Wither the old banking models?

THE cracks in the banking system have once again been ripped open. Twice in the past decade, banks all over the world have slid considerably on all parameters. The 2008 crisis brought down many banks, nationalised many others, changed the metrics for their measurement and ushered in new adequacy and stress norms. This regime is not even 10 years old, a small period in industrial cycles. We are already in the midst of the next tsunami.

The Chinese banks are not the only ones to show severe stress. Global banks like Citi, HSBC, Standard Chartered and Deutsche Bank have had more bad news in recent weeks than they have had over the past five years. These and others have been scurrying for remedies that include massive layoffs (what's new?), sale of significant parts of the businesses or geographies and reorientation of the business itself. None of these banks have secured any assurance from the regulators or the retail investors that they have a good plan. Even the better run banks in Singapore, for instance, have shown some vulnerability of late, arising from serious issues in oil and gas, property sectors, etc. The US banking industry was racing towards a record year of profits by the second quarter of 2015 but has since shown weaknesses with unquantified provisions for bad loans and significant other scums floating to the top.

While each bank has a slightly different ailment, the broad issues are the same. Overexposure to risky assets, slow adequacy compliance, lack of innovation in stagnant market segments, bloated overheads, continued overpay for top executives and in some cases, rudderless voyage. Since 2008, governments have had more ownership and more say in the running of "too big to fail" banks. It is debatable if that has improved performance or led to complacency or merely shared the blame.

Who will bail them out this time? And more importantly, what will be the contours of the new banking industry? The 2008 fix has taught us that whatever was done was a symptomatic cure. The long-term malaise continues. Let us examine some of the holy grails of the past.

The 80s and 90s saw a major consolidation of banks all over the world. Becoming big was everyone's KPI. Banks bought others as big as themselves or bigger. Economy of scale was touted as the management principle behind these moves. (It was proved in 2008 that individual grandstanding was an equal contributor). This theory is now proved wrong, except in one or two cases. Banks are therefore shrinking to avoid collapse. CEOs now tell us that consolidation brought together incompatible entities or the grafting was poor. The slow global growth is another handy alibi.

Asset-backed consumer lending was considered safer than lending to over-leveraged corporates. This myth was partially broken during the sub-prime mortgage crisis which sent property prices crashing and left open gashes of uncovered debt. Fannie May or Freddie Mac became famous names out of nowhere. The new stress comes from high personal loans. In several economies, the percentage of personal debt to GDP has leapfrogged and regulators jumped in to rein them in. So a once lucrative segment for banks has become anaemic.

The large American banks and financial institutions invented the next big profit lever - non-interest advisory income. That had an amazing run of three decades and is still chugging along, albeit slowly. Some very large deals like the Pfizer- Allergan and SAB Miller (Anheuser-Baush) have clouded the aggregate numbers in the past year. Competition for the same pie would put pressure on pricing in this fee business.

Technology was the new mantra that would pull banks out of the morass. New consumer benefits, ease of banking from home, mobile banking, ease of investments and self-management of portfolios, etc., have definitely ushered in more power in the hands of the consumer and therefore redefined bank-customer relations. It is not clear if the massive investments in technologies have been fully compensated by cost savings from operations and manpower. Thus banks have merely shifted costs from one head to another. The new age banking is still not a large opportunity.

New geographies were to be the sunrise opportunities. Countries in Africa, Asia and Latin America still have a large unbanked population, in some places exceeding 50 per cent. The entry and early profitability in these markets are difficult, but those who have staying power can reap the rewards. It is a 20-30-year haul. This opportunity has been disrupted by mobile banking and new generation payment apps. Some African consumers have a smartphone but no bank account. Banks have been too slow to embrace this business and have watched telecom players, technology startups and others seize the initiative. If you are not a borrower but just need to be able to handle several small payments, you need only a mobile wallet.

Non-technology innovations have been hard to come by. The necessity should have spurred it, but firefighting has sapped the banks of energy and the vision for radically new thoughts. Given this scenario, banks have had to fall back on the traditional sectors of large corporate and government borrowing, including unsecured credit. Without doubt, that has jeopardised the risk profile. NPL (non-performing loans) have climbed up steeply everywhere. Countries have become bankrupt (Greece) and so have many large borrowers (Kodak, Quicksilver Resources). The energy sector trauma has not yet fully played out. An NPL of 2-3 per cent of the portfolio is already considered alarming. The Chinese banks are supposed to have undeclared NPLs of over 10 per cent. Many of the Indian banks are slowly bringing out the skeletons, thanks to a nudge by the Reserve Bank of India.

In the meantime, the hot button topic of top management compensation for bankers has surfaced again. CEOs continue to be delinked from institutional fortunes. Some have lost their jobs but many have actually stayed on and improved their wealth. No lessons learnt from the 2008 scar. It is still beyond comprehension why the sector should pay its CEOs US$10-30 million per annum while other sectors generally languish below the US$10 million mark, often much lower. The pressure on salary bills is met by retrenchment - myopic but cheering news for investors.

Bill Gates said in the 90s, "we will need banking but not banks", referring to predictions on technology. Times are therefore ripe for a major course correction for the global banking industry. What will be the new model of business? Is going back to nimble, smaller and risk-balanced banks the alternative? One of the most profitable banks in the US is US Bancorp, that returns over 15 per cent on equity (this is not even their best year), about 50 per cent more than what is achieved by large banks (industry average 9.22 per cent) and is only about 15-20 per cent of the large banks in terms of asset base. There are other similar examples in the US and other markets.

In the meantime, the private equity players have maintained their financial health, although the heady days have gone. These players have diversified into corporate debt (yes, the same risky asset class that we talked about) and even large real estate investments (with implications for short-term liquidity). So, are they in for some shakeout as well?

Credit expansion is one of the barometers of economic progress. Except for the United States, credit is not expanding significantly and this bodes ill for a global growth takeoff. Large sectors like oil and gas and commodity are in winding mode. Banks need a paradigm change, too soon after the 2008 rescue. Along with it, some metrics will change. Size of loan portfolio, net interest margin and short-term profits to drive stock prices may give way to risk, liquidity, capital and consistency measures. The icons will change from large global banks to consistently well-run local and regional banks. And maybe the era of superman bankers will change too. It is deja vu.