The fall of Silicon Valley Bank (SVB), the emergency merger of Credit Suisse with UBS, and most recently, the seizure and sale of First Republic Bank quickly dissipated much of the trust that had been slowly returning to the banking sector.
The question remains: if central banks continue with their more aggressive approach to interest rates in an effort to combat inflation, then how many more asset bubbles will begin to burst, leaving many banks vulnerable?
How you try to answer that question will, of course, depend on whether you see recent events as temporary aberrations that have no deep significance or whether you consider them symptoms of a deeper malaise within the sector.
Undoubtedly, there is still something wrong with banking. The reaction of the market to this trio of collapses — 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 — certainly reflected a widespread unease in the marketplace.
A continuing profit problem
Of course, it would have been naive to think that the post-2008 financial crisis regulatory reforms would have been a panacea for every banking ill, but it is obvious that banks must take some transformative actions if they are to become not just more resilient but also more profitable. And profit is a continuing problem.
The sad truth is that too few banks are generating a sufficient return on equity (ROE) to meet their cost of capital, and they have been for a while. Even during the more favorable conditions of 2022, the average ROE for banks in Europe was just 6-7%, much less than the 9-11% required to match the cost of capital, and this is before we even acknowledge the need for any risk premium.
So entrenched is this issue that it is now almost assumed by default that it is almost impossible for banks in the eurozone, for instance, to generate sustainable profits because of the current environment of low-interest rates and sluggish economic growth.
If that is the case, given the significance of banks as a primary source of financing, then we have a major problem if they aren’t in a position either to collectively support the real economy or create the shareholder value that investors demand.
But does such a proposition even stand up to scrutiny? Are the hands of banks so tied that they must sit becalmed, waiting for the financial gods to bless them with the right conditions?
Well, to answer that, let us point you in the direction of two banks that twinkle brightly while others do not: Bawag in Austria and OLB in Germany, both of whom are significantly outperforming their rivals in highly competitive markets where profitability is traditionally low.
But if we compare their cost-to-income ratios for 2022, then [Bawag’s 35.9% and OLB’s 42.3% respectively, are significantly more impressive than the 59.7%, which was the European average for the first half of that year. So, why are they so different?
Back to basics
One answer is that what they do involves solid everyday management. In other words, these are banks that concentrate on doing the basics well. If we look at why SVB failed, for instance, one of the main reasons was their poor control of interest rate risk, something you cannot take your eyes off.
These banks are also focused on delivering their core competencies well rather than following the traditional universal banking model, which involves providing a wide range of services to a broad audience of customers. While this once may have worked in a high-interest rate and high-margin environment, it is no longer possible to contain a plethora of business lines with differing risk and return profiles under one banking roof. And any bank that tries to do so will increasingly find themselves having to cross-subsidize unprofitable offerings from ‘anchor’ products and services. That is a potential recipe for a slow decline.
If they are to achieve sustainable profitability, instead of persisting with this all-in-one model, banks need to focus on the distinctive delivery of their core competencies, whether these lie in investment, private, commercial, or somewhere else. Doing anything else will simply dilute this core offering and trap capital where it is not being put to best use. On the other, pare back your portfolio, and immediately you release the funds for major initiatives, like the faster, broader, and digital transformation that all banks should be embracing.
The status quo no longer works
While there will undoubtedly always be challenges for any bank looking to make any kind of long-term change, the justifications for taking no action do not actually stand up to scrutiny. Banks need to start putting their house in order by proactively seeking to bring about the positive changes that will make them more resilient and profitable. Unfortunately, despite the pressing need for rapid and radical transformation, too often, the status quo still wins out, with excessive expense, complexity, and risk repeatedly cited as the reasons for inertia. But while avoiding the challenge of change may offer some short-term comfort, doing little or nothing hardly seems like a sound long-term management strategy.
But if banks don’t do something to become more profitable soon, they won’t be able to attract the funds they need to transform. This problem will be even more acute for non-listed institutions because they generally have to demonstrate an even greater capacity to generate a strong ROE.
The collapses we have seen recently should be a wake-up call to the banks that have been slow in transforming themselves for this new environment in which the traditional universal banking model, in particular, is no longer sustainable.
This means that if banks truly want to protect themselves from what could be coming down the road, then they need to do the basics well and focus on what they can do best rather than indulging in allocating capital to trading activities or becoming distracted trying to support an unsustainable product portfolio. That way, not only will they be able to support the real economy but also create the shareholder value investors are craving.
Martin Rauchenwald is a Partner in Arthur D. Little‘s FSG practice. He spent close to 25 years in financial services as a top executive, investor, entrepreneur, and advisor transforming financial institutions. His particular focus is on banking. He supports clients throughout Europe with strategy and growth challenges, technology-enabled transformation of business models, corporate finance, and mergers & acquisitions.
Philippe De Backer is Managing Partner, Global Practice Leader, Financial Services at Arthur D. Little. A seasoned banker, investor, and strategic advisor to government and corporate leaders, and has deep experience in digital banking. With over 25 years of experience, Philippe has helped large financial institutions around the world in their growth and global transformations.