Bank to the future

This is article forms part of the cover feature for the July/August edition of Insto magazine. We examined the future of Australian banking from a variety of angles and created a cheesy move poster cover to get the point across that banking was going 'back to the future'.

http://www.insto.com.au/story/feature/001019/bank-future

Insto surveyed analysts and bankers on their views for the future. Their collective opinion is that a rear vision mirror will be more productive than a crystal ball, as Jonathan Shapiro explains.


The banks that go back to basics will prosper in the 2010s.

"I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones," Albert Einstein once said. We’ll probably never know if he was right, but the prediction has rung true for global banking. The annihilation inflicted by highly complex structured products to once mighty institutions has left the industry unable to dabble in anything other than centuries old vanilla banking.

So, after the first decade of the 21st century, is the sector in retreat? And what does the future hold for Australian banks, which for the large part withstood the credit crunch? Insto’s special survey on the future of banking explores the outlook for the region’s banks from a number of angles.

A strong focus on old fashioned banking, or customer loans, was a key reason for the limited impact of credit crisis in the region. This focus looks set to continue. The way our banks do business, and the customers they seek will not change. What will be different is how they attract money. Conservative funding will prevail for years to come, restraining returns for shareholders as leverage is reduced.

But opportunities are there for Asian and Australian banks. They will develop new ways, independent of existing European and US models, to develop technologies, seek growth opportunities and service their customers.

The local regulators attained national hero status for their proactive approach to overseeing the banking system, but they can’t afford to rest on their laurels. In a globally connected world they will have to ensure that our policies still hold up after a wave of regulatory change has washed through the developed world. Regulators will also have to find the delicate balance between ensuring our four pillars stand firm and giving the next tier of local institutions a fair go.

Who will banks hire to take them into the brave new world? Banks will still attract the best and brightest but they will be enticed by the promise of stability rather than the prospect of bonuses and stock options. And it will be a person with a specific focus rather than Mr Multipurpose that banks will desire. This is the bank of the future.

Traditional is the new chic

By luck or design, a focus on age-old business products helped Australia’s banks avoid many of the massive losses their global peers suffered. What the crisis has changed, possibly forever, is the way banks fund themselves.

“For many years going into the crisis, the liquidity levels of the banking industry were not a great area of focus. That’s going to be a lasting legacy, particularly because Australian banks have a reasonably high reliance on deposit funding,” says James Ellis, Credit Suisse’s banking analyst.

“Banks have increased their focus on deposit gathering and looked to reduce their reliance on short-term funding. At the same time, capital levels have been increased significantly. While this is to some extent a function of the times, I think that even once markets settle down leverage levels will remain comfortably above pre-crisis levels,” adds Tim Roche, an associate director at Fitch Ratings.

This reduction in leverage through increased capital, and the need to hold lower yielding but more liquid assets will hurt profitability.

“All things would point to return on equity coming under some pressure. The question is: what’s the sustainable ROE using cross-cycle assumptions? Going forward, cross cycle assumptions might mean that bad debts will be higher, system credit growth won’t be as strong and liquidity might be permanently more expensive,” says Ellis.

Shareholders could eventually force banks to shed their risk aversion.

“How long this continues will depend on shareholders. They are likely to be tolerant to ultra conservative behaviour for short periods of time but as competing banks take on more risk and chase yield others may be obliged to follow suit,” says Sharad Jain, a credit analyst for Standard and Poor’s.

Guaranteed to reach its use-by date

The government’s guarantee scheme was a hastily introduced at the height of the crisis, to prevent a flight of capital away from the banks. The wholesale debt component is likely to be phased out.

‘The government guarantee for deposits and wholesale funding in its current form is unlikely to be a permanent feature of the banking system, although it will probably take a while for it to be unwound,’ says Roche.

Sharad of S&P agrees. “It is most likely to be a coordinated winding down in consultation with the governments of other G-20 countries, and after the global financial markets have sufficiently stabilized,” he says.

The guarantee scheme on deposits will stay, bringing it in line with other developed nations’ deposit insurance schemes.

“Australia was fairly unique in that it’s had no deposit insurance mechanism in place amongst the developed world. The one thing I can see potentially being changed is the current cap of $1 million, which is relatively high in a global context. A global benchmark is more like $50,000 to $100,000,” says Ellis.

Lending for more than interest

Corporate lending has been a source of pain for Australia’s banks. They’ll be demanding more than additional yield from their big ticket clients.

“Banks don’t want to do just straight lending; particularly as risk-adjusted returns are not very attractive there. I think there are more banks trying to get a greater share of wallet from institutional customers, which they are providing loan facilities to,” says Ellis.

“Because the banks have got liquidity in capital from which to provide lending they’ve used that to get additional collateral business to make a more profitable customer relationship,” he says.

The credit crunch exposed the shortcomings of some of the major banks’ wholesale operations. ANZ spent 2008 dealing with damaging fallout from their “hobby businesses” such as private equity and margin lending. Westpac and CBA had mixed success with intentions to build or improve on their equities distribution businesses and NAB took heavy hits on assets in its structured credit conduits.

“Basically they were going down the path of the ‘originate, warehouse and distribute’ models so it will be interesting to see whether they revisit that model again, because there’s been a substantial pull-back from it,” says Ellis.

It’s AA all the way

Australian banks might be cleaner and leaner but they still face challenges. While S&P has enough confidence to reaffirm the coveted AA stamp on the major banks, they see three potential risks that would lead them to downgrade the banks’ credit ratings:

the banks’ losses could be underestimated;

another disruption to wholesale funding markets could leave the banks once again struggling for funding; and the banks may shed their risk aversion through acquisitions or other strategies.

It’s been a close-run race at times, but our banks pulled through, and what didn’t kill them has made them stronger.