The day after tomorrow

UBS News for Banks, Summer 2009

We are moving towards a new world of banking, not necessarily a brave one. The havoc wrought by the financial crisis will reshape the financial landscape. In the new order, financial institutions will inhabit a difficult and challenging environment that will likely persist for a considerable time. Business models will be refocused and regulations redefined. Consolidation is inevitable and the resultant playing field may be uneven. Even after the crisis has passed, growth, profits and returns may be constrained.

Today’s banking crisis has exposed business models that are broken and need to be fixed. The originate and distribute model – constructing packages of securities and selling them to a range of investors – has attracted much criticism. Its shortcomings have played a major part in destabilizing the financial markets.

A key weakness of originate and distribute was that it loosened the link between debtor and creditor, leaving banks with less incentive to look at the debtor’s creditworthiness. Banks and quasi-banks could generate credit at an exceptional rate, unconstrained by any capacity to hold risk. A major lack of transparency in the model also created unknown risks – the bundling of traditional asset-backed securities and new products based on subprime mortgages to create complex and arcane structured products led ultimately to a complete breakdown in market confidence.

So do securitization and the originate and distribute model have a future? Yes, but probably in a scaled down, simplified and tightly regulated framework. The new model will have to be underpinned by a better flow of higher-quality information to market participants, as well as improved incentives structures, risk management practices and credit ratings.

The past two years have also seen the demise of the standalone capital markets model, largely due to its reliance on funding from the wholesale and capital markets. Industry capacity is expected to shrink further. Meanwhile, a shift towards transparency and liquidity, as well as increased regulatory rigour, will slow product innovation, heighten scrutiny of underlying collateral, and lower overall profitability.

Investment banking will move towards simplicity and lower leverage. It will become more risk-adverse and transparent, while refocusing on core businesses and lower costs. There will likely be strategic shifts towards advisory services and facilitating client transactions and away from internal capital usage and proprietary risk.

The fallout from today’s banking crisis could put pressure on banks to revive traditional banking virtues, such as knowing their borrowers, and focus on plain vanilla lending. Under pressure from regulators, politicians and investors, banks will look to simplify business models, avoid or mitigate risk-taking while enhancing disclosure standards. There will be a greater emphasis on transactions, processing and feebased activity.

That said, banks are unlikely to turn back the clock to good old-fashioned banking as epitomized by the old 3-6-3 rule: borrow at 3 percent, lend at 6 percent and be on the golf course by 3 p.m. Reverting to the 1950s in this way would raise the cost of credit, shrink its supply, and crimp economic growth.

Today’s severe dislocations in wholesale funding markets (bond, commercial paper and interbank markets) will incentivize banks to build up a stronger core depository platform with the longer maturities that are needed to lower loan-to-deposit levels, improve liquidity and reduce duration mis-match.

Banks will adopt a stricter risk management framework and become more focused. Maximum loan-to-value ratios will remain lower for longer. There will likely be limits on loan growth both in terms of product as well as geographically (lending will likely be domestically focused at the expense of overseas expansion). Compensation structures will also have to be recalibrated so that they are more closely linked to long-term profitability and value creation.

In the new world order, there could be a movement back towards the integrated model. The universal-banking model is expected to re-establish its primacy. Large, vertically integrated banks have solid fundamentals built on strong customer relationships and are funded mainly from deposits. They should be well placed to gain market share and generate scale benefits.

The geographical balance of global banking will also shift, to the benefit of domestic and regional banks. Global banks will be distracted by their own problems, while those that have resorted to government life-support could come under pressure to scale back overseas operations and focus on domestic core businesses. Foreign competition is expected to decline, in some countries sharply, creating opportunities for local players.

Regulatory forbearance has always been temporary. When financial stability returns, we expect regulators to push through major reforms that will likely be centred on a statement of principles, multilaterally adopted to create a level playing field of greater oversight and regulation under the guidance of the Financial Stability Forum (FSF) and within the BIS framework. We envisage three areas of reforms:

The process of bank consolidation is already underway and will accelerate in the years ahead. Extreme stresses in financial and credit markets have already resulted in a number of bank closures with more to follow. There are two categories of bank consolidation:

A two-tier banking system will emerge as the inevitable outcome of rising capital requirements and increasing government intervention. On the one side, there will be independent banks, privately owned that will seek to maximise profits and returns for shareholders. On the other, there will be state banks that could be subject to political influence.

For example, in the US, following the recent stress test, some privately-run banks will be capable of immediately repaying Troubled Asset Relief Program (TARP) money. Others will not. In our view, the state-supported banks could be required to support national objectives in the following ways:

State banks facing pay limits may be vulnerable to a brain-drain to private banks. The emergence of a dominant state presence could also destabilize market pricing for the banking industry and create an unlevel playing field. As an exit strategy, governments will look to re-privatise their stakes in banks, possibly within 3–5 years after the crisis. In preparation, state banks will seek to maximise profits and returns in a process that should help restore rational pricing behaviour.

A step back from wholesale funding, capital markets and risk-taking does not augur well for the banking sector’s growth prospects. The pre-crisis engines of growth face major cyclical and structural challenges: retail banking will be undermined by consumer de-leveraging, which is likely to persist for years; capital and wholesale markets face major regulatory constraints; while emerging markets such as those within Eastern Europe, will first need to reestablish economic stability.

Today’s financial crisis will prove to be as transformative as it is destructive. The post-crisis financial landscape will be radically different. In a capital-constrained world, the banking system will be smaller, more transparent and subject to stricter governance. Banking models will be simpler and more cost-conscious with a greater focus on transaction, processing and fee-based activity. In this new world, industry profits will recover, but a dominant state banking presence alongside major regulatory constraints indicate a period of sub-par growth and below-trend returns.

Philip Finch
UBS Investment Bank, Global Banks Research
philip.finch@ubs.com