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Banking world: Major challenges to operating models


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B K Mukhopadhyay
The new rating results have raised a furor over the banking world. Even India's State Bank of India, ICICI, has not been spared, not to speak of Sri Lanka's and the world's top 15 biggies. Investors have been reassessing the banking industry's long-term growth prospects and re-rating the sector.

On this score the situation that reveals cannot be said to be all right indeed: ever rising cost of doing business - complying to new regulation requiring banks to hold more capital and liquidity to ensure that the industry better withstands future shocks, and at the same time countering the menace of scarcity of capital and liquidity, plus dealing with the dominant factor the changing consumer behaviour (growing number of customers opting for mobile and online channels, and diverging regional growth paths).

In a word, challenges galore. The global economic situation remains far from being satisfactory and as such it is very difficult to presume that the downslide would not recur along with the fear that the developing block would be facing harder days to keep heads above water.

If we glance back it can be located that it was 2010 when global banking revenues touched a record $3.8 trillion, and after-tax profits jumped from $400 billion in 2009 to $712 billion - above their 2008 level, if not the 2007 peak. Side by side, this picture did not necessarily reflect a bright future for banks in Europe and the United States in as much as 90 per cent of the profit improvement was attributable to a reduction in provisions for loan losses.

Rather it was from emerging markets wherefrom the better picture emerged. The major factors - declining cross-border capital flows, high bank credit-default-swap spreads, as well as persistently low market valuations - pointed to declining investor confidence in the industry's future long before the latest alarms over sovereign debt during the latter part of 2011.

The real picture is: despite a strong global profit performance in 2010 and the first half of 2011, the return on equity (ROE) of banks in Europe and the United States still not recovered to the point where it adequately could cover their cost of equity - the gap rather set to widen further in the wake of new regulatory requirements. It is clear that without radical action (shrinking balance sheets, cutting costs, and bolstering revenues), banks will be unable to attract sufficient new capital from the investment community and to play their critical role in underpinning economic recovery and growth.

In fact, the global financial crisis and its aftermath of economic and regulatory change present major challenges to the traditional operating models of banks in developed countries and are undermining the sector's ability to deliver a sustainable level of returns to shareholders. A new McKinsey report - The state of global banking: in search of a sustainable model - shows that despite a strong global profit performance in 2010 and the first half of 2011, the return on equity (ROE) of banks in Europe and the United States still not recovered to the point where it covers their cost of equity. Practically, the gap is set to widen in the wake of new regulatory requirements.

So, what is the writing on the wall?

To what extent the ongoing situation will be affecting developing countries depends on a number of factors: level of interdependence with international capital markets; level of export trade diversification and of foreign direct investment (FDI); level of liabilities in foreign currencies; level of foreign currency reserves and the trade deficit; level of inflation and the budget deficit; diversification of local economy and macroeconomic stability; and then obviously performance of local institutions.

In case the recessionary trend develops in the medium to long term different negative impacts on the different sector of the economy would be there. Of course, the real impacts will depend on a range of factors (the extent of the economic downturn globally and the resulting decrease in commodity demand and prices). Other major determinants are the impacts of the crisis on private capital flows.

Specifically, to evaluate the impact on the developing economy, four basic areas on this score come to the fore: (i) the direct impacts of the crisis on the economy's finance and banking system; (ii) the potential impacts on private capital flows and ODA levels; (iii) the potential impacts on commodity demand and prices and (iv) the potential impacts on macroeconomic indicators, growth and the Millennium Development Goals (MDGs).

Experience shows fact that instability in financial markets around the world spills over to the 'real economy' in poorer countries. It is vital that policymakers understand how this crisis could be avoided so that developing countries are saved from far reaching consequences. It will be necessary to bring out impacts on aid, appropriate social protection measures and implications for financial architecture.

The set of policy responses can, therefore, be considered with regard to what is needed immediately and in the medium to long term to minimize the probable loss of welfare owing to such a possible hit. Optimal policies therefore should be perceived in terms of what is possible in the short run as a response to any recurrence to global financial turbulence, and what should be the long-term objective in order to avert reoccurrence of recent past experiences while minimising the impact in terms of welfare losses for the people.

So the best way is to look forward in a positive manner to capture new opportunities. Banks have overcome previous crises by finding innovative ways to increase the top line. Although opportunities may seem to be limited, huge scope is there to improve pricing, to adapt products to the needs of customers, and to find new pockets of growth (taking advantage of the better risk-management processes many have introduced in the wake of the crisis). Banking remains one of the most fragmented sectors globally, and depending on the stance of national regulators some institutions should be able to pursue large-scale mergers and acquisitions.

Even before the industry digests the additional capital requirements from Basel III and other surcharges as considered by global and national regulators, banking in developed countries would be facing a significant returns gap and naturally corrective measures remain a must for them as well.

Is it then that there would be no silver lining?? Mckinsay's assessment indicates the probable happening: emerging markets will contribute nearly half of all banking revenues around the world by 2020, compared with just one-third today, and will represent 60 per cent of all revenue growth in banking over the next decade. To achieve an ROE of 12 per cent by 2015, European and North American banks will have to add more than $350 billion of net profits in the intervening period - double the current level - the sum being more than the total profits of the global pharmaceutical and automotive industries combined!

The upshot: banks in both Europe and North America must find ways to work with less capital and to use what they have more efficiently (shifting a substantial part of their lending to the capital markets so that banks do less direct lending and help revive the corporate-bond market - in case of Europe such bonds account for only 20 per cent of the credit needs of companies, as compared against 60 to 70 per cent in the United States).So, all depend on the specific region-wise situation vis-à-vis market trends, among others. It is clear there are no short cut routes available in hand and taming down the menace depends on taking up a realistic strategy indeed. In fact, banks can eliminate as much as half of the cost of their branches by moving sales and service online. Some banks have shown what can be achieved through the application of lean and other techniques (like cutting the time to process a mortgage to 60 minutes, from days). It is clear that without radical action to shrink balance sheets, cut costs, and increase revenues, banks will be unable to attract sufficient new capital from the investment community and to play their critical role in underpinning economic recovery and growth

Dr B K Mukhopadhyay, a Management Economist, is attached to the Department of Business Administration, Gauhati University, Guwahati, India.

[ VIEWS & OPINIONS ] 2012-07-02