The Day After Tomorrow

Financial services will adapt to its new world with significant changes to its traditional models argues a new PricewaterhouseCoopers (PwC) paper

The global financial landscape has reshaped significantly, states a new PwC paper, “The Day after Tomorrow’’. The paper analyses the emerging themes and new models as the fallout from the credit crisis continues and financial services providers grapple with a new environment.

According to the PwC paper, a distinguishing feature of the new landscape is an accelerated shift of economic power towards the East; a simpler more transparent form of banking based on a more classic banking model; Governments “inside the tent’’, raising significant conflicts of interest; a stricter governance structure based on national and international regulation; and the need for sustainable business models that move financial institutions from survival to longer term strategies.

Commenting on the new financial services world order, Richard Kibble, PricewaterhouseCoopers partner in the Financial Services Strategy team, said:

“Financial transformation of this kind is unprecedented and as the financial crisis has developed it has become clear that the only thing you can expect is the unexpected. Consequently, old ways of working may no longer apply in some instances and wholesale change across the sector can be predicted. The interdependency of the global markets combined with the vast array of stakeholders - government, regulators, management and shareholders - with interests in returning to less volatile times, make it ever more vital that action to deal with uncertainty is taken. What began as a crisis for individual markets and institutions has now undermined the foundations of the entire global financial system. Systemic problems require systemic solutions”

Key findings of the paper include:

The rise of Nouveau Classic banking

A smaller, more tightly regulated banking system and the dominance of the universal banking model will be central features of a new banking landscape. The shadow banking system will largely be dismantled and banks that relied heavily on capital markets for their liquidity and that were specialist, rather than universal, are having to restructure.

Kibble says that in future, this “Nouveau Classic” banking model will be simpler, more risk averse and more transparent. “Profits will be lower, but risk-adjusted returns will not drop by as much, because the risk profile of the business mix will also decline.”

Tom Winterboer, PwC SA, Banking and Capital Markets Leader, says that banks will return to prioritising strong capital ratios, putting solvency before profitability, cleaning up the risky areas on their balance sheets and installing appropriate liquidity buffers that stand up to stress testing. “Banks will also revisit their credit and risk criteria, making these more stringent, managing their collections more effectively, and reducing risk concentrations to those industries which are presently vulnerable. Risk management and capital allocation will be key focus areas.”

SA banks, with a limited and isolated funding pool at home, do need to look offshore for expansion capital. Overseas funding available to emerging markets, and that includes SA, is now limited. Future projects that showed positive returns a year ago are no longer viable in the new capital raising and will need to be cancelled. For those who can move ahead with new projects, these will tend towards the less risky type of investments.

Winterboer says that the shadow banking system will not completely disappear in SA and we will still retain aspects such as hedge funds and other operations which are highly focused on derivative instruments.
Globally, banks will retain a larger part of their own origination and will take more responsibility for the due diligence necessary to ensure credit quality.

Government “inside the tent”

Governments are expected to intervene more heavily in the way the financial system operates, in order to stimulate worldwide economies. This intervention is already evident in the US and the UK with pressure being applied to state-supported banks with respect to re-possessions and foreclosures and SME lending. More conflict should be expected as Governments reflect society’s wishes and exert influence on banks’ governance, tax, dividend policy and compensation. After such a massive bail out, society expects that the banks will adjust their behaviour to reflect the wider public interest and not necessarily shareholder interests.

During these times of uncertainty and volatility, South African authorities are expected to apply pressure, to increase capitalisation levels, which in time may become more formalised through regulation.

The pursuit of “zero-risk” regulation

The fundamental weaknesses in the regulatory regime have been exposed, and material, substantive changes to the regulatory environment will be made. There is recognition that regulatory shortcomings cannot be dealt with on a national basis alone. The G20 has already outlined an Action Plan for Regulatory Reform. However, while establishing one regulatory college would be fraught with conflicts of interest, it is an approach that must be strongly reviewed. The concept of regulatory colleges is not new, but giving more authority to the lead supervisor would strengthen the concept. At the very minimum, the idea of a college of supervisors must be pushed to the limit, with a strong lead supervisor with the mandate to direct local regulators.

The on-shore sector will have more regulation in more areas. Overall, financial stability will be the primary concern and anything that affects it will be regulated in one form or another. This will be aligned with a greater influence from Government over state-supported banks’ strategies.

Winterboer says this trend toward zero-risk regulation will spill over to SA as the SARB does tend to follow the approach of the UK’s Financial Services Authority and the US Federal Reserve in many aspects. “We must also give credit to SARB for its historically strong regulatory approach, being an early adopter of international regulatory trends, and its foresighted approach as served SA well. Our exchange controls, the strong regulatory influence of SARB and its prudent responses have all benefitted SA in the build up to this global crisis. And while SA and the rest of the world can never get down to zero risk in a banking system, we should migrate towards much more acceptable levels of risk than seen in the past.”

Unprecedented fiscal pressure

Tax implications will be great for Western Governments that will face intense fiscal pressure as the recession and the decline in asset prices both reduce tax revenues. Banks will face a short-term reprieve but, in the longer-term, taxes will have to go up. Given the importance of financial services to the economies of the developed world, it is natural that Governments will seek to tax the sector more heavily. The Government will tell the banks – “we saved you from disaster, now we want you to pay your fair share”.

Shift in global power towards the East

The shift of financial power from the West to the East has accelerated. The credit crunch has burst the asset bubble predicated on the investment flows generated by the macroeconomic imbalances in a US-centric global economy. The new patterns of world trade and investment that emerge from this fundamental rebalancing will look very different from the US-centred system.

Kibble comments: “We are moving to a multi-polar world where Western financial centres could be bypassed. Successful globalisation has always followed its customers and therefore banks will follow their customers’ natural trade routes. As the East invests to protect the natural resources it needs to fuel its economies, the banks will follow this investment.’’

Kibble says we could see one or more of the big Chinese banks buying a significant stake in a western bank, perhaps taking majority control or even outright ownership. “This may happen sooner than expected, as in the current financial turmoil most governments would find it hard to reject a serious private sector offer in place of taxpayers' money if another bail out is needed. Alternatively, they could react when the governments' stakes in banks are put back on the market.”

In South Africa, and Africa, the presence of Far Eastern financial services has been growing over the past few years, and in the medium term Winterboer says we are likely to witness cross-border tie-ups between emerging markets. “The Bank of China and China Construction Bank have both set up operations in SA. The most notable penetration of the Chinese in SA is the acquisition by Industrial and Commercial Bank of China of a 20% stake in Standard Bank. This deal established a clear springboard for ICBC into Africa as a whole and into all other countries where Standard Bank is established. An investment by an emerging economy in another emerging economy buys not only footprint but expertise of a very high order.”

From survival mode to sustainable strategy

Financial institutions must resist the temptation to become completely reactive at the expense of longer-term considerations. At the same time, they must adjust to the realities of doing business in a world where the interest of multiple stakeholders – governments and society in general – have become more important.

Kibble says “To get financial institutions working, a sustainable business model is needed. Most institutions are stuck in survival mode, when their executives need to be taking decisions now on where the business will be in two or three years’ time. My concern is that a lot of organisations won’t address the problem now, which will put them at a competitive disadvantage in the future.”

Winterboer agrees that companies and their leaders do need to make key decisions now despite the uncertainty and they cannot passively ride through these times. “Financial institutions should be assessing whether they really belong in certain sectors of the market and they should exit their nonperforming operations. They should also reallocate capital to more profitable areas and look out for acquisitions which can be made at very attractive prices. They must revisit their pricing of credit and higher risks need to carry a premium. Overall, they must become leaner, and on the one hand while trimming their cost structures, they should remain alert to talent coming on to the market and even hire people where appropriate.”

Winterboer cautions that although we have seen most of the financial crisis filter through the global economy as structured products unwound, giving rise massive losses, we are now facing a second wave of uncertainty – that of the economic crisis. “Commentators point to anything between 400 000 to 600 000 jobs being lost in the SA economy. Demand for resources is shrinking and export and related industries are being affected. Despite moving into a declining interest rate cycle, we still face inflation and current account deficit risks. The implications are serious and business needs to be prepared to survive what could be an equally onerous onslaught. However, besides riding out a second wave of challenges, it remains important for banks to also strategically position themselves to capitalise on the opportunities once the cycle turns.”