MACROSCOPE
Macroscope
by

Why being smaller makes sense for post-crisis banks

PUBLISHED : Tuesday, 07 July, 2015, 11:12am
UPDATED : Tuesday, 07 July, 2015, 11:12am

Ever since the global financial crisis seven years ago, the banking industry has had to deal with the seemingly never-ending march of regulation.

Banks complain of regulatory overkill as they face steep declines in return, yet the fundamental question facing the industry refuses to go away: should universal banks still be funding the balance sheet of investment banking operations with depositors’ money?

To understand how we got to the present situation, it is necessary to rewind to the immediate aftermath of the financial crisis. Early calls to break up the large bulge bracket banks by separating risky investment banking from the more mundane but safe task of deposit-taking were successfully fended off.

All other things being equal, shareholders and the banks themselves should have reaped the benefits of staying integrated because it kept the playing field tilted towards incumbents with global scale and access to retail deposits that lower the costs of capital.

However, the understandable need to protect taxpayers from future bailouts led governments and regulators around the world to build regulatory capital buffers around activities of the banks, which were perceived as putting bank balance sheets at risk.

This came in various forms from ending proprietary trading (Dodd-Frank), to making large banks hold more capital (Basel III), to reducing the use of some of the more complex derivatives (Basel III), amongst other measures. In addition, compensation structures were overhauled to cap and defer bonuses to prevent bankers being rewarded for taking aggressive bets.

While regulators may have reduced the chances of systemic banks failing, there have also been wider industry repercussions that are only now being recognised as these new measures are implemented.

By effectively taxing the banks for risk-taking involving depositors’ money, large global investment banks are increasingly disincentivized from building a large IB footprint and balance sheet. This is leading them to re-think the strategic importance of the businesses they conduct.

The high-yield market is a great example. As high-yield paper attracts higher capital charges from a regulatory capital perspective, it becomes a more “expensive” strategy to run – requiring higher returns to generate the same ROEs as prior to regulation.

Here the impact of regulatory, imposed capital buffers has been to force many large banks to exit altogether from trading and making markets in these bonds. In this environment, independent market makers now play a crucial role to ensure the secondary market has liquidity and price transparency.

Regulation has also had a far-reaching influence on the culture and efficiency of large banks. In order to circumvent bonus caps and retain talent, base salaries of investment-banking staff were significantly raised. This has saddled banks with a much higher fixed-cost component of operating expenses, while also dulling some of the risk-taking incentive and motivation of staff due to the “comfort zone” of high base salaries.

Meanwhile, in order for universal banks to retain their ability to operate in multiple areas, additional layers of regulation and compliance have been troweled on, acting as a further drag on innovation. At the same time, important questions remain about whether banks that straddle multiple areas of banking can be relied upon to put clients first and not give conflicted advice.

In fact this issue has if anything become more material after a series of scandals where large banks have been caught fixing markets ranging from interbank market rates to foreign exchange. It is difficult to say how much this is due to new zeal by regulators or just universal banks unfairly using their market power.

But what can be said with more certainty is that the myriad difficulties facing the giants of the industry has provided opportunities for new players to steal a foothold in niche areas. If new institutions can enter an area of specialization, with a focused risk-management team and concentrate on offering a better product, starting small should not be an insurmountable disadvantage.

Of course, any new banking intermediary still faces considerable challenges; to prove it has credibility, an adequate balance sheet and is able to recruit strong talent as well as earn the trust of clients.

Regulation rightly has moved to align the remuneration of bank employees and company longer-term (rather than this quarter’s) earnings. Aligning the uses of the balance sheet - where it is partly funded by depositors - with returns that make sense for shareholders will necessarily be tougher.

Here the industry remains in an uneasy limbo.

Unless universal banks do more to win back the trust of the community and customers, the political pressure for further tightening of the regulatory screw is unlikely to abate.

But push too far and banks might decide it is in their interest to split up their business. The attractions of being small only appear to be growing.

 

Michel Löwy is Co-Founder and Chief Executive Officer of SC Lowy