Game Changer I: Regulations
The first big game changer (especially in Europe) is the plethora of new REGULATIONS. It’s going to be a real challenge for the regulated banks.
A tsunami of new rules and regulations in the coming years threatens to overwhelm the financial sector:
- New capital requirements will put enormous pressure on bank profitability leading them to be significantly challenged as they try to redefine their business model and assess how best to add value to their targeted customer base.
- New regulations and the lessons from the crisis (cross-market dependencies, dynamic liquidity, ...) are leading to an explosion of risk management and compliance. How do they make sure that this continues to improve the business and doesn’t put development and growth at risk?
- The new Basel requirements will require even greater innovation from the banks as they try to serve the financing needs of their corporate clients. They’ll need to help them gain access to the right capital market channels in accordance to their business requirements and risk profile. (Did you know that banks in Europe finance 80% of loans where as in the U.S.A., it’s only 20% with 80% coming through the capital markets?)
- And it’s not just banks that will be affected, for the Solvency II regulation touches insurance companies as well.
There have been a series of financial setbacks over the last 6 years and each one has added fuel to the regulatory fire. First off in 2008, there was the banking crisis that not only severely dented balance sheets but also damaged the hard won trust of the public. Then in 2010, there was the European sovereign crisis that put some countries in the Euro on the verge of bankruptcy. No wonder then that governments – with the public behind them – have forced the industry to accept new and wide-ranging regulations.
Ignace Combes, Chairman of the Vlerick Centre for Financial Services
Basel III, Solvency II, Bank Union, Single Supervisory Mechanism, ...
Already from November 2014, a huge change is on the cards for all the banks within the Euro zone (and even for some outside it). For no longer will the national regulators supervise their local banks, instead the ECB will be responsible for their solvency and supervision. The fact is that by creating a Single Supervisory Mechanism (SSM), the ECB will almost certainly break the close connection between the banks and their home country, meaning that supervision will be more intrusive and less “friendly” for Eurozone banks.
The Basel III agreement will also require Eurozone banks to have more equity capital and a much bigger and more sustainable liquidity buffer, and they’ll also be obliged to take less risk and have less leverage. All of this is likely to lead to higher funding costs and lower income, meaning that the ROE will be squeezed still further especially as old business models become increasingly unsustainable.
Big bank irony
It’s incredible how quickly perceptions have changed. Once upon a time the big systemic banks were considered to be the champions of risk management, yet now it is they that are considered a potential threat to society and its financial stability. This is just one reason for the additional capital requirements, their zero risk tolerance, and the obligation to split retail activities from investment banking.
It’s tough out there, for banks have to digest the legacy of the crisis, comply with the new rules, and develop new, profitable business models. But what makes it so particularly difficult is that it all has to take place against a backdrop of low economic growth, deleveraging and extremely low interest rates.
The increased capital cost from lending is also challenging the role of banks to finance the corporate market, particularly the SME market. Banks will need to relaunch their core role by developing new financing vehicles and by supporting their corporate relationships by offering access to the capital markets.
It’s a game of football, but not as we know it
The new regulatory regime has been compared to a football match. Up until now, it was clear that everyone knew the rules and though there was a referee that managed the game, the teams were able to do whatever they could to win, with decisions and actions left pretty much up to them. Now in the future, everything will be much more disciplined and not only will the referee and rule makers check that everything is done correctly, they’ll be much more intrusive even giving an opinion on the things the teams are allowed to do.
In general, most banks do appreciate that more regulation is needed, but there is a fear that the regulatory pendulum is now swinging too far in the other direction. There’s a danger that Basel III will suffocate them, and that the only way to maintain their profit levels – as shareholders expect - will be to cut costs and shed employees. Already we see that banks have deleveraged and restructured and that to further avoid getting stuck in the pure cost game, banks will need to be even more focussed on the needs of the customer, thereby achieving competitive differentiation to achieve sustainable profitability levels.
The new regulations are already having a serious impact on what the banks can and can’t do and influencing what’s a worthwhile investment from a financial standpoint. Indeed, some of the non-banks are taking advantage of this and already this is leading insurance companies and banks to work together on long-term finance projects. Given the imposed constraints, hybrid models of cooperation are the new order of the day: with banks doing the risk assessment - their area of expertise – and providing short-term financing, then handing over the project to insurance companies for the longer-term lending, more aligned to the business model of insurance companies.
Banks haven’t done themselves any favours recently and the financial crisis has hurt them badly. But worse than that it has hurt their credibility and standing in the market and with the public. It’s now time they positioned themselves more clearly and explaining their basic function as the oil of the economy. And how society as a whole would be poorer without them at the heart of the economic system, as we know it today.
The 64000 $ question
Will people and industry be happy dealing with shadow bankers and hedge funds more in the future – essentially unregulated financial institutions? Or will they prefer the more ‘ordinary’ and shall we say safer, regular banks? Time will tell, but it’s clear that the market is nearing a tipping point, with consequences for both parties (both banker and client) if a new equilibrium is not reached soon.