Banks: Tough days ahead?

Banking executives around the world are asking a crucial question: What's in store - what's writing on the wall?

Global banking regulators  rightly observe that the world's largest banks have already met the elevated capital standards set after the 2008 financial crisis ---- nearly five years before they fully take effect in 2019.

IN THE AGE OF BASEL III: Along with capital levels, Basel III established several measures of funding, including a liquidity coverage ratio [LCR] and the net stable funding ratio [NSFR]. The LCR is a measurement of whether banks have enough cash or assets easily convertible to cash on hand to meet their needs for 30 days under a stressed scenario, such as a financial crisis.

Incidentally, it may be mentioned here that Tier 1 capital is the type of funding that is 'best able to handle an economic shock, with common equity and cash reserves being the most favored version of such funding'. Basel III called on banks to have a minimum 4.5 per cent Tier 1 capital ratio -- but also set a higher target of a 7.0 per cent ratio. Financial institutions deemed to be 'Global Systemically Important Banks' (G-SIBs) are also required to maintain an additional level of capital (known as a surcharge).

Under the Basel III standard, banks are to meet 60 per cent of the requirement by the start of 2015 -- rising to 100 per cent by 2019. Some regulators (such as the Federal Reserve) have imposed their own more aggressive timelines for compliance in rules derived from the accord. The Basel Committee released a revised version of the NSFR (Net Stable Funding Ratio) proposal in October, 2014 and the Fed and other U.S. banking regulators, among other leading economies, are currently at work on implementing rules for the banks they supervise.

IMPORTANT FINDINGS: The Basel Committee on Banking Supervision said that a monitoring exercise that covers a total of 226 banks found that as of June 30, 2014, all of the 98 largest banks surveyed would meet the minimum 4.5 per cent Tier 1 capital requirements (as set in the 2010 Basel III international banking accords).  

In its recently conducted survey, the Basel Committee found that the largest banks fell short of that higher target, but not by much. The survey found that the largest banks, including G-SIBs, fell an aggregate €3.9 billion ($4.4 billion) short of that level as of the end of June -- a remarkable improvement compared to data from the end of December 2013, when the largest banks fell €15.1 billion short, according to the Basel Committee.

The data established the fact that the bulk of that improvement came from the European banking sector. Among the 126 smaller banks included in the survey, the Basel Committee found a shortfall of €100 million at the 4.5 per cent capital requirement and of €1.8 billion for the target 7.0 per cent level. Those banks would not be subject to additional surcharges.

The largest banks had an average LCR (liquidity coverage ratio) of around 121 per cent as of the end of June 2014, an increase from the 119 per cent average that the Basel Committee said it found at the end of December 2013. Smaller banks also saw a rise in their LCR.

The Basel Committee also found increased compliance with the net stable funding ratio, a requirement that forces banks to hold sufficient cash or assets that can be quickly turned into cash to cover their potential losses over the course of a year.

HEAVY TASKS AHEAD: Though it remains difficult to parse future economic trends, yet no global bank can afford to sit idly by and simply hope to be able to react to future changes. Rather, in place of that based on the functioning of global banking sector of yesterday and today, one can analyse the current situation and make logical deductions about how the banking landscape will shift tomorrow. Two and two not always make four in the business world!

In fact, in this fast-changing world of innovention [innovation + invention] the entire banking world has been witnessing such things which were hitherto not much in existence. The modern banking industry has brought greater business diversification. Banks in the developing world also like their industrialised counterparts have been entering into investments, underwriting of securities, portfolio management and the insurance businesses, among others. In fact, since the beginning of the 21st century, the biggest banks in the industrial world have become complex financial organisations that offer a wide variety of services to international markets and control billions of dollars in cash and assets.

Supported by the latest technology, banks are working to identify new business niches, develop customised services, implement innovative strategies and  capture new market opportunities. With further globalisation, consolidation, deregulation and diversification of the financial industry, the banking sector will become even more complex.

While over the past decade there has been an increasing convergence between the activities of investment and commercial banks, because of the deregulation of the financial sector, today, some investment banking and commercial banking institutions, credit services,   deposit services compete directly in money market operations, private placements, project finance, bonds underwriting and financial advisory work. Taken together, these changes have made banks an even more important entity in the global business community on the one hand, while, on the other, the risks dimensions have leapfrogged.

RISK IS WHERE THE BUSINESS IS: Today, the main function of any bank would continue to be risk management. Banks have to adopt appropriate risk management approach to maximise shareholder value/net value and to conform to the Central Bank's  guidelines. Again, the adoption of ALM (asset liability management) and diversification of activities to earn fee income resulted in the assumption of risks which had to be hedged by derivatives. Since major banks are foreign exchange dealers, exchange risk and interest risk have to be covered. Again, derivatives themselves carry a lot of risk which has become a major concern of regulators.

PERFORM OR PERISH: Especially for the small banks (in public sector too) the need is there to better operational performances. One of such vital areas has been comparatively high cost-income ratio. The cost-income ratios of some of the small banks are still unfavourable (quite high) compared to the biggies and thus these small banks must improve upon by increasing their business rapidly.

As profitability is one of the prime business evaluation indexes, it occupies the central place. Efforts must be on to move towards that direction so that within a reasonable time the ratio becomes nearer to the peer group level.

The betterment, in turn, is hinges upon two vital wings - minimisation of cost (interest plus operating) and maximisation of income (interest plus non-interest). The first area has been on the rise due to external factors as well as internal factors, while the second area reflects better picture emerged from the segments.

Finally, what is written on the wall? The banking sector is set to consolidate globally with only five or six lenders emerging as major players (viz. HSBC, Deutsche Bank, Lloyds' Bank, etc.).  As per the Deutsche Bank assessment, for example, only one European bank will remain among the global majors after the consolidation process and that must be Deutsche Bank.

 Dr. Bibhas Mukhopadhyay, a Management Economist, is

attached to the West Bengal State University, India. m.bibhas@gmail.com