By Joseph Neu
Over the next several years, corporate treasurers should expect to witness fundamental changes in the banking sector as banks seek to reorient their activities to account for new regulatory requirements and a dynamic global business landscape. In response, bank relationship management needs to be recalibrated from its current focus on near-term counterparty risk.
A PriceWaterhouseCoopers (PwC) report released over the summer, Banking Industry Reform: A New Equilibrium, can serve as a helpful guide. The report fits with PwC‘s much broader “Project Blue” research, which looks at the global business outlook, including myriad tax, regulatory reforms, shifting trade-flow patterns, demographic and technology changes and their impact on various economic sectors. Here are some highlights:
- Profound change cannot be ignored. The central message from PwC’s Project Blue is one that all firms should internalize: “whatever companies may be doing in the short term, either in dealing with the crisis or just going about their business, they should recognise that the world around them is changing profoundly.“
The implications for banks is that they cannot simply respond to reforms spurred by regulators, they also need “to take account of the way their world is changing. Otherwise, banks run the risk of emerging from the crisis recapitalised, restructured, reformed…but irrelevant.”
- A new equilibrium. Another key message is that banks will not only have to reset their business models for 9-11 percent average return on equity (RoE) and 1-2 percent economic profit margins, they will also have to recognize a broader set of stakeholders that support their industry. “Banks need to renew their ‘licences’ with the investors, communities and customers they serve.”
- Pricing adjustments will need to account for these broader stakeholders. Accordingly, banks need to be careful that their efforts to return to pre-crisis levels of RoE and profitability don’t spark a backlash. Anti-bank sentiment, born from the financial crisis, has not gone away.
- Focus more on the economic spread. The PwC report also advocates that banks and their stakeholders focus more on economic spread (RoE less Cost of Equity) than RoE alone. As banks adjust their business models to rein in capital and operational costs, there will be increasing disparity in capital structure and risk profiles. An economic performance measure can better assess each banks’ success relative to its peers.
- Economic decisions should trump regulatory ones. While the current focus is on meeting regulatory capital and liquidity requirements, economic considerations should still remain primary. For example, the report notes: “Although regulatory formulations dictate aggregate capital requirements, they should not feature unduly in business decisions at the margin, in areas such as business mix and deal pricing.“
All banks will seek to optimize their offerings within the regulatory constraints, but, according to the report, “the basis of optimisation should be economic, and not be corrupted by regulatory bias.”
In addition, PwC sees longer-term strategic considerations such as the integrity of the franchise, competitive positioning, and future growth options coming into play, especially as banks look ahead to when the regulatory constraints ease.
- Prudent banks may be those that ignore the reg noise. Taken together these and other key messages from the PwC report paint a more varied picture of how banks will be responding to current reforms than the bleak, higher pricing and exiting key businesses than is typical.
Indeed, the report implies that there is a chance that “prudent” banks may have it wrong. Prudent banks being those “taking a lead in reformulating their pricing models to take account of the new market and regulatory ‘realities,’ “ that are also “happy (ish) to allow others to pick up business on uneconomic terms, viewing them essentially as victims of adverse selection who will pay a price in the end.” Maybe banks leaving pricing to win share have it right. To know for sure treasurers need to recalibrate their relationship management—and performance scorecards—to assess banks’ “new equilibrium” cost structures and encourage those that take the long view.