https://www.securities.io/banking-blip-or-something-more-serious/
The regulatory reforms that followed in the wake of the 2008 financial crisis were designed to bring new robustness to banking.
And though they undoubtedly have played a part in keeping the sector on a more even keel, as the recent collapses of Silicon Valley Bank (SVB) and Credit Suisse have shown, the global banking system still retains an inherent vulnerability.
The unease in the marketplace was certainly reflected in the Euro Stoxx Banks index falling to a four-year low, the increase in the number of credit default swaps, and the massive loss of value suffered by big banks Barclays, Deutsche Bank, and Societe Generale.
If that weren’t enough, we didn’t have to wait long for another shock, the sharp fall in First Republic shares, down 40% in a day, the consequent frantic measures to keep the bank afloat, followed by its seizure and subsequent sell-off to J.P. Morgan, to reinforce the fact that all is not well in the world banking.
Blip? Or something worse?
But are these just temporary blips in the banking continuum or evidence of something more serious?
On the face of it, banks have been faring better of late. That’s, of course, good. But the reality is that most banks are not generating a sufficient return on equity (ROE) and haven’t been for a while.
Even in 2022, when economic conditions weren’t overly testing, the average ROE for a European bank was just 6-7%, considerably less than the 9-11% needed to cover the cost of capital.
Such has been the persistence of this state of affairs that there now exists an underlying mindset that presumes banks will not be able to produce sustainable profits while an environment of low-interest rates and sluggish economic growth environment persists.
But is this perceived wisdom actually true?
Perhaps we can test this hypothesis by looking at just two banks that have significantly outperformed their rivals, Bawag in Austria and OLB in Germany, both in highly competitive markets where profitability is traditionally low.
And yet, in 2022, the cost-to-income ratios for Bawag and OLB were 35.9% and 42.3% respectively, much better figures than the 59.7% that was the European average for the first half of that year. So, what are these ‘outliers’ doing differently?
A recipe for success
Perhaps most tellingly, their everyday operations are underpinned by sound, solid management. In other words, they do the banking basics well. One of the major reasons for SVB’s fall was its poor control of interest rate risk.
They also focus on playing to their strengths rather than trying to be all things to all people. Banks running a ‘universal’ model that entails juggling a myriad of business lines with differing risk and return profiles will struggle as using ‘anchor’ products and services to support unprofitable offerings becomes ever more costly and complex.
It is also not the way to create the unique value proposition that’s needed to successfully differentiate you from your competitors.
So, the lesson here is to first decide on your core competencies, whether they lie in investment, private, commercial, or somewhere else, and then double down on delivering them to your target audience. That means eradicating all ‘opportunistic’ and sub-scale business lines because their underperformance will continue to drag you down. Only then will you be able to concentrate on the product and service offerings that are going to offer you a long-term, sustainable competitive advantage.
But be mindful that doing this is likely to require more than just cosmetic trimming.
Radical change required
Of course, knowing what you must do is irrelevant if you then don’t do it. Unfortunately, too few banks are sufficiently proactive in making the positive changes needed to become more resilient and profitable organizations. The truth is that it is much easier to stick with the status quo, justifying inertia by citing the excessive expense, the complexity, and the risk attached to embarking on any kind of rapid and radical change, even though this is exactly what’s needed.
However, this is what they need to do, especially if central banks continue with their more aggressive approach to interest rates in an effort to combat inflation. This extra pressure would likely burst more asset bubbles, leaving more banks vulnerable and adding further to the loss of trust already brought about by the fall of SVB, the emergency merger of Credit Suisse, and the demise of First Republic.
And given the banks’ significance as a primary source of personal and commercial financing, it’s imperative that they put their collective house in order so they can focus on what they should be doing, supporting the real economy and creating the shareholder value investors are desperately seeking, rather than indulging in allocating capital to trading activities. This is a lesson yet to be fully learned.
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