Home Banking Is the Global Banking Sector Swimming Naked Again?

Is the Global Banking Sector Swimming Naked Again?

by internationalbanker

By Sanjay Sharma, Ph.D. Adjunct Professor of Finance and Business Economics, Marshall School of Business, University of Southern California

 

 

 

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A ship is safe in harbor, but that’s not what ships are for.

William G.T. Shedd

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Banks in several global geographies are emerging from a challenging 15 years since the 2008-09 global financial crisis (GFC). This is when the tide of easy credit receded rapidly, and the sector’s naked exposures and practices were brutally revealed. Some banks never fully recovered; the walking wounded, such as Credit Suisse, had to be subsumed by other banks through shotgun marriages. Others, such as Deutsche Bank, appear to be clothed, but not in the eyes of the equity investors who value its book value at a mere 0.4—very nearly naked and vulnerable to drowning. Its low price-to-book (P/B) ratio indicates overstated loan portfolios and high-risk exposures, alongside low expectations for generating returns on capital.

The longstanding providers of emergency raincoats are running thin on their abilities to help themselves—the largest being the US Federal Reserve (the Fed), with its balance sheet registering an eight-fold increase since 2008, and the European Central Bank (ECB), with a four-fold increase—a bit decent but nothing compared to pre-2008 days of ample dry powder to cover many a capital-deprived damsel in distress.

Calm seas seem everlasting, but tidal shifts are inevitable. The seas will churn as they always have. We cannot predict if tsunamis will be caused by geopolitical events, widespread crumblings of real-estate behemoths such as Evergrande Group in China, macroeconomic shocks, liquidity crises or contagious credit defaults. Recent World Bank estimates show high double-digit recession probabilities for most countries and geographies. This should not be taken lightly. To prepare for tidal shifts and strong undercurrents, we should be ready with life jackets and breathing apparatuses.

Here is a five-point checklist for suiting up for rough tides:

  1. Invest in businesses with strong and sustainable returns on capital (ROC) and business and functional units while exiting the others.
  2. Invest aggressively but selectively in new technologies to enhance operating efficiency and maintain competitiveness.
  3. Use optimal operating and governance models to deploy generative AI (GenAI) across business and functional units.
  4. Embrace and capitalize on climate-risk mitigation and impact.
  5. Condition business units for inflationary scenarios and prolonged recessions; create liquidity buffers and backups for systemic contagion risks.

Selective investment and capital across business segments

Over 2022-23, banks posted the highest profits and returns on equity (ROEs) in more than a decade. Can this be sustained? It is highly unlikely that global economies will find a steady balance between consumption and net investment and ward off recessions and inflationary pressures. Goldilocks economic conditions are seldom long-lasting. At this point, global macroeconomic prospects present a mixed picture. We are entering a cycle in which economic conditions across geographies will diverge, creating pockets of strong growth (India and Pan-Asia) and stagnation (Europe). Demographic differences will also drive this cycle.

Given this outlook for the global economy, international banks should be extremely selective about their investments in capital commitments across businesses and specific geographies. Banks holding balance sheets with mass intermediation footprints and prowess, as well as client proximity and stickiness, should not be compelled to compete in businesses in which they have critical size. The most prominent businesses are payment and transaction services, in which nonbank firms have made massive investments to achieve scale, strong returns and unassailable competitive positions. Universal banks should pick their battlegrounds in selective geographies across payment services, capital markets, commercial banking, investment banking, retail, cards and wealth management.

Investments in technology

Most universal banks with established histories have technology-stack amalgams of legacy systems overlaid with pockets of newer applications. This is largely the result of bank mergers and decades of band-aid approaches to system renovation and integration. During lean periods, banks’ discretionary technology budgets are generally first on the chopping block. As business and functional units learn to make do with the band-aid approach, operating on lean budgets is taken for granted, and subsequent budget cycles are adapted to lower baselines. This continues until high costs and poor efficiency eat into the bottom line. Large capital outlays are then deployed for “transformative” projects that often have long implementation timelines. Often, it is too little, too late. Laggards in technological investment and efficiency risk losing their competitive positions and market shares.

As financial-technology (fintech) cycles have become shorter with the advent of GenAI, banks cannot consider capital investments in core and customer-facing systems as discretionary. They have already ceded the payment-processing sector to firms that, not long ago, were considered upstarts. Banks with strong capital positions and discretionary investment capacities must make “offensive” investments in emerging technologies to gain a competitive edge.

Deployment of generative AI across business and functional units

Hype aside, the potential of generative AI to transform the efficiency of financial services is vast—including innovation and the creation of new products and services. Beyond the risk of being on the bleeding edge, banks can get caught up in flawed or suboptimal operating models for deploying game-changing technologies. While the contemplated uses of GenAI span the gamut—including customer service, fraud detection, product-creation customization, advertising and business collaterals, regulatory reporting and software-code development—it is critical to configure the types of operating, governance and management models under which they will be deployed at the outset.

As banks leap into GenAI—through their technology personnel or outside specialists—they must contemplate and consider the operating models that fit their cultures and organizations and the types of GenAI technologies being deployed.

Typical operating models for technology at banks range from central command, execution and control to fully decentralized at the business-unit level. For conventional or pre-GenAI technologies, the choice of operating models was between agility, control and cost.

Because the use cases for GenAI can span across business and functional units, the potential for their wider deployment can be constricted if they are used in siloed operating models. On the other hand, this technology presents a different paradigm—at least until the “bleeding edge” of intense innovation and experimentation settles into the “cutting edge” and the “widely adopted”. Middle-of-the-road models centrally guided and executed at business levels are also feasible but will be conditioned by the complexities, scales and cultures of individual banks.

Proactive management of climate risks and tighter regulation

Credit deterioration and defaults from climate risks are inevitable, coming with increased frequency and ferocity—crop failures, damages to homes and commercial real estate, carbon levies and taxes are on the way. The outlook for fossil-fuel producers could change on a dime if large-scale green technologies become mainstream and economically feasible. With estimates of $20+ trillion to be deployed over the next decade towards green technologies, this will be a historic opportunity for banks to anchor their positions across countries and geographies. Basel regulations (of the Basel Committee on Banking Supervision, or BCBS) promulgate active management and reporting of climate-change risks (both physical and transitional) for their loans, counterparties and investment exposures. If banks wait too long, some of their exposures will suffer losses similar to commercial real estate, particularly in the United States.

Liquidity stress and capital preservation through macroeconomic turbulence

Global regulators are already expanding the breadth and depth of their rules and oversight. They are aware of the social backlash that can ensue after isolated or systemic bank failures (Silicon Valley Bank is a case in point, where poor management and supervision came under public and governmental scrutiny).

Belts and suspenders may feel a bit more expensive when you have a jacket, but they do hold up trousers in rough waters. Basel IV, V and VI will eventually come—and much faster if we go through a scare, however small it may be.

 

 

ABOUT THE AUTHOR
Sanjay Sharma, Ph.D., is the Adjunct Professor of Finance and Business Economics at the Marshall School of Business, University of Southern California (USC). Sanjay is also the Founder and Chairman of GreenPoint Global. His career in the financial-services industry spans three decades, during which he has held various C-level positions at Royal Bank of Canada, Goldman Sachs, Merrill Lynch, Citigroup, Moody’s and Natixis.

 

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