The Shape of Things to Come

This report is built on research we have conducted over the summer of 2013, looking in detail at historic bank performance and the revenue and asset dynamics of the sector.

It outlines what we expect for the industry in the coming years across a range of areas, including:

•   Changes to the competitive landscape
•   The role of shadow banking
•   The relationship between banks and governments
•   The returns delivered to shareholders
•   The agenda for senior industry executives

"The Shape of Things to Come" demonstrates that European banking has proved surprisingly resilient in recent years, though returns have declined dramatically and the sovereign influence has become increasingly dominant in both performance and valuation. As a consequence of our diagnosis, we believe that institutions will need to address three important challenges in 2014: the growth agenda and strategy, managing deleverage and decoupling from the sovereign, and simultaneous improvement of cost efficiency and customer service.

Increased capital to meet regulatory demands has further depressed returns

Returns for European banks have collapsed, from highs of ~20% in 2006 to ~4% in 2012. This is because of large provisions for non-performing loans (NPLs), a flood of other extraordinary charges (restructuring and conduct-related fines), significantly increased equity-to-asset ratios and insufficient reduction of operating costs. The rise in regulatory and compliance costs has swamped cost reductions.

European banking future Oliver Wyman

1Who are the biggest competitors to traditional banks?

Small new competitors are emerging and, whilst they do not pose an immediate threat, incumbents would be wise not to discount them in the medium term. Additionally, significant equity value is being created at the periphery of the industry by non-banks delivering infrastructure and information-based services. Banks need to wake up to this trend to avoid significant transfer of value to companies outside the established industry. (We explored this in more depth earlier this year – see The State of the Financial Services Industry 2013
2Shadow banking has been described as a threat to banks for a long time – is this still the case?

We expect the role of non-bank balance sheets in financing to grow in Europe. However, the threat of the shadow banking sector to bank earnings and intermediation has proven to have been overblown. As leverage constraints kick in, banks have every incentive to find ways to finance their issuer clients without consuming balance sheet. And there are lots of opportunities, from underwriting fees for bond issuance, to origination and credit facilitation for loan investments from insurance companies, sovereign wealth funds and pension funds, and also the opening up of securitisation markets.
3Will governments remove their injections of tax-funded capital in European banks?

State funds designed to avert economic calamity by ensuring banks could continue to intermediate credit flows have provided vital support to banks. Since 2007, European banks have raised about €700BN of capital, about €350BN of which is from the public sector. Most European governments don’t want to be long-term investors in banking and the banks want to return to private shareholder ownership. The public sector still owns about 17% of European banks’ equity. Whilst there has been some recent activity in this area (e.g. with LBG’s recent share sale) there is a long way to go.
4What does each sovereign’s economic status mean for their domestic banks?

Our research shows just how strong the links are now between sovereign and bank returns and valuations, which opens the decoupling discussion. Decoupling means the scope for the performance, risk profile and valuation of the banks to separate from their sovereign and vice versa. Since banks have received significant government equity and liquidity, government balance sheets are now exposed to the performance of the banking sector. On the flipside, banks have built up additional buffers of government debt. Additionally, the broader economy is reliant on a functioning banking system to support growth, which impacts government deficit positions. So each party wants to disengage, or decouple and the report explores ways in which that can happen
5What should banks be doing about all of this?

Lots of important factors are out of their hands, such as interest rates, NPL ratios, economic growth and regulation. However the banks have important choices to make: how aggressive a growth strategy to pursue vs. knuckling down and driving out efficiency in home markets, how to shape their balance sheets, how to set up their legal structures and how to channel much needed investment to get costs down are those we would highlight for 2014.