Day of reckoning for European retail banking McKinsey report July 2012 The dynamics of the global banking sector have been in flux since the beginning of the 2008. Irate creditors everywhere have called for more stringent regulation to ensure that that the interests of financial institutions are more closely aligned with those of their customers and shareholders. The global, European and national authorities have responded with vigour and the regulatory reform to which all banks, wholesale and retail, will be subject in the coming years will have an important impact on their bottom line.
The single biggest cause of a reduction in retail banks’ ROE will come from the global regulatory mechanism Basel III, which will place greater capital requirements on banks and more emphasis on adequate funding and liquidity. Furthermore, three important European regulatory instruments, the EU Mortgage Directive, the Markets in Financial Instruments Directive (MiFID II) and the Single Euro Payments Area (SEPA), Payment Service Directive, will also considerably diminish ROE. Finally, the implementation of new national regulation will create further downward pressure on ROE, though this will vary considerably from country to country.
This report provides estimates on the impact on capital, revenues, costs and profit margins of all the relevant regulations on each product (both asset- and liability-based) in each of the four biggest European markets – France, Germany, Britain and Italy – which combined constitute 66% of the EU27 retail-banking market. ROE is the standard metric used and the report calculates the cumulative effect of all regulation as if it were all put in place immediately, using 2010 as the baseline year. The paper reaches some important conclusions.
Firstly, with regard to national and continent-wide retail banking markets, ROE will fall from approximately 10% to 6% when all four markets are taken as a whole. Below is a breakdown of the effect in each of the national markets: Country France Germany Italy UK ROE Pre-Regulation 14% 7% 5% 14% ROE Post-Regulation 10% 4% 3% 7% Delta -29 -47 -40 -48 The impact in the UK is particularly caustic as national regulation is extensive. In terms of the effect of regulation on the different product offerings of retail banks, asset-based products are generally the harder-hit.
In the UK and France, mortgages and small-business loans will be the most adversely affected. Similarly in Germany mortgages, personal and small-business loans will be the most negatively influenced. In Italy, the value of every asset-based product will be impaired. The disheartening truth of the matter is that across the board the ROE of asset-based products will fall below 10%, which is currently the estimated cost of equity for retail banks. On the other hand, liability-based products will prove more resilient.
Deposits will become more valuable to retail banks as they are an advantaged form of funding and liquidity under new regulation. Geographically speaking, in France and Germany only investment products and debit cards will be negatively affected and in Italy most liability-based products will escape relatively intact. However, once again domestic regulation in Britain will play a role in reducing retail banks’ ROE, to the extent that all liability products in the UK will be adversely affected. An important section of the report discusses global systemically important financial institutions (GSIFIs).
Such pecuniary establishments are considered too interconnected and universal to be subject to the new regulation imposed on smaller-scale retail banks. The Financial Stability Board has therefore proposed additional capital requirements for G-SIFIs, which will induce a further reduction of their ROE of anywhere between 0. 4 percentage points and 1. 3 percentage points depending on the institution. In addition, it will be obligatory for all G-SIFIs to prepare a recovery and resolution plan (RRP) that will provide a strategic map for authorities to wind down the bank in the event of dissolution.
The Basel Committee on Banking Supervision (BCBS) is also developing new global rules on risk IT for G-SIFIs which are expected to be issued by the end of 2012. Such regulation will mean that these organisations will be subject to exhaustive supervision and many ad hoc requests, thus amplifying costs and absorbing management resources. The general conclusion of this paper is that it is improbable that banks across the board in Europe will return to pre-regulation ROE levels in the short to medium term. The UK will be particularly adversely affected due to its inflexible domestic regulation.
Nevertheless, the paper proposes four mitigative measures retail banks can employ in order to cushion the blow of new regulatory forces on their ROE levels. The first is “Technical Mitigation”, which essentially involves improving efficiency of capital and funding. Secondly, “Capital – and funding-light operating models” seek to further improve funding efficiency and reduce risk-weighted assets (RWAs) by implementing changes to their product mix and characteristics and ensuring more vigorous pursuit of collateral and better outplacement of risk.
Thirdly, and although they will be severely limited in doing so by regulatory authorities, banks can execute “repricing” in order to compensate the shortfall in ROE. The paper predicts more repricing in fragmented industries, which implies that the scale of repricing will be limited in the UK, a highly concentrated industry. Types of repricing include new fee-based pricing, modular pricing, partial performance remuneration and value-added packages. Finally, and perhaps most dramatically, financial institutions can engage in “Business-Model Alignment. Such restrategizing would involve two principle shifts. The first centres on a new, rigorous focus on ROE in retail banks, meaning greater investment in management systems and strengthening their resource allocation processes. The second important shift can be denoted as “Sustainable Retail Banking,” and comprises four key elements: expansion into new revenue sources, creation of advice for which customers will pay, reconfiguration and refocusing of the distribution system to render it leaner and simpler and cutting absolute costs by 20 – 30%.
By exercising the above levers, retail banks can create a bulwark against the weight of new regulation and cushion the inevitable reduction in their ROE. Anticipatory forward-planning of mitigation measures is central in adapting to the new regulatory environment engulfing retail banking and will help banks that are fully committed to returning to pre-regulation ROE levels to achieve their post-regulatory reform potential.