No doubt banking plays an important role in society. It transforms savings into credit and accelerates economic growth.
No doubt banking plays an important role in society. It transforms savings into credit and accelerates economic growth. But after staggering losses of US$2.3 trillion in the financial crisis, confidence and trust have evaporated. Reconciling the demands of society with our banking system is one of the biggest policy challenges today, and this would not be possible without fundamental structural reforms. A much safer financial system is required.
How did we get there?
The financial crisis of 2007–2011 was the deepest since the Great Depression. It was thought to be a “local” problem originating in the US housing market. But the contagion spread with the demise of Lehman Brothers in 2008. Its root causes were a loose monetary policy, incomplete regulation, overleveraged banks, the search for yield by investors, reckless selling of products and the globalisation of finance.
To prevent the collapse of the banking system after Lehman, governments had to inject vast amounts of capital. Later, large stimulus programmes were necessary to prop the faltering economy and combat unemployment. While government money stabilised banks and the economy, it made investors worried about the sustainability of large government debt. This eventually triggered the sovereign debt crisis in 2010.
Reform from the outside
Whilst bank business and capital are being rebuilt, regaining the trust of both the public and investors is a long way off.
In the demanding business of evolving to a safer business model, regulators have been in the lead.
The first priority is regulatory reforms. Closing gaps in scope of supervision, staffing up of regulatory agencies and a set of new rules are all part of this process. The latest iteration of these efforts are Basel III and MiFID 2 along with the US Dodd-Frank act: banks are asked to hold much more capital and liquidity, their leverage will be restricted, derivatives will have to be cleared electronically through Central Clearing Counterparties (CCP), “best execution” is required for all capital market transactions and proprietary trading will be banned.
But we are not done yet. Far less progress has been made in upgrading the financial markets infrastructure. Whilst CCPs and large exposure rules take care of the systemic risk of derivatives and interbank lending, systemic risk also spreads through payment and settlement systems and reaches the real economy via deposits, current accounts and money markets.
Unfortunately, there are no initiatives to overhaul the “grid” of the financial system. A failing bank could still take down the payment system of an entire nation. By ring-fencing payment systems they can make bankruptcy remote. For deposits, the story looks more encouraging. Increasing the insured amount and closing the funding gap were important milestones, but we are still some way off from real-time protection which gives customers access their money even when their bank goes into resolution.
Another unreformed part of our infrastructure is the current disclosure regime. If capital markets are ever to play a disciplining role again, improving the disclosure of financial institutions is crucial. As anyone in financial research would know, analysing banks is rather difficult. Despite 400-page annual reports, the sudden collapse of banks in 2008 surprised even the industry’s best analysts. The reforms undertaken so far have been piecemeal and gradual.
Not least, if banks are ever to be successfully resolved, a special chapter in our bankruptcy code is required. In principle, the resolution of a bank is not much different from the resolution of a corporate—banks are incorporated! However, time is of the essence. A judge has to be able—if necessary—to impose haircuts on different liabilities in the capital structure within a weekend.
Reform from the inside
As regulatory reforms gather pace and start re-shaping the financial industry, banks have remained remarkably silent on how they plan to adjust their business model. In a nutshell, they have to demonstrate that their future business models are beneficial to society, that they can run their business safely and that they are able to restore profitability to a level which makes them attractive investments again. Given that most banks are still trading at market capitalisations well below their book value, the third goal is as demanding as the first two.
As banks hold six to eight times more capital for their trading activities and new liquidity rules constrain maturity transformation, they face higher capital and refinancing costs. In addition, trading margins will be compressed because electronic clearing standardises products and makes pricing transparent. We have seen this already once in the US stock market a decade ago. With trade clearing via CCPs, the advantage of the banks’ proprietary trading platforms will thus diminish and new competitors (derivatives exchanges, independent brokers and hedge funds) will join the fray. Not surprisingly, investment banking will become far less profitable than in the past. It thus makes inherent sense to curtail the banks’ trading activities, refocus investment banking on its three core competencies of underwriting capital markets issues, market making and helping clients to manage risk and to reallocate capital to henceforth more profitable traditional banking.
This renewed focus will address one of the thorniest issues that plague the industry. As we know from International Monetary Fund and Institute of International Finance reports, European banks deleverage. Over the next few years, the credit volume might shrink by up to 2 trillion Euros. How this works could be seen last year in London’s commercial real estate market. When the German and French banks pulled out, margins increased sharply, adding significant cost to the UK economy. Implementing counter measures to offset this negative development is vital for economic growth in both.
By actively re-allocating capital from investment banking, banks should also be able to take the sting out of the political debate about the usefulness of the financial industry.
As discussed earlier, improved disclosures is vital for the health of the banking industry. Banks do not have to wait until the accounting boards devises new disclosure rules. As I know from my own professional experience, it is easily possible to demonstrate a bank’s performance and risk profile in a few pages. A healthy bank does not have to hide the way it manages liquidity and funding, which businesses make good returns on its capital and which risks could actually topple it. It is no accident that AA-rated banks trade at credit spreads of weak BBB names. Given where European banks are, we may need to phase-in enhanced disclosure. However, transparency maintains management discipline.
As mentioned, investment banking’s profitability will drop. Without management, its return on equity will fall to levels where super safe utilities trade. It is no surprise that many institutional investors stay away from bank equity. Restoring profitability will require drastic actions. Standardisation of products and process automation will have to replace the tailor-made approach of many trading desks. Information technology investments in the range of billions will be necessary. The number of people on the trading floors will have to drop to levels currently seen at exchanges. Compensation levels will have to normalise to levels as seen in other services industries. Capital-intensive inventory for securitisation will have to return to its originators. Market making will have to be re-thought and move back to exchanges and back-offices will have to adopt lean production methods as seen in modern manufacturing.
These changes will differ from bank to bank but eventually lead to a process revolution as we experienced in retail banking in the early 1990s.
New regulations, changing behaviour of investors and a demanding public are changing the world of finance. Not enough has been heard from the financial industry on what it will do to make banking safe, useful and profitable. Any society needs a banking system that is able to extend credit. By actively designing and implementing a new business model that delivers sustainable risk rewards in a transparent fashion, the financial industry will be able to regain acceptance.
Dr. Hugo Bänziger is Deutsche Bank AG’s Chief Risk Officer and has been a member of its Management Board and Group Executive Committee since 2006. He also serves as the chairman or director on the board of various subsidiaries of Deutsche Bank. His email is decb64_aHVnby5iYW56aWdlckBkYi5jb20=_decb64