The downfall of Silicon Valley Bank (SVB), the emergency merger of Credit Suisse with UBS, and the recent seizure and sale of First Republic brought an end to a period of slowly recovering trust in the banking sector.
The question is, what’s next?
Are these events temporary deviations or indicative of deeper problems within the industry, the tip of an iceberg with many more asset bubbles waiting to burst beneath the surface, particularly if central banks persist in their aggressive interest rate strategy to combat inflation?
Certainly, the market’s reaction to the trio of collapses — the Euro Stoxx Banks index dropping to a four-year low, the rise in credit default swaps, and the significant decline in value of major banks like Barclays, Deutsche Bank, and Societe Generale — reveals a widespread unease in the marketplace.
No escaping the underlying reality
So, while banks may have been doing better of late, there is no escaping the underlying reality, which is that most are not producing the return on equity (ROE) that they should be. And indeed, they haven’t been doing so for a while.
If we look at 2022 when the economic environment wasn’t overly challenging, the average ROE for a European bank was no more than 6-7%, and this is poor when you consider that 9-11% is the minimum needed to cover the cost of capital, and that is without even factoring in any risk premium.
Banking stagnancy entrenched in eurozone
This stagnancy is particularly entrenched in the eurozone, where the prevailing mindset seems to be a belief that banks cannot produce sustainable profits in the prevailing environment of low-interest rates and sluggish economic growth.
However, we think it’s right to challenge such thinking, and we can do so simply by looking at banks that don’t conform to the stereotype — Bawag in Austria and OLB in Germany — both of which significantly outperform their rivals in what are highly competitive markets.
So, in 2022, for instance, while the average cost-to-income ratio for a European bank was 59.7%, for Bawag and OLB the numbers were 35.9% and 42.3% respectively
So, what makes the difference?
Focus is key
Perhaps if you were to single out one thing, it would be that their everyday operations are underpinned by sound, solid management. Put it another and you could say that they just do the banking basics well. This is in contrast to a bank like SVB. One of the major reasons for its failure was that managers took their eyes off critical activities, such as the rigorous control of interest rate risk.
Bawag and OLB also don’t try to be all things to all people but instead play to their core strengths. This is an important lesson to learn for banks that are continuing to run a ‘universal’ model. In today’s marketplace of high cost and complexity, attempting to juggle a myriad of business lines with differing risk and return profiles will not work and will just result in you having to use your ‘anchor’ products and services to prop up unprofitable offerings.
Deciding on your core competencies, whether they are in investment, private, or commercial, and then doubling down on delivering them to your target audience is also the only way to create the unique value proposition you need to successfully differentiate yourself from your rivals.
Eliminating poor business lines
To achieve this, it means eliminating all business lines that are ‘opportunistic’, difficult to scale, and long-term underperformers and then concentrating on the product and service offerings that are most likely to provide you with a long-term, sustainable competitive advantage. What we are talking about here is much more than some cosmetic trimming around the edges.
The capital that you release from doing this can then be better employed on new initiatives that will make a real difference, such as ensuring digital transformation is as rapid and comprehensive as possible.
Radical change required
Unfortunately, too few banks are as proactive as they should be when it comes to implementing the radical changes required to turn themselves into the more resilient and profitable organizations they need to become. Why is that?
Because it is much easier to seek comfort in the status quo, justifying their inertia by citing the expense, complexity, and risk attached to embarking on any kind of rapid and radical change, even though this is exactly what’s needed.
And what if central banks, in an effort to combat inflation, continue with their aggressive stance when it comes to interest rates? Would the extra pressure this generates lead to a fresh set of burst asset bubbles? More than likely, in which case, what would be the impact?
Of course, there will always be banks that, through circumstance and frailty of management, go to the wall. But we need to make sure that these are exceptional events. That requires banks to stop indulging in wayward ventures, such as allocating capital to trading activities, and focus instead on supporting the real economy and creating the shareholder value that investors are demanding.
Written by Martin Rauchenwald, Arthur D. Little
and Philippe De Backer, Arthur D. Little
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