Banking Insights: Mistaken Strategies

‘Banks can no longer be all things to all men'

Most banks believed their optimal strategy was to be a ubiquitous player in the market. They’re wrong, argues RICHARD KIBBLE of PwC.

In the film The Day after Tomorrow, a climatologist tries to figure out a way to save the world from abrupt global warming. He must get to his young son in New York, which is being taken over by a new ice age and he knows that the basic rule of storms is that they continue until the imbalance that created them is corrected.

I was mindful of this as I watched the recent TV coverage of the Indonesian volcano eruption, which has covered their ‘world’ in a grey ash. Then the heavens opened and the ash was washed away – nature has a clever way of dealing with its ‘imbalances’.The financial services industry needs to be similarly clever as well to recreate itself and deal with its imbalances after its own, and very public, storm.

Over the last 50 years banking has experienced buoyant growth, increasing complexity and disintermediation of funding, followed by crisis. From 1987 to 2007, there was a rapid and unsustainable financialisation – Europe saw faster growth in bank assets relative to nominal GDP, than was observed globally. This period also became the ‘era of universal banking’ as global banks increasingly sought economies of scale and scope through multidisciplinary offerings.

The financial crisis means the environment in which bankers have spent most, if not all, of their careers has changed. The future will not be like the past. Sustained GDP growth in the West, may be replaced by low GDP growth, raising two questions:
• The growth of the Western financial sector was significantly above that of the economy as a whole – but will this be replaced by Western financial sector growth being equal to or less than GDP?
• The emerging markets created opportunities for Western banks – but, in the future, will these emerging markets initiate lockdown and challenge the Western banks on their own ‘turf’?

Multiple drivers of change are acting on the industry – the short term will be dominated by regulatory reform while, in the longer term, there will be the rise in power of the East and the South. The E7 is rapidly gaining share from the G7, both in terms of economic growth and banking assets and the trade flows between South and Central America, Africa, China and Middle East have grown and now constitute an important proportion of world trade.

The result is that a bloc of countries, consisting of South America, Africa, Asia and the Middle East (SAAAME) is emerging as a cohesive bloc for trade and investment. Already SAAAME does not have to look to the US and Europe for capital, consumers, manufacturing, labour, natural resources or oil. This shows that although traditional trade flows remain, trade between emerging nations is growing at a significantly faster pace.

The largest banks in the world by market capitalisation are now Chinese and these high growth emerging markets appear to be making it difficult for foreign banks to expand in these regions. Despite the surge and economic stimulus, the foreign banks (in China) fail to gain any extra traction. While they have continued to be proactive in seeking out new opportunities, they remain challenged by policy constraints that dictate the pace, scope and direction of their market penetration.

Is it likely that Europe remains central to decision making and economic power in banking or will the East become the financial centre of the world?

Will a shift in demographics require banks to change their product mix and customer segmentation in a significant way? Ageing populations in key European countries mean that the market will offer low or no growth and this will impact on how the banks interact with their customers – the German population is shrinking and ageing, while the Irish population is ageing but projected to grow.

Banks will have to change the way they do business and be more precise – instead of being all things to all men. Samuel Beckett was right when he said: “In the landscape of extinction, precision is next to godliness.”

Ubiquity included high or increasing financialisation, where bank deposits shrunk relative to GDP, which created the illusion that all users of capital were earning superior returns. Most banks believed that the optimal strategy was to be a ubiquitous player in the market. Monetary authorities encouraged ubiquity by maintaining lax monetary policies without due concern for systemic risk. And finally, investors trusted global investment banks to sell their products in line with their client’s best interests.

The dawning new reality will mean a flat or declining market where growth will only come from a renewed focus on key client franchises and niche opportunities. Constrained capital will mean banks must focus on driving improvements in economic profitability – capital must be reallocated to fit the new reality.

Banks will come under increasing pressure from both Government and the regulator to drive sustainable long term returns that contribute to the real economy. Banks will be required to demonstrate that they are socially useful. Investors are sceptical of investment banks and will increasingly demand greater transparency of the benefits and risks associated with their products.

Regulatory change is already beginning and this is the start of a ‘tsunami’ of regulation intended to prevent future financial crises. Regulatory change will reshape financial services fundamentally and it could shift financial activity from banks to asset managers or other less regulated entities; distort other financial services activity, such as insurance and asset management, due to overspill effects; distort the geographic profile of financial activity due to regulatory arbitrage; or unintentionally introduce more risk.

Put simply, the purpose of all this regulation should be to address the underlying issues emerging from the crisis, namely: improve the resilience of individual firms; promote systemic stability and allow banks to fail; restore trust in banking; and create sustainable growth. As Rahm Emanuel said: “You never let a serious crisis go to waste. And what I mean by that, is that it's an opportunity to do things you think you could not do before.”

The bottom line is that things will change as the world de-levers so there is major change ahead in business models across financial services. It is a chance for banks to put their house in order and focus on the drivers of change which will impact their business going forward. The multiple drivers of this change will be triggered by unprecedented regulatory change.

Above all, the financial services industry needs to work together to rebuild trust, reputation and confidence as it rises from the ashes.

RICHARD KIBBLE is partner and head of financial services strategy at PwC

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