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BBA FCA Seminar - Evolving Business Models in Banking

3 Mar 2011

Presentation by David Sayer, Partner, Global Head of Retail Banking, KPMG LLP

I am going to attempt to give my perspective on how business models in Banking are likely to evolve after the Financial Crisis and the still reverberating aftershocks.

First thoughts: regulation and reaction

The causes of the financial crisis have been widely analysed and largely agreed. It is however proving more difficult to reach a consensus on the solutions. It is obvious that there is now a widespread political imperative to ‘stop this ever happening again’. A surfeit of ideas are being developed, at national, regional (in our case European), international and supra national (G20) levels. Most have some merit. Many are slightly contradictory. All will have consequences both for banks and for the wider economy. But few of the consequences of these changes are widely understood, or entirely predictable. We are all taking part in a great experiment – called ‘how to fix financial services’.

The G20 summits are progressively redrawing the boundaries of banking practice. The ‘Dodd-Frank’ Act in the USA envisages a raft of detailed new regulations, whose precise execution is still not clear. Here in the UK, reviews are under way which could, at the extreme, result in the forcible break-up of banking institutions – or more likely in the ring-fencing of ‘core’ and retail investment banking activities.

The manifest fragility of the banking system was a wake up call. With rigorous analysis we can identify measures which would have reduced the risks of systemic failure in the circumstances of2008. It is difficult to cost the solutions, but estimates have been made. It is harder still to identify who will pay the price for implementation between shareholders, bank staff and customers. What are, however, almost impossible to predict at this stage are the full implications for the global economy in the longer term of a banking system with much higher liquidity and much lower leverage.

At the moment, regulators have a pretty free hand in proposing new restrictions. Despite multiple causes of the crisis, there has been a single-minded focus on only one of these – "greedy bankers" – and therefore on only one set of solutions: the immediate result will be higher capital requirements, lower leverage, more liquidity, more restricted products and more intensive supervision.

In addition to actions being imposed by regulators, banks themselves have initiated dramatic measures to increase capital, reduce leverage, attract liquidity and improve lending security. This market response has been considerable and largely unacknowledged. Massive deleveraging is occurring globally, both within banks and in the previously vast secondary banking markets. There are real risks that the market response combined with the global regulatory response will have unfortunate results for the real economy.

Since the industrial revolution, banks have played a vital role in maturity transformation and in supporting businesses and consumers alike. The crisis has actually served to emphasize that a functioning banking system is vital to the wider economy. Hence, providing short term liquidity to fundamentally sound and solvent institutions facing a short term run on deposits has been and will continue to be a critical role of central banks in fulfilment of their objective to help maintain financial stability. It is a legitimate role and one that still exists. However, as Northern Rock demonstrated, in a world with 24-hour rolling news coverage central bank support is insufficient and only governments can intervene to stop a run on a bank. The point at which Governments around the world had to become involved in banking was the point at which remedies to banking regulation acquired, inevitably, a political dimension. This means that solutions have to be politically feasible as well as technically realistic.

None of the long term consequences of the changes now being introduced are well understood. Even whether their broad objectives can be achieved is unclear. But what is clear is that there will be unintended consequences.

A good example of the law of potential unintended consequences is the entirely sensible concept of recovery and resolution plans. One of the premises underlying this is that it’s not only shareholders who suffer from bank failure, as they did in Northern Rock, RBS and HBOS. Bondholders also face haircuts as do uninsured depositors. One of the key reasons for developing recovery and resolution as a policy is that during the crisis regulators were faced with the unacceptable binary choice of either rescuing an entire entity or letting it fail - which applied to Lehman. Recovery and resolution should provide a richer palette of choices.

But do we really understand the systemic consequences of letting a major subsidiary fail or causing a credit crunch in the bond markets? With hindsight was it right to let Lehman fail without understanding the collateral damage to AIG and other major firms around the world? To be credible recovery and resolution would have to mean that bondholders and depositors could lose. However, if depositors around the world believe that they will lose, and lose quickly, are we not putting a hair trigger around potential crises of confidence? Mere rumours could lead to runs on banks out of a clear blue sky with catastrophic consequences. What does that mean in terms of the stability of the financial system which regulation is supposed to secure?

In fact, recovery and resolution planning is an entirely sensible measure. I merely suggest that there are realistic scenarios where it might create problems. There are no easy panaceas here. Also the next crisis will almost certainly be different from the last, not least because a new asset price bubble can only be created if investors believe that a new paradigm exists – or sufficient time has elapsed since 2008 for memories to fade.

Reactions: rethinking the business model

It is inevitable that the crisis and its aftermath are having a severe impact on many banks’ business models; especially in those institutions based in Europe and the US, and that many are finding it hard to develop a sustainable response. Although a large number of banks, most notably those outside Europe and the US, were not directly affected initially, they were indirectlyimpacted eventually by the knock-on effects in the international financial markets and by the response of both governments and international and national regulators.

Retail banking in the UK has had a comparatively good crisis. Impairments have not risen dramatically, as borrowers have been able to afford repayments so long as they have been in work. Margins on mortgages have risen to 300bp from 50bp in 2007, measured against LIBOR; this has compensated for the increased cost of funding through deposits and the fall in new lending. Re-pricing the back book on mortgages has more than offset a sharp reduction in the profit earned from every other product. The level of competition from challenger banks such as HBOS, Northern Rock and Bradford and Bingley has reduced markedly. Quantitative easing has helped to maintain house prices, as it was intended to.

But new capital and liquidity regulations will impose new costs on banks in the UK as they will in Europe and Asia Pacific. They will have to work out ways of reducing costs in other areas to maintain profit. On the revenue side, they need to find new customers and cross sell to existing customers, increase margins, gain more market share, regain (or at least, maintain) customer trust, and respond to new and innovative market entrants. On the cost side they need to pare down costs where they can, reduce their risk profiles and improve the quality of loan portfolios.

But this is not simply a matter of regulation. Many banks have had a sharp reminder that capital and liquidity are as vital for a sound banking business, and are now the most critical variables in setting the overall cost of banking business: banks have learned again that they need to manage cash flow as closely as any other corporate enterprise. There is not an infinite pool of liquidity for solvent banks to dip into as needed.

Before the crisis, the key task of successful banking management was optimizing shareholder value within capital constraints. Since the crisis, the task has become much more complex. Not only are there continuing and increasing capital constraints. Liquidity constraints impose equally severe requirements. And the shareholder family is now extended to include bondholders and other stakeholders with additional needs to satisfy. Resolution and recovery planning will also force large banks to re-think business and structure to suit a death, rather than a growth, plan – with clear implications for returns to investors of maintaining resolution optionality. No one has really coasted the implications of turning Global Banks into ring fenced subsidiaries. Not only will Capital requirements be higher, the use of Capital will be much less efficient.

Trust and customer focus

Banks’ reputations are arguably at their lowest ebb since the 1930s, and recovery is happening slowly if at all. The reputation of banks fell steadily through the crisis and continues to fall. A long process of rebuilding relationships and trust with customers will be necessary, and this will be a major focus for the next four to five years.

During the crisis, banks were almost solely focused on survival, but to rebuild their business many, particularly in the developed economies which were harder hit by the crisis, are going ‘back to basics’. This includes, among other things, simplifying products to meet customer needs, reducing costs, restoring profitability and focusing on retail deposits for funding.

While many banks are now enjoying widening asset margins, liability margins remain very constrained. Both investors and regulators are demanding that Banks reduce further their funding from wholesale markets and eliminate funding from central banks. A war for retail deposits is about to break out. This will further erode NII margins and put weaker deposit takers under some pressure leading to further consolidation. Many banks are responding by concentrating on domestic services and downsizing the business by exiting non-core portfolios. Many are stressing a new, or renewed, focus on customer service – refurbishing branches, restoring the ‘bank manager’, returning call centres to the UK, extending opening hours etc.. Many are seeking to reposition themselves as more than just suppliers of products and services, instead as providers of ‘solutions’. However, they face a challenge in overcoming customers’ historic reluctance to pay more for advice and services.

Mobile banking will become increasingly important, especially to attract and retain the ‘mass affluent’ consumer category. Internet banking supplemented replaced telephone banking, and the two are now being combined as an ‘app’ to give us internet banking from our telephone. The future will increasingly be one of ‘bricks, clicks, texts and apps’.

A renewed focus on customer protection is being seen in the way regulation of banks’ conduct is supplementing prudential regulation. Banks are under pressure to develop simple, clear products which can be easily explained to and understood by customers. While this is in some ways to be applauded, another unintended consequence may be a major constraint on the availability of products which are more complex but appropriate to certain customer groups. Some consumers may no longer be able to buy products which would meet their specific needs, because the banks will deem them too risky to sell in future. Examples include equity investments for pensioners over 65, and there are many more.

A return to charging

The loss leader role of the current account is less valuable now the product profitability mix has shifted towards mortgages, which have lower cross-sell rates, and away from cards, savings and personal loans, which have high cross- sell ratios. The loss of revenues from overdraft fees and lower interest foregone creates further pressure for a return to charging.

All parties agree that the present free-in-credit model is unsustainable: both consumer bodies and regulators hate the lack of transparency. Added-value accounts are probably reaching saturation point at 20% of customers, and in any case are problematic in terms of bundling and of treating customers fairly. Overt charging would also eliminate the cross-subsidy from poorer customers who go overdrawn to more affluent customers who maintain accounts in credit.

However, no bank wants to be first. As Lloyds showed with its introduction of Access card charges in the early 1990s, a bank can lose a third of its customers before its competitors re-balance the pitch by following suit. The disruption could give a massive boost to new entrants such as Tesco and NBNK. We are in the odd situation where consumer bodies, regulators, government and most banks think a change to explicit charges would be the right step, but no one knows how to make the first move.

The shape of UK retail banking

The Independent Commission on banking, chaired by Sir John Vickers, is considering, among other things, separating retail from investment banking. In a speech on 22 January this year, Sir John set out some preliminary thoughts on the corporate structure of banks.

He described the role of retail banks as taking retail deposits, providing retail payment services and lending to retail customers and SMEs. He argued that the overriding economic, social and political imperative to maintain the continuity of these services meant that it was not credible to rule out government intervention to save retail banking services in future crises. The priority for financial stability is therefore to impose tough capital and liquidity requirements on retail banks; to prevent them from using implicit government support as a means of cross-subsidising risky trading activities; and to avoid these banks running into difficulties because of risks taken elsewhere in banking groups. However, he clearly does not favour the most extreme versions of narrow retail banking, such as limiting the assets of retail banks to government bonds, or providing retail banking services as a state-owned utility. The pre-1985 role of the TSB will not be revived.

Investment banks are portrayed as taking wholesale deposits, lending to larger corporates and undertaking trading activities. It is not clear whether this description was supposed simply to reflect the natural order of banking (we know that in practice the business models of retail and investment banks are not so clear-cut), or whether he envisages the imposition of regulatory requirements to enforce such a clear distinction. To the extent that retail banking is separated or insulated from investment banking, and subject to tight constraints on both its operations and on return on capital, we shall in effect see the final shift of banking to a regulated utility status. The impact of the Retail Distribution Review and other measures could result in the disappearance of advice services and a comprehensive re think on bancassurance. The drive for change will be reinforced by the impact on capital requirements of both Basel and Solvency II – which seem to disadvantage bancassurers.

Industry restructuring

All of this means we are heading towards a period of significant industry restructuring, both in the UK and more widely. The first stages have seen the collapse of insolvent institutions and the – hopefully temporary – absorption into public ownership of others. The next stages will see divestments and acquisitions, both voluntary and in response to pressure from policymakers. Nationalized institutions will eventually return to the private sector, no doubt in somewhat different forms. New entrants are beginning to appear. A wave of consolidation among smaller institutions, especially for instance in the USA, will continue. These developments will magnify the impact of new business models and change the landscape of retail banking.

New entrants to the market could pose a serious competitive threat to traditional, long-established players. New start-up banks are already being set up to buy parts of large banking groups that are being sold to slim down balance sheets or because governments say they must be disposed of to meet competition rules. Other newcomers are non-banking organizations – high street or online retailers who want to use their loyal customer base as a launching-pad into retail financial services.

However, new entrants may struggle to make much of an impact. The costs and barriers to entry may be too high for established bankers to be truly threatened. The Basel III regulations on capital and liquidity – not to mention the multitude of other regulatory developments – will act as a deterrent and make it harder and more expensive for new entrants to enter the market.

So while there will be a number of new banks coming on to the scene, banking globally is likely to become more, rather than less, concentrated in the next few years. The mergers that have happened in Europe and the US are indicative of this trend toward consolidation.

New business models, new global environment

So: within Europe and the USA, banks are responding to the new environment by shifting their focus from growth and revenue to prudent balance sheet management. The spectre of tighter regulation means they are reviewing business models to concentrate on core business activities which can remain profitable in the new environment, and on streamlining operating models and infrastructure to squeeze out greater efficiencies. They are facing a more constrained and circumscribed future.

Banks have responded with sensible moves to consolidate their business. The need to hold more capital will mean that profitability in terms of return on capital will decline even as profit on turnover stabilizes. The idea that the Modigliani and Miller Capital Asset Pricing model will apply and the cost of capital will not increase as capital rises is unlikely to work in the real world. After all, no real allowance was made for the implicit Government Guarantee pre 2007 and yet the real value has been very apparent since. Those banks in public ownership have a greater incentive to shrink their balance sheets and dispose of non-core businesses voluntarily: this is likely to be the best way of avoiding compulsory dismemberment. It is likely that the process of writing off toxic assets has some way yet to run.

Away from the heart of the crisis, in Latin America, Africa and to some extent Asia, banks have a different outlook. Global external factors mean their prospects are to some extent also constrained. But assuming economic growth in these regions continues, the prospects are good for business models which target operating efficiencies, organic growth, new products and markets and some judicious acquisitions.

Uncertainties remain, however, principally over the strength of global economic recovery and banks’ role in the new financial environment. Across the major economies, banks are continuing to deleverage at a historically unprecedented rate. Despite government incentives and exhortations, this process will continue to drain credit from the global economy and act as a brake on growth.

A further uncertainty is when and how far the wholesale funding markets will loosen. Interbank lending remains anemic. Concerns over sovereign debt hang over the market. The two most important economic areas, the USA and the eurozone, continue to throw up indicators both positive and negative. The challenge is how to interpret them. However they have yet to show decisive evidence of sustainable growth.

Government ownership; conflicting priorities

Until they can eventually be returned to the private sector, those banks which have had to be recapitalized or nationalized by government will inevitably continue to cause major distortions in the market. Governments are already beginning to realize that actions which seemed simple and essential at the time are carrying unintended consequences. Politicians are relying on retail banks to resume lending to customers and businesses to underpin what remains a fragile recovery. At the same time, pressure from regulators and also from shareholders is driving these banks to shrink their balance sheets, increase fees and charges to rebuild profits and adopt highly defensive risk-averse strategies.

The clamour for banks to play a responsible role in supporting recovery is getting louder: and louder still as governments realize they have no further capacity for fiscal loosening or monetary expansion. The banks are advertising that they are ready to fund any and all ‘bankable’ prospects. But at the same time, their need to rebuild balance sheets means they are having to call in loans or impose higher rates across much of the western economy.  On the borrowers’ side, many consumers and businesses are choosing to pay down debt and reduce future borrowing while significant uncertainty continues. These major distortions to the market are still with us, and create a challenging and uncertain environment for those independent banks developing and pursuing new business models.

The bad news is that there is a further storm coming as interest rates rise in the next two years combine with increased cost of living and the disproportionate impact of the Government austerity programme on areas dependent upon the public sector. In the 1990s Banks were unpopular because small businesses failed in a harsh economic environment. They are unlikely to be more popular if a weak recovery is accompanied by rises in Regional unemployment and the failure of more Small Businesses.


Time will result in a pragmatic and sensible balance of solutions to these issues, but it will take several years. There will then be a growing belief that new risk management tools and a changing economy mean that the rules can be relaxed, assisted by the effects of regulatory arbitrage. We will see new better hybrid forms of capital, and a new paradigm will emerge.

Eventually, this will fail too, just as the old one did, but for rather different reasons. Just when everyone is finally convinced that it can never happen again, it will. Keynes said that Banks fail together, effectively because they have to take the same view of the world. Seventy years later the CEO of a major Global Bank kept his Bankers dancing whilst the music was playing. There will be more downturns and all we can realistically aim for is that the consequences are less damaging. In 2007 we found what happens when we fall off a 15 year asset price bubble. Let’s hope the next cycle is shorter and the fall less precipitous.

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