Global Risk 2017: Staying the Course in Banking

This is an excerpt from Global Risk 2017: Staying the Course in Banking. The full report is available for download in PDF format.

The banking industry continues on the road to recovery, staying the course of recent years. The globally averaged performance of banks, measured by economic profit (EP), inched higher in 2015 for the fifth year in a row, according to BCG’s seventh annual study of the industry’s health. Our study assessed the EP of more than 300 retail, commercial, and investment banks in 2015.

Banks’ performance comes against a backdrop of intensifying regulation. As we forecast in 2016, the seas of regulatory change have continued to surge worldwide, producing a strong impact on banks’ strategic and operational planning efforts. Asset Managers Face Rising Regulatory Scrutiny, therefore, must remain a priority. The increasing costs of doing so will pressure all banks to create more effective and efficient processes. Top performers will use the opportunity to incorporate technical innovation even as they optimize the allocation of scarce financial resources.

Economic Profitability

Despite the steady, if slow, global improvement, banks’ performance diverged considerably by region. At the same time, the gap between high-performing banks and those performing below par continued to widen in some regions.

In Europe, banks’ balance sheets continued to contract, and their negative EPs remained at the level of the previous year. Income rose, but so did operating costs, and the slight reduction in risk costs wasn’t sufficient to regain positive EP. Moreover, the divergence between top and bottom performers in Europe continued to grow, unlike in North America, where the range of EP was stable.

Banks in North America continued on a positive path. Their balance sheets grew, and they reduced both operating and risk costs. Changes in income did not significantly affect EP.

Bank performance in other regions was similarly diverse. In the Middle East and Africa results continued to improve, while the EP of Asia-Pacific banks shrank slightly. Banks in South America experienced a sharp decline in performance, mainly as a result of increased risk costs.

We have observed that leading banks in the West are focusing on tight and efficient management of resources and costs to tackle the challenges of bolstering and building EP. Also, these banks are finally focusing on regulation at all levels of strategic and operational planning.

Regulation

The era of constantly evolving and increasing regulatory requirements persists. The number of individual regulatory changes that banks must track on a global scale has more than tripled since 2011, to an average of 200 revisions per day.

We have identified three overarching themes in this evolution. The first is that increasing regulation is here to stay—much like a permanent rise in sea level as opposed to an incoming tide that will ebb. We expect this theme to hold despite recent political developments in the US that may augur critical challenges to regulatory implementation. While many of the major, top-priority reform packages are already in place, banks will now face the burden of implementing technical regulatory measures and responding to audits. Second, actions by individual jurisdictions, rather than by globally coordinated initiatives, will remain the source of most new and changing requirements that banks must comply with. Third, the influence of regulation on strategic and operational planning will continue to be significant; for example, regulation still consumes the largest share of banks’ project portfolios. For all three reasons, tracking and complying with regulation needs to remain high on banks’ agendas.

To assess the current status of regulation, we organized the global spectrum into three clusters: financial stability, prudent operations, and resolution.

• Financial Stability. This is the most developed area of reform, although evolution continues. Capital remains the name of the game, as pressure by investors and peers pushes capital requirements higher. Achieving Common Equity Tier 1 ratios above 12% seems to be a minimum goal. The Basel IV reform package, however, is adding both uncertainty and complexity to this environment. The leverage ratio is the second most important indicator in the capital game. We believe that the minimum ambition level for this ratio will rise to 5% to 6%. Stress testing will gain importance, from both a quantitative and a qualitative perspective. The latter perspective requires a governance framework that includes audit processes on scenario relevance and the use of stress test results for management decisions and bank steering.
• Prudent Operations. Since the 2007–2008 financial crisis, strict regulatory enforcement has brought cumulative financial penalties of roughly $321 billion (through the end of 2016). While US regulators have assessed most of the fines, their counterparts in Europe and Asia will likely step up the pace. Managing these costs is a major burden for banks, requiring the creation of a strong non-financial-risk framework to avoid errors of the past. Changing values and ethical standards are already reframing banks’ business judgments and individual executives’ decision making, as the question “Was it lawful?” becomes “Was it legitimate?”
• Resolution. Relative to other areas of reform, resolution remains the least developed and most pressing. There is still no consensus on how to close down (or unwind) banks or on which preparatory, structural measures might be needed. However, some potentially significant contributions to bank resolution are emerging from measures that have already been implemented by some banks or that have been specifically requested by regulators in certain jurisdictions. These include both quantitative and structural adjustments and changes. Quantitative measures include increasing liquid assets, ensuring sufficient “bail-in-able” debt, and reducing balance sheet size. Structural measures include the implementation of nonoperating holding structures at the group or intermediate level within a specific jurisdiction, the reduction of legal-entity complexity, the separation of critical economic functions (which often relate to home markets), and the provision of solutions out of separate service entities.

An Agenda for Staying the Course

Ultimately, managing regulations will remain high on the agendas of banks’ risk and steering teams. Defining an efficient mode of interaction between banks and regulators will be a critical task. However, there are two additional challenges to staying the course using a resource-based strategy.

Bank steering functions, for one, will need to become more involved and effective in overall cost management. Their tools for doing so are varied—from adjusting the organization and operating models to harnessing the strong potential of new technologies. Partnering with both fintech and regtech startups can provide access to innovative capabilities and solutions relevant to bank steering. Offerings include more flexible IT infrastructures that are based on advanced analytics and big data and on improvements in process efficiency and automation.

Nonetheless, banks must not forget that their risk and steering functions are responsible for optimizing the scarce financial resources of capital, liquidity, and funding. Success will require closer collaboration of those functions and more integrated management of the banks’ P&L and balance sheets.

Acknowledgments

The authors are grateful to Trent Reasons, Markus Wiemann, Martin Grossmann, Clemens Elgeti, Anand Kumar, and Sishank Narula—among other colleagues in BCG’s Financial Institutions practice and risk topic—for contributing the knowledge and insights that made this report possible.

The authors thank Jonathan Gage for his assistance with writing the report. They also thank Katherine Andrews, Gary Callahan, Philip Crawford, Catherine Cuddihee, Lilith Fondulas, Kim Friedman, Abby Garland, and Sara Strassenreiter for their assistance with its editing, design, and production.