Banks are letting a good crisis go to waste

There was a point during Deutsche Bank’s investor day last month when, in an otherwise lucid presentation, Colin Fan, the new co-head of the bank’s corporate banking and securities division, slipped into fluent bankerspeak: “One of the things that is hard to demonstrate on a two-dimensional piece of paper is the giving-up of optionality, convexity, whatever you want to call it. All of the things in the past we thought would be a good, cheap cost to maintain optionality: gone.”

To translate: what Fan calls “optionality” or “convexity”, you or I would probably call “procrastination” or “stalling”. But he is absolutely right: the time when banks could sit on their hands rather than rolling up their sleeves and re-engineering now defunct business models is surely drawing to a close.

Analysis by Financial News, published last week, shows that banks have barely started the long task of getting their houses in order. Over the three years to the end of June, the balance sheets at a sample of nine large investment banks actually increased by 6% in dollar terms when measured by total assets, while revenues across the industry have slumped by around a third and pre-tax profits by two thirds.

Last week, consultancy firm McKinsey released its annual review on the global banking industry. It found that only 6% of banks had improved costs and revenues over the past year; the performance of 30% of banks actually went backwards. Banks have still not got to grips with their bloated cost structures, dreamt up new ways of becoming profitable in the current environment or consolidated in any meaningful way.

What are they waiting for?

In a research report also released last week, Huw Van Steenis, the lead banks analyst at Morgan Stanley, wrote: “Banks simply can’t hoard as much optionality” – (there’s that word again) – “and players that are lacking scale or hugely capital constrained have to make tough decisions to enhance returns. We were struck on our wholesale banks field trip how this was really starting to play out.”

Starting to play out? Five years on from the beginning of the credit crunch, are we really only here? How can it be that banks are only now realising they can’t keep all their options open (which is what I’m guess bankers mean by “optionality”) indefinitely?

Part of the problem can be traced back to 2009, when market activity bounced back after the first shock of the credit crunch. That gave management teams the false belief that the boom years might return once the dust settled. It is now clear they were only a brief aberration.

Last week, JP Morgan provided another of the brief rays of light that have occasionally penetrated the gloom since, announcing record third quarter results in which underlying revenues were up nearly a third compared to last year and pre-tax profits quadrupled. As John Cleese said in the film Clockwise: “I can take the despair. It’s the hope I can’t stand.”

In recent months, however, there have been signs of a dawning realisation that the fundamental issues banks face aren’t going away anytime soon. Most will be struggling with them, in the words of one head of a European investment bank, “for the rest of my natural working life”.

But, even now, there is the danger of further procrastination. McKinsey is very clear about which direction to point the finger of blame for this: “State aid and central bank policies have significantly alleviated consolidation pressure and impeded a major shake-out. There have been only 30 bank failures in the United States year-to-date, compared with a high of 157 in 2010.

“Globally, some $1.7 trillion of direct support has been injected into the banking system, with no clear visibility as to when this support will be withdrawn or when the sector will be required to fend for itself. Transformation momentum will only accelerate when state interventions subside.”

Which way now?

Those in any doubt about this theory need only consider the apparent contradiction on display last week when Robert Jenkins, a member of the Bank of England’s financial policy committee, gave a speech railing against the dangers of an over-leveraged banking system.

This followed the committee’s recent recommendation that banks need to further strengthen their balance sheets, possibly by raising new equity. And yet, at the same time, the Financial Services Authority was relaxing rules to allow UK banks to treat corporate loans as risk free. The FSA’s move is designed to stimulate lending and boost the economy.

Critics of the Bank of England’s hard-line stance point out that UK banks are among the best capitalised in Europe. But, equally, it is difficult to pick holes in Jenkins’ assertion that Basel rules to limit loans made by banks to 33 times their own capital will leave leverage still too high.

So which is it to be? Should banks be further shrinking their balance sheets and raising equity as advocated by the Bank of England or participating in the FSA’s experimental use of bank regulation to boost the economy and loading up with corporate loans?

Van Steenis wrote in his report: “Profound, complex and multi-year deleveraging will be an ongoing challenge to European banks and will keep an unusual dependency on policy stimuli for years to come.”
In fact it is the confluence of these two often contradictory trends – deleveraging and government policy – that will produce the most difficult and disorientating eddies and whirlpools for banks to navigate in the coming years.