By Ronan O’Kelly, Partner and Global Head of Corporate & Transaction Banking
This article first appeared as a blog on LinkedIn
As most of the northern hemisphere departs for well-deserved summer breaks after an extraordinarily challenging first half, corporate and transaction banking leaders will be reflecting on what is to come in the second half and how they re-boot their strategies. In this short note, I share perspectives on the top priorities for corporate banking leaders in H2 2020.
The first half of 2020 has been the perfect storm. Corporate banking has gone from being the growth engine of wholesale banking to being on the front line of the crisis. Provisions have spiked to the highest levels in a decade (~14x pre-crisis levels); net interest income (NII) has collapsed as central banks cut policy rates to near zero or negative (transaction banking revenues -8% YoY); and banks have had to manage the operational challenge of meeting the extraordinary demand from corporates and SME for emergency credit (often via government schemes). While banks have done well to support their clients through the crisis (which should pay dividends in future), the economic impact on corporate banking has been real.
At the same time, the competitive threat of disruption from new entrants and expansive incumbents has not gone away (though the neo-bank threat has somewhat subsided as their own business models are challenged).
Our outlook for full year 2020 is for overall revenues for corporate and transaction banking to be down around 10%, as net interest margin (NIM) remains compressed, loan volumes subside, and GDP recovery remains patchy. Net profit and return on equity will be negative for many, driven by high levels of impairments. The outcome is highly sensitive to the trajectory of the pandemic (whether a second wave peaks or remains localized; when a vaccine can be deployed at scale) and the effectiveness of government action (whether government lending schemes and other economic stimuli are sustained to drive an economic recovery).
The outlook also varies by region with markets that enjoyed higher rates pre-crisis facing further to fall than the Eurozone, which has been living with low rates for some time.
We see four key priorities for corporate and transaction banking leaders in H2 2020 as they navigate this challenging and uncertain environment.
1. Managing adverse credit impacts
New provisions for H1 2020 are at record levels, and there is likely more to come. Our analysis suggests, however, that in Europe credit losses will be less severe than in the financial crisis and that banks are better capitalized to sustain losses. Nonetheless credit impairments will have a material impact on post-provision revenues and returns for corporate banks, and require decisive action on managing the existing credit portfolio as well as how and where to extend new credit. Traditional credit decisioning models based on prior year’s financial accounts are of limited value in such an unusual and uneven economic situation.
We are working with a large number of banks to develop highly flexible sector and country specific stressed cashflow and liquidity models to identify the viability of individual companies, and the sustainability of new debt. Our model suggests that in a ‘second lockdown’ scenario 30% of corporates will be unviable or unable to service new liquidity requirements. The outcomes are highly skewed by sector.
This will have an important bearing on both forward-looking provisioning as well as new credit extension. Furthermore, many banks are starting to think about the potential conduct impacts of COVID-19 related lending and ensuring they demonstrate that actions taken during the crisis were fair, consistent, and transparent.
2. Hunt for fee income
Net interest income (which for many corporate banks represented around 70% of total transaction banking income pre-crisis) has fallen off a cliff as central banks have dropped policy rates to near-zero or negative. Most expect rates to remain at current levels for at least through to 2022 as central banks try to support the recovery. This is forcing banks to focus on driving fee income to partly substitute the lost NII. In a rising rate environment fees were frequently waived (for up to five years) to capture payments and liquidity mandates, which were monetized via NII on deposit balances; that strategy no longer works. Banks are working on a number of fronts to mitigate this loss:
- Deposit re-pricing using behavioral characterization to better align deposit value to bank funding requirements and regulatory ratios (NSFR and LCR)
- Charging for deposits in negative yielding currencies via large balance charges or negative credit interest structures
- Incentivising corporates to place excess deposits in higher yielding investment funds such as money market funds, reducing the returns drag from excess deposits as well as earning arrangement fees
- Greater discipline on fee collection, including scaling back use of waivers, ensuring contractual fees are collected, and embedding much stricter controls for discounting
- Creating new fee income streams for services such as channel access, API usage, reporting and operational servicing
3. Cost discipline
Cost is back on the agenda for corporate banks after many years of growth and investment. It remains one of the few controllable levers in a challenging economic environment. The challenge will be to take out as much near-term cost as possible to mitigate revenue falls and impairment impacts, whilst protecting investment in longer-term transformation and innovation. Banks are focusing on a number of levers:
Tactical cost reduction: reducing discretionary spend (for example travel), re-prioritising the investment portfolio, reducing use of contractors
Footprint reduction: exits of certain sub-scale markets or segments, unproductive client relationships and product lines, with a view to removing entire segments of the cost base and freeing up risk-weighted assets (RWA) to be redeployed more productively
Organizational simplification: combining operational and support teams across Cash, Trade and Lending, and client segments; hubbing teams in fewer and lower cost locations; creating utilities for common activities (such as client servicing, document management)
End-to-end process streamlining: re-engineering major processes such as credit, onboarding or documentary trade, to structurally take cost out end-to-end and improve the customer experience. This often relies on cross-functional collaboration (including with Risk), and deploying an integrated workflow solution to support straight-through-processing
Technology re-platforming: demising legacy technology and deploying new, cloud-based and modular technology platforms to support end-to-end digital journeys, lower operational cost and superior customer experience (and thereby market share gain). While the capex for these initiatives is high, the case is to move to a structurally lower (and variable) cost base for the future.
4. Breakout growth
There is a need to reset the growth story for the business in light of a more challenged outlook. While almost all corporate banks benefited from a rising tide in the previous cycle, we believe that breakout growth will require much more active pursuit and not all banks will be positioned to capitalize on it. While there are many angles and opportunities, we see three major trends emerging across the industry:
Sector-led growth: re-orienting the corporate bank to place sector as the primary axis of organization, balance sheet strategy and capital allocation, to skew focus towards faster growth and avoid excess exposure to adversely impacted sectors. Leading banks are deploying deep sector insights and analytics to support client conversations, and are developing targeted sector propositions to specific sectors (such as real-time payments solutions to automate insurance claims settlement, or ecommerce marketplace lending solutions). Sector will also play a critical role in financing the transition to a low carbon economy, and banks are starting to more explicitly embed this into client selection and portfolio strategy.
Group-wide payments: many banks are making big plays on payments-related businesses across the group (including wholesale and retail payments, cards, transactional FX and merchant services). The objective is to expose more of the value of these businesses to the market to boost valuations; to drive faster growth through investment and innovation in these businesses; and to develop innovative cross-segment propositions to drive growth (for example B2B2C opportunities). Examples include scaling up physical or virtual merchant services offerings (Citi Spring, or Natwest Tyl), or reorganizing group-wide payments into a single unit to benefit from synergies and investor visibility (for example JPM Wholesale Payments)
Banking-as-a-service (BaaS): a number of banks are exploring how they can develop BaaS offerings to leverage existing capabilities and create new and more stable income streams. These solutions are typically anchored on scale business offerings for existing banks, such as payments or FX. These can be offered to smaller banks who may struggle to cover the fixed cost base of technology and operations for these products and are looking to move to a more flexible cost structure. The offerings range from execution and clearing services, to operational processing, full-stack technology provision, and white-labelling of customer channels. The market remains somewhat nascent and has previously been held back by competitive concerns as well as challenges of operational resilience. There is hope that this crisis – as well as modular technology offerings – provides the stimulus to turbo-charge this new business opportunity, benefiting both provider and ‘customer’.
Striking the right balance between the tactical and strategic will be critical. Some of these themes will remain relevant for many years after the crisis. Every major crisis shifts the competitive landscape through a combination of structural forces weakening (or strengthening) specific sectors and the best firms mobilizing quickly to their advantage.
Today’s conditions are very different, but offer similar potential for leaders to outmanoeuvre the competition to create sustainable competitive advantages.