How are banks managing through unprecedented regulatory and macroeconomic times?

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1 Forces of Change A Three-Part Series Making a Case for Change in Cross-Border Payments Part 3: Regulatory & Macroeconomic Risk How are banks managing through unprecedented regulatory and macroeconomic times? The banking world changed forever after the global financial crisis. Quantitative easing (QE) programs and new regulations reduced yields and raised compliance costs, while higher capital and liquidity requirements put immense pressure on bank returns. As a result, banks spent the past decade adjusting their business models to cope with these changes, and will continue to do so as challenges posed by new macroeconomic and regulatory environment changes. While there may be more clarity in the regulatory outlook, what happens as policymakers slowly raise rates from a zero base and as central banks start selling assets remains uncertain. Key Takeaways: Macroeconomic and regulatory policy have permanently affected banks business models With fortress balance sheets, large US banks are particularly well positioned to help drive sustainable economic growth Banks globally must focus on their strengths and deploy their balance sheet accordingly Mark Smith, Head of Global Liquidity for Global Transaction Services at Bank of America Merrill Lynch, has thoughts on how banks are adapting to this unprecedented environment. Q1: How have banks business models been forced to change? Banks faced a triple threat in recent years in terms of reduced revenues, increased costs and lower returns. Net interest margins have been under pressure due to low interest rates and QE programs, which have compressed the spread between the rate paid on deposits and the interest yield on loans. A flat yield curve has squeezed banks earnings Average spread between 3 month and 10 year US Treasuries, % Compounding the issue, companies have hoarded record amounts of cash on their balance sheets, reducing their need to borrow from banks. This has led to slower loan growth, tighter loan pricing and a record surplus of deposits over loans on bank balance sheets. These factors, coupled with a low, flat yield curve, have acted as a drag on bank yields and revenues. Source: US Treasury (*To end-may 2017) 1

2 Corporate cash reserves rose steadily after the financial crisis The leading 1,200 public non-financial companies had $3.5 trillion in cash reserves at end-2013, up from $2.1 trillion at the end of 2007 US banks reserves have skyrocketed They rose more than 1000-fold from $1.8 billion in December 2007 to $1.9 trillion in December 2016 Source: Deloitte, 2014 Source: Federal Reserve Bank of St. Louis, 2016 While yields have been declining, the cost of complying with new regulations has been rising. In 2016, some 69% of compliance professionals at financial services firms expected their compliance budgets to rise, squeezing profitability. (Source: Thomson Reuters, Cost of Compliance 2016) Completing the perfect storm, higher post-crisis capital requirements have meant the return on equity across the banking industry is significantly below pre-crisis levels. New regulations affecting capital and liquidity Rules requiring banks to hold high quality liquid assets on their balance sheets include: Liquidity Coverage Ratio Net Stable Funding Ratio Recovery and Resolution Planning Internal Liquidity Stress Testing Rules requiring banks to hold more capital on their balance sheets include: Basel III advancement of risk-weighted assets Supplementary Leverage Ratio Global Systemically Important Banks (GSIB) buffer US Comprehensive Capital Analysis and Review (CCAR or stress testing ) 2

3 Q2: How have banks evolved? Those banks that reassessed how they do business in response to new rules are in a stronger position to take advantage of a brighter economic and regulatory outlook. For example, while US universal banks haven t fundamentally changed their models, they have adjusted them to the new environment. They ve had to measure how their activities consume balance sheet and capital, how they attract risk and compliance costs, and then reduce exposure to products and markets which don t generate adequate return on balance sheet/capital, or relative to risk. Large European banks have generally had to adjust more severely, with many cutting balance sheet size significantly and others exiting products and geographies in order to focus on core markets. In Asia and Latin America the financial crisis was less severe, while post-crisis regulation is more nascent. The challenge for banks in these regions, with no common regulatory bodies, is anticipating how regulations will unfold in each individual country, and how much regulatory compliance will cost. Crucial to all of this is understanding and measuring how a bank s activities attract capital and risk. How do banks develop metrics to optimize returns on that capital and on those risks? If you can t measure it, you can t manage it. Q3: What has been the impact on correspondent banking? Rules associated with KYC and sanctions screening have materially increased the compliance costs associated with correspondent banking. On average financial institutions spend $60 million a year on KYC and Customer Due Diligence (CDD) procedures. Some banks are reported to spend in between $100 million and up to $500 million on KYC/CDD and client onboarding. (Source: Thomson Reuters Survey, 2016). But even if you set higher compliance costs to one side, the risks associated with correspondent banking related to money laundering and sanctions violations are much higher than for most banking activities. Against that, correspondent banking remains a high-volume, high-margin business typified by economies of scale and straight-through processing. Consequently, top tier correspondent banks will find it much easier to find partners and are likely to enjoy competitive pricing for their business. Smaller, less well known correspondents will find it harder to attract partners, are likely to experience higher pricing and be pushed out further in the network. Q4: Are US banks in a stronger position? The US has generally implemented prudential regulations more quickly than elsewhere, and while it has been a painful transition since 2008, large US banks are now arguably in a position of regulatory strength relative to the rest of the world. Stricter regulations have required US banks to build and maintain fortress balance sheets, buttressed by increased levels of liquidity and capital. The challenge has been generating an adequate return on post-regulation capital and balance sheets. While they have adjusted their models to focus on their strengths, universal banks like Bank of America Merrill Lynch have still maintained a diversified product offering, enabling them to serve clients in multiple sectors and geographies. Crucially, this broad wallet penetration across credit, capital raising, advisory, global markets and transaction banking can still earn a good return on capital and balance sheet. US universal banks with fortress balance sheets are therefore in a strong position to benefit from a more stable regulatory environment to help drive sustainable economic growth. 3

4 Q5: What risks are banks facing? Risks to the economic outlook remain, including those from unpredictable geopolitical events. We re also in uncharted monetary policy territory. While we ve been through rate rising cycles before, we ve never started this low, nor increased this slowly. There is no precedent for the unwinding of quantitative easing and how that will affect the yield curve. That said, there is probably much more upside than downside for US banks, which have learned to survive in a low or flat rate environment. Fortress balance sheets, rising benchmark rates, and the prospect of a steeper yield curve offer US banks the opportunity to benefit from, and support, responsible economic growth. The same cannot yet be said of banks in other regions, where economic recovery and regulatory reform has been slower than in the US. In Europe, for example, a number of banks are still recovering from the crisis rebuilding their capital and refocusing their business models. The risk for such banks is that they fall behind their US counterparts and lose market share. Another interesting risk relates to the repatriation of dollars to the US, a large quantity of which is held by foreign banks and used to fund their dollar assets. How easily will those non-us banks be able to find alternative USD funding? In unprecedented territory The US federal funds has never before risen from a zero base Source: Federal Bank of St. Louis, 2015 Q6: How will the regulatory environment evolve over the next five years? The US is likely to see a more stable environment, where major regulatory changes are generally known and accommodated. The hope is that banking regulation will become more efficient by precisely targeting risks in the system, freeing up resources, liquidity and capital which banks can then use to help drive economic growth. For example, US regulations require banks to manage deposit liquidity risk under at least five different scenarios for three major rules Liquidity Coverage Ratio, Recovery and Resolution Planning and Internal Liquidity Stress Testing. These rules generally treat the same deposit differently. Simplifying these into one or two scenarios that banks and supervisors agree are most effective would make it easier for banks to allocate liquidity against liquidity risk, speed decision making, and free up resources to help drive growth. The picture elsewhere is less clear. Regional banks in Asia-Pacific and Latin America face the challenge of complying with evolving regulations in each of the jurisdictions in which they operate, inevitably pushing up compliance costs. And even where there are supra-national regulators, such as in the EU, the pace of adoption of prudential rules such as Basel III has been behind that of the US. This could make it harder for some European banks to compete with their US peers, whose business models and balance sheets have already adjusted to a more mature set of regulations, and who are now well positioned to support clients in an environment of economic growth. 4

5 Q7: How should banks adjust to this new reality? Since 2008, banks have learned that the balance sheet, including capital, is a precious resource, and a binding constraint. Accommodating anything for any client at any time and at any price is no longer an option. Banks need to measure, analyze and understand their binding constraint their capital and balance sheet and orient their activities to those clients and products which generate an adequate return. Exiting sub-hurdle products and relationships is painful, but the only way to position optimally for the opportunities presented by economic growth in the new regulatory world. At Bank of America Merrill Lynch, we view disruption as an opportunity, not a problem. So in a world where continual change is the norm, we tailor solutions, ranging from global cash management to structuring green bonds, that help future-proof our clients businesses and propel them forward. For more information please forcesofchange@baml.com Some or all products/services may not be available in all jurisdictions and are subject to change without notice. Bank of America Merrill Lynch is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., Member FDIC. Securities, strategic advisory, and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation ( Investment Banking Affiliates ), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp., both of which are registered broker-dealers and Members of SIPC, and, in other jurisdictions, by locally registered entities. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Professional Clearing Corp. are registered as futures commission merchants with the CFTC and are members of the NFA. Investment products offered by Investment Banking Affiliates: Are Not FDIC Insured * May Lose Value * Are Not Bank Guaranteed Bank of America Corporation. Please click, here to view the Latin America disclaimer. ARGMX93Q 5