What shape is your bank in? If it’s a European financial institution, probably not good. Two reports out this week highlight the problems being faced by the industry from the economy, regulation, and the need for transformation in culture and business models.
The International Monetary Fund (IMF) says that risks to global financial stability have increased since its last report in April and that confidence in the global financial system has become “very fragile.” The main culprit? The euro zone.
Recent announcements from the European Central Bank were designed to allay investors’ fears about a breakup of the euro — “redenomination,” in the parlance. But the IMF says that “delays in resolving the crisis have increased the expected amount of asset shrinkage at banks.” Worst affected will be the euro-zone periphery, where “the combined forces of bank deleveraging and sovereign stress are generating very strong headwinds for the corporate sector,” it says.
More generally, the IMF adds that not much progress has been made on the regulatory front over the past five years in making the sector more transparent, less complex, and less leveraged.
While Basel III rules “should enable institutions to better withstand distress,” the IMF warns that this regulatory regime may encourage the development of nonbank institutions not covered by the rules. Worse, it says “innovative products are already being developed to circumvent some new regulations.” With commendable restraint, the IMF notes that these “same traits have been linked to the crisis, suggesting financial systems remain vulnerable.”
A report from McKinsey & Co. doesn’t make for much happier reading. Based on an analysis of 300 banks around the world, it says that they’re still searching for a sustainable business model amid tighter regulation, shifting consumer dynamics, and economic volatility. The sector still must regain the confidence of investors and society.
McKinsey’s analysts calculate that despite an improvement in Tier 1 capital ratios by 0.4 percentage points to 11.7% last year, risk in the European banking sector has increased. Leverage remains high and southern European banks “remain reliant on the drip feed of [the European Central Bank] and emergency funding.” Bank revenues in Western Europe fell slightly and are still 16% below precrisis levels. Costs rose, and return on equity (ROE) was zero (or a lowly 5% if you exclude the troubled peripheral countries).
The firm has calculated the financial impact of incoming regulation. It says that, had all regulations in the pipeline been in place in 2010, retail banking in the larger western European countries would have seen ROE fall from 10% to 6%. Similarly, ROE in capital markets activities would have been slashed from 20% to just 7%.
Technology, says McKinsey, is challenging traditional business models and creating new entry points for innovative new competitors. “Switching banks has never been easier — a dangerous proposition given current high levels of distrust,” according to the report.
Globally, corporate banking revenues have grown by 2% over the past year. While less affected by the impact of regulation, McKinsey says that banks no longer have the benefit of lower funding costs than many of their large corporate clients. “Leading banks are responding by expanding their product range and cross-selling” other services, the firm says.
Capital markets revenues fell sharply, down 17% last year, and now represent just 7% of overall revenues. Massive cost-cutting is needed.
But so, too, is “fundamental cultural change,” which, McKinsey says, has begun, in part through a redefinition of customer value and by reforming remuneration models. “Banks should view cultural transformation as a strategic issue, not a public relations problem,” the firm concludes.
Andrew Sawers is editor of CFO European Briefing, a CFO online publication.