Building the Resilient Bank: The Future of Credit

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1 Building the Resilient Bank: The Future of Credit Financial institutions will need to become more innovative if they are to preserve their franchise and profits in the new regulatory environment. 1

2 If you are in banking, you know that the industry is largely built on confidence and trust. Both are essential in a business based on short-term deposits and longer-term loans. When institutional errors bad loans, bad investments, or unwise management practices become apparent, a financial institution s resilience is tested. Today, a bank s credibility with governments and reputation with opinion leaders and the general public is particularly low. Just 21 percent of Americans say they have a great deal or quite a lot of confidence in U.S. banks; in Europe, more than 61 percent lack confidence in their national financial institutions. 1 This should not be surprising. Government bailouts of one financial institution after another have enraged the public and left public finances reeling in several countries. The Liikanen Report places the cost of bailing out financial institutions across the European Union at 13 percent of gross domestic product. 2 The U.S. bailout caused an enormous expansion in the balance sheet of the Federal Reserve and a takeover of the two major government-sponsored but private mortgage institutions, Fannie Mae and Freddie Mac. A harsh spotlight has been shone on banking practices, and legislators and regulators have been forced to act (see sidebar: The Regulatory Squeeze on page 3). Banking reforms in the United States and Europe, together with the Basel III international regulatory framework, are aimed at increasing resilience by ensuring sufficient capital. In addition, regulators are enforcing behavioral changes in response to evidence that institutions are more focused on short-term profits than on long-term investment or credit risk. A common approach to reform has emerged on both continents: Require banks to raise more capital and subordinated opt-in debt to provide a larger cushion against losses Demand higher cash reserves Improve the quality and depth of regulatory review Separate traditional banking activities from proprietary trading activities Tie management incentives to long-term lending and investment outcomes rather than up-front fees These new regulations, while designed to make banks more liquid and crisis-resistant, may also cause a loss in part of your natural franchise, particularly in credit. In fact, the need to reduce leverage is likely to fuel a trend toward securitization, as financial institutions face constraints on what can be retained on balance sheets. Furthermore, credit-hungry companies may turn to alternative funding sources, such as bond markets, corporate lending to suppliers and buyers, and crowdfunding. The decline in lending can already be seen in Spain and Greece, where credit volume to households and businesses has plummeted. Combined with a reluctance to roll over existing interbank loans, estimates suggest that banks average leverage factor could fall from 16 times down to 10 times over five years. From a credit-risk perspective, those who move to alternative funding sources are apt to be more creditworthy, reducing the credit quality of remaining borrowers with loans that may be more difficult to move off the balance sheet through syndication. 1 Americans Confidence in Banks Falls to Record Low, Gallup, 27 June 2012; EU Residents Confidence in Banks Sinks, Gallup, 6 November High-Level Expert Group on Reforming the Structure of the EU Banking Sector: Final Report, European Union, 2 October

3 While it is difficult to predict what will happen next, there could be a spillover effect on deposits. Households may prefer to buy corporate bonds, especially if they are liquid, because they will present better yields than traditional bank savings accounts. Corporations that are flush with cash tend to use it to extend payment terms to customers or provide advances to suppliers (perceived to be a better use for it versus storing it in the bank), which means they have less cash on deposit. Tight interbank credit markets will compound the problem since callable deposits in many European countries are remunerated at 50 to 75 basis points above the interbank rate. The impact will be different for each bank, depending on its net funding ratio, its savings pricing strategy, and the composition of its interbank lending and borrowing portfolios. Nevertheless, a bank could lose about 15 to 25 basis points in net interest margin. The Regulatory Squeeze Today s regulatory reforms demand larger risk buffers and less leverage. Both are imperative in a volatile world where governments are constrained in their ability to save problem banks. But there will be side effects. One is a less international and integrated financial market, causing a rise in transaction costs and competition for liquidity. The increased capital buffer will also make it more costly to provide credit, both in terms of absolute volumes available and the spread needed to obtain adequate margins and return on capital. Before the crisis, 2 percent of a typical bank balance sheet was core equity, supplemented by 6 percent of hybrid capital for a total of 8 percent. The target was a 15 percent return on core capital and a 7 percent return on hybrid instruments. This combination led to a required margin on assets of 72 basis points. Basel III proposes roughly a 10 percent core equity requirement; if a 15 percent return continues to be the target, then the asset side of the balance sheet will have to provide 150 basis points to compensate the capital alone. This will have three consequences: Increased cost of credit. Because total lending capacity is a multiple of available capital, the cost of credit will have to be higher. Less direct on-balance-sheet lending will have to be accompanied by syndication or securitization to supplement lending capacity into an overall hybrid facility. The higher price may make other sources of finance (such as corporations with excess cash) more attractive. Increased financing of public-private infrastructure. If banks can obtain sufficient equity and improve risk controls, significant volumes of project financing of publicprivate infrastructure may be enabled. For this lending to be attractive, it must come with higher spreads, more monitoring expertise, and greater use of risk-mitigation techniques such as parallel equity raising, syndication, and derivatives. Bundled risks. Bundling well-understood risks and selling them via securitization and syndication will be important as a less expensive way to get funding, but the right documentation and risk protection will be crucial. Circuit-breaking provisions, such as countercyclical buffers and extra charges for systemically important banks, will add to the credit squeeze. Better margins on the remaining credit volumes could partially compensate. As long as central banks ensure liquidity, banks can enjoy the benefits of short-term borrowing and longer-term lending. But as the Bank for International Settlements argues, high levels of short-term liquidity distort the market and create a false impression that money is cheap. Added to this deceptively low pricing, some governments are raising tax rates to control debt. Higher taxes could reduce the capacity of consumers and businesses to repay principal or interest, driving up defaults. Bank projections of loan losses under austerity conditions can be thought of in two ways: as a stress test to check capital adequacy and as a tool to influence governments to adopt pro-growth and pro-employment policies while keeping risks under control. A return to normal business conditions, once current central bank support is lifted, will be a delicate exercise. 3

4 Meanwhile, about 30 percent of a bank s costs are typically linked to credit activities, and only 30 to 40 percent of those costs are purely variable. Therefore, a loss of one-third in credit volume could translate into a cost reduction potential of only 3 to 4 percent. Combining this with the net volume effect and absent any offsetting measures a bank with a cost-to-income ratio at 60 percent could see it rise to between 63 and 68 percent. This is clearly unacceptable, and suggests a need for innovation and a reconfiguration of the value chain, at the very least. The focus must be on five areas: 1. Bolster securitization capabilities 2. Develop fee-based credit management services for well-funded corporations 3. Step up participation in the corporate bond market 4. Carve out a role in non-bank financing, such as crowdfunding 5. Develop bundled offerings in retail banking based on investment banking concepts Securitization: The New Underwriting Under new banking regulations, balance sheets become an expensive place a high-cost hotel of sorts to hold assets (see sidebar: Balance Sheets: An Expensive Hotel for Money). As a result, securitization will remain a vital tool for banks, and paradoxically, will actually increase in importance for many financial institutions. In fact, an active market continues to exist for securities comprising well-chosen, high-quality assets particularly for institutional investors seeking an alternative to government instruments. However, documentation quality and risk buffers will need to be drastically improved to be acceptable to buyers, rating agencies, auditors, and regulators. When securities are combined with derivatives as a risk-reduction tool, greater transparency into the chain of counterparty risk becomes indispensable, and limits on counterparty risks have to be more severe to avoid risk concentration. Lack of transparency brought down AIG and contributed to the freeze-up of interbank lending in While interbank lending today is significantly reduced and additional disclosure is required about standard derivatives, systemic risk continues unabated and is perhaps insufficiently understood. Balance Sheets: An Expensive Hotel for Money Industry reforms will not only ensure that banks have less leverage and risks but also reduce the apparent return on equity (ROE), at least before considering risk. Banks generally argue that reduced return on equity will raise the cost of new equity and depress market valuations of their stocks. However, in reality, cost of capital is based not just on ROE but also on the riskiness of how capital is deployed. A bank that demonstrates through disclosure and performance that its riskiness is lower will have less difficulty in raising equity or subordinated opt-in debt than banks with poor disclosure and weak performance. One could also argue that past reported earnings (pre 2008) and overstated profits, along with claims about future lower ROE, do not take into account the massive writedowns for poor lending and proprietary investments that should have been applied to the historically overstated returns. Increased disclosure and more transparent risk management will change the profile of risk management in organizations. In the past, doing the deal and making loans was the route to the top. In the future, managers will be rewarded for risk management in some cases for not doing deals or for superior risk disclosure. The basis of management incentives will be longer periods of time with less emphasis on up-front fees. 4

5 For securitization to work and help keep the cost of capital down, four separate but vital activities must operate as one smooth-running machine: Incentives. Align incentives for issuers with those of investors. In practical terms, this means that when a securitized asset portfolio incurs losses, the consequences should affect both the holder and the originator. The degree to which this is visible in the offering will affect both the branding and the price tag of the offering. Risk assessment. Assess risk more elaborately, rigorously, and with more variability and uncertainty. Rating agencies will be forced to improve their analyses, new participants may enter the market, and securitized or syndicated offers may be subject to more demanding evaluations from multiple institutions. And pressure to resolve the inherent conflict of interests whereby rating agencies are paid by the issuers of securities will likely continue. Performance. Gauge performance more transparently and from more sources of information. For example, a mortgage portfolio might have to incorporate microeconomic data, regional prices, and household income as part of the information package. Also, the production process might need to be externally certified and audited. Risk exposure. Ensure that inter-institution risk exposure becomes more visible, which suggests a need to reveal more information about exposure to non-standard derivatives. In addition, a truly neutral appraiser of this more granular information must emerge to assist both professional and retail investors as they consider their investment decisions. With these four activities operating as one smooth process, your bank becomes the prudent originator that your clients expect. Credit Management Services for Corporate Lenders It is not unusual for corporations today to have stronger credit ratings than banks and sovereign states, as they enjoy excellent profitability and hold significant cash reserves. Apple s cash and investment reserves of $145 billion are roughly equivalent to 25 percent of Greece s total public debt. Such vast amounts of cash and reserves require a careful reflection on concentration risk. Why deposit money with an institution with a lower rating than your own and perhaps at a higher risk for bankruptcy? Indeed, large corporations have begun replacing banks extending credit to customers and strategic suppliers, providing advances to suppliers based on their superior ability to assess and absorb risks. Some corporations have a long history of using financing to increase demand for their products and services or to gain competitive advantage. And unlike traditional bank lending, corporate lending decisions have little to do with financial margins; they are often a temporarily better alternative to deposits with almost no yield at a financial institution whose future seems less than secure. Consider a few examples: GE operates medical scanners on a pay-per-scan basis and GE and Rolls-Royce price airplane engines on a per-mile flown basis. The embedded financing creates higher profits than straight supplier financing, with profits increasing based on a learning curve effect (the more engines produced, the lower the per unit cost), margins on spare parts and service, and reduced demand volatility. 5

6 Some corporations use their cash reserves to preempt constrained sources of supply. Apple helps its suppliers build capacity and absorb risk in an effort to have premium parts that differentiate its iphone, ipad, and ipod offerings. A smart banker will look at these situations and see new ways to conduct business. What do corporations that extend credit terms to customers or pay advances to suppliers need more than anything else? In a word: protection. Why not fashion such protection as an additional credit facility or derivative to provide insurance? Or offer bulge financing should a customer exceed a corporate-defined exposure limit? What about selling outsourcing credit and rating advisory services, or management services, to corporations that lend to small- and mediumsize enterprises? For corporations with cash sitting outside their home markets and difficult to repatriate tax free, a good banker will find opportunities to assist tax optimized capital movements. Step Up Participation in Corporate Bonds Banks by no means have a monopoly on credit; other institutions can and do take on lending roles. It happened before in the United States when the Glass-Steagall Act of 1933 forcibly separated investment banking from commercial banking and triggered the development of the corporate bond market. Today, there are signs that the issuance of corporate bonds is growing in Europe too, with many mid-market corporations going to debt markets for the first time. Figure 1 illustrates the rapid growth of corporate bonds and may well signal a new, disintermediated future for banks, although current data suggests there is still a long way to go before corporate bonds match the volume of debt issued by financial institutions. Figure 1 Corporate bond volume has grown faster than financial institutions but is still relatively low Corporate $ billion Financial institutions $ billion +113% 22, % 23% 20,549 6,903 6,097 30% 25% 4,015 13% 13% 2,678 17% 12% 10% 17% 13% 7% 19% 8% 50% 47% 59% 60% 9,640 13% 17% 25% 45% 13,467 12% 9% 15% 64% 5% 18% 54% 28% 5% 17% 50% Other Japan EU5 United States Notes: EU5 refers to the European Union Five (France, Germany, Italy, Spain, and the United Kingdom). Other includes 46 additional countries. Sources: Bank for International Settlements; A.T. Kearney analysis 6

7 Bank finance may no longer be so valuable a proposition for larger corporations particularly if borrowing from large, systemically important banks is subject to higher equity requirements. Although there are only a handful of Triple-A corporations left in the world, a major multinational in good standing can often obtain cheaper financing in the bond market than from banks. Where does this leave you, the retail banker? Taking on the role of primary broker is a definite possibility if you can explain the credit story for mid-sized issuers and develop distribution syndicates with sufficient placement power. Providing liquidity in the secondary market is another possibility. Although universal banks are best positioned to succeed in the bond origination space, traditional retail banks can also capture a fair share of distribution. Non-Bank Financing: Think Crowdfunding Two forces are acting to open up novel forms of non-bank financing. The first is government concern that regulations are making it too difficult for small businesses and individuals to raise funds, leading some to press for exceptions such as providing startups with more access to lending. The second force is the spontaneous emergence of crowdfunding sites that offer monies directly to entrepreneurs and consumers via online platforms without a banking or creditoriented intermediary. Crowdfunding establishes an emotional link between lenders and creditors, something lost in the complex financial engineering of a balance sheet-driven financial industry. More than 400 platforms have emerged in recent years. Zopa, Lending Club, and Prosper are prominent examples. The concept could ultimately undermine the traditional lending and deposit function. In fact, Lending Club reports that nearly 75 percent of its borrowers use their loans to consolidate debt or pay off their credit cards. And some investors find a crowdfunding investment to be a fun or more socially desirable alternative to a traditional savings account. Crowdfunding is still in the early stages, but it is quickly ramping up, with volume nearly doubling between 2011 and 2012 (see figure 2). Whether or not the concept will achieve mainstream Figure 2 Crowdfunding: new and growing worldwide $ million +91% 2, % +61% 1, Source: crowdsourcing.org 7

8 acceptance remains to be seen, but the true strategic risk for the banking industry would be if a large, well-funded social network or a major e-commerce player were to bring its formidable user base and marketing power to bear in such an endeavor. Google s recent $125 million investment in Lending Club illustrates that this scenario might be closer than thought. A financial institution s role in the crowdfunding phenomenon is yet to be defined, whether as qualifier, certifier, or collateral manager among other possibilities. Any one of these roles will be difficult to orchestrate legally unless or until there is a way to be compensated for providing implicit credit assurance. While interbank lending is down and additional disclosure is required for standard derivatives, systemic risk continues unabated and is insufficiently understood. In some ways, crowdfunding could become a revival of cooperative financing, where individuals pool their savings to provide credit to the community. If this Cooperative Banking 2.0 movement catches on, we might expect some operations to be outsourced to well-established financial institutions to take advantage of their IT and ATM infrastructures, establishing a new revenue stream for them. Bundled Offerings, or the Retail Version of Investment Banking Banks will still be around as long as people continue to need financial solutions to buy homes, save for retirement, and send their children to school; and as small- and mid-sized businesses still look for services such as cash management, foreign exchange, and stand-by credit lines. The engineering and brokering of such solutions is the true value of the financial services industry. As banks struggle to maintain per-customer income levels, bundled offerings will become more important. These will require reinforced product design and risk assessment capabilities, more granular customer segmentation, and deeper intelligence on customers. As for lost volumes and revenues, mechanisms from the money and capital markets will help compensate for these losses. Imagine an affluent customer with a securities portfolio seeking a loan to refurbish a vacation home. Why should this be sold as a loan with its attendant impact on balance sheet leverage? Why not use a repurchase agreement instead? Could parents use a similar method to get cash to fund their children s educations or to make a down payment on a home? Offering such services in a retail market will require not only imagination, but also new and improved credit systems, internal processes, and sales force training. 8

9 Time for a New Business Model As deposits and loans move off the banking balance sheet, you can expect a spike in competition for depositors and borrowers. But interbank or retail funding is expensive, so capital requirements and leverage limits will constrain any such strategy. Overall, balance sheets will shrink a desirable outcome for an industry that needs deleveraging. To compensate for the revenue losses, the focus will need to be on innovation around fee-based services and comprehensive solutions. Clearly, there is a need for a new business model along with a new set of capabilities. You can fight or embrace the change. Your choice will determine whether you emerge as a winner or a follower. Author Johan Kestens, partner, Brussels johan.kestens@atkearney.com 9

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