The following is a guest post by Martin Rauchenwald and Philippe De Backer of Arthur D. Little.
It was always fanciful, of course, to believe that the regulatory magic wand waved after the 2008 financial crisis would resolve every banking issue.
But the hope was that it might start to pave the path to greater robustness within the sector.
Unfortunately, the recent collapses of Silicon Valley Bank (SVB) and Credit Suisse have once again shone a spotlight on the continuing vulnerabilities of the global banking system.
So, what are we to make of this? But how serious is this problem? An isolated temporary aberration? Or is something more systemic?
Indeed, the Euro Stoxx Banks index falling to a four-year low, a spike in credit default swaps, and big banks like Barclays, Deutsche Bank, and Societe Generale all suffering a massive loss of value is indicative of a widespread unease in the marketplace about the future performance of banks.
And as a not-so-gentle reminder of the pressure banking remains under, a recent sharp sell-off in First Republic saw its stock price fall by 40% in a day, leaving authorities frantically struggling to stabilize yet another unviable bank.
Despite a period of recovery, the reality is that most banks have not been generating a sufficient return on equity (ROE) to cover their cost of capital for a while.
This has been a long-standing issue in the eurozone, so much so that there is almost a perceived wisdom that banks cannot generate sustainable profits against a backdrop of low interest rates and sluggish economic growth.
Acceptance is unsustainable
If that is true, then where does that leave banks? Just having to accept unsustainable cost-to-income ratios and anemic ROEs, which, even in the very benign year of 2022, average ROEs in Europe were just 6-7%, less than the 9-11% needed to cover the cost of capital, let alone acknowledge any risk premium.
This hardly seems a satisfactory response.
Instead, shouldn’t individual banks be looking to be proactive in affecting positive changes that make them more resilient and profitable? However, despite the need for rapid and radical change, the status quo often still wins out, with excessive expense, complexity, and risk repeatedly cited as the reasons for inertia.
While there will always be challenges for any bank looking to make any long-term change, do such justifications for taking no action stand up to scrutiny?
And to see what is potentially achievable, we need only look at two banks, Bawag in Austria and OLB in Germany, one of the most competitive markets and where profitability is inherently low. In 2022, the Cost-Income ratio for Bawag was 35.9% and OLB 42.3%, far better than the European average of 59.7% in the first half of that year.
Homing in on core competencies
Here we have a pair of financial institutions significantly outperforming their rivals in the same market. They effectively cook with the same ingredients but produce very different results because they follow another recipe.
Perhaps most tellingly, their everyday operations are underpinned by sound, solid management that does the basics well. One of the significant reasons for SVB’s fall was its poor control of interest rate risk.
Put your house in order
The fall of SVB and the emergency merger of Credit Suisse, a ‘global systemically important bank’ considered ‘too big to fail’ with UBS, have quickly dissipated much of the trust that had been slowly returning to the banking sector in recent years.
If central banks continue their aggressive approach to interest rates to combat inflation, more asset bubbles may burst, leaving many banks vulnerable.
And given their significance as a primary source of financing, it’s critical they put their house in order at a collective level so they not only support the real economy rather than indulging in allocating capital to trading activities but also start creating the shareholder value investors crave.
Radical change, not cosmetic trimming
Though weak everyday management and inadequate regulation will always create fragility within banks, there is something we believe is driving a deep fault line through the center of the sector, and that is the continued and unsustainable reliance of too many banks on the traditional universal banking model that seeks to offer a wide range of services to a broad audience of customers.
Here we’ve set out some of the fundamental steps banks need to take urgently because if they don’t become profitable soon, they will be paralyzed, unable to attract the funds they need to transform. The issue will be even more significant for non-listed institutions, which generally have to demonstrate an even higher capability to earn compelling returns to attract the new capital they need.
While this may have worked in a high-interest rate and high-margin environment, it is now no longer possible to hold together many business lines with differing risk and return profiles under one umbrella. Any bank that tries to do so will increasingly struggle as the cost of cross-subsidizing ‘anchor’ products and services outweigh the gains from maintaining these unprofitable offerings.
Focus on core competencies
So, instead of seeking to maintain some hybrid model, banks must focus on the distinctive delivery of their core competencies — investment, private or commercial — since this is the only way they will be able to create a unique value proposition that differentiates them from their competitors.
As it is, there are far too many ‘opportunistic’ and subscale business lines adding complexity, so embarking on a program of cosmetic trimming, as some banks have done, is not and will never be enough.
This means homing in on current product and service offerings that offer a long-term sustainable competitive advantage and exiting those that don’t. The capital released can be deployed more profitably, with far more rigorous cost discipline imposed in parallel and significantly improved balance sheet productivity.
On top of this, if it isn’t already, ever-faster digital transformation should be made a priority because, without this, it will be impossible to achieve the improvements in efficiency and customer experience required for success.
So, let’s consider what happened to Silicon Valley Bank and Credit Suisse as a cautionary tale that’s heeded and which leads to change because a failure to act increases the chances of the 2008 financial crisis repeating. Are banks ready to rise to the challenge, or will the pull of the status quo prove too strong?