’s announcement by Barclays that it was withdrawing from Africa, Owen Jelf, global and Europe lead at consultancy Accenture Capital Markets, said that an industry seeking to restore its profitability would see its major players carefully review each product line and pull out of those that no longer made business sense. This, however, should result in a period of equilibrium, as many major banks would abandon their efforts to be truly global but regional players would step in to fill the gap.

On the issue of banks making greater use of technology, the panel was asked if some names were embracing it better than others. Lord Davies cited Wells Fargo as a good example. “They realised early on the value of supply chain finance and end-to-end processing,” he suggested. However, the financial services industry was one of the more reluctant to enter into partnerships with tech firms – with certain exceptions, such as several Indian banks – and this was something they needed to overcome.

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