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THE SHAPE OF THINGS TO COME 2 INTRODUCTION 4

1. INDUSTRY CONTEXT: THE GREAT SURVIVAL 7 1.1. SURPRISING RESILIENCE 7 1.2. GROUNDS FOR CONCERN 14

2. RETURNS, LEADERS AND LAGGARDS 18 2.1. THE COLLAPSE IN ROE 18 2.2. A CAUTIOUS OUTLOOK 20 2.3. SOVEREIGN INFLUENCE – THERE’S NO PLACE LIKE HOME 23 2.4. DELEVERAGING AND DECOUPLING 27

3. THE CHALLENGES FOR BANKS 30 3.1. A BOND OR EQUITY STRATEGY 30 3.2. GETTING DELEVERAGING AND DECOUPLING RIGHT 32 3.3. CHANNELLING INVESTMENT 34 THE SHAPE OF THINGS TO COME

This report examines the recent history of the value from the growth of the ‘direct’ European banking industry and attempts to credit markets. outline some of the salient dynamics underway. These include the changes to the competitive 3. Deleveraging likely to accelerate … but landscape, the role of shadow banking, the remain more limited than many think relationship between banks and governments, the returns delivered to shareholders, and Asset disposals to date have been very low, the agenda for senior industry executives. principally due to public funding support, Anchored in a hard analytical and shareholder a bank-heavy credit intermediation market value lens, we try to extrapolate what we do and structure, the need for net interest margin to do not know about the shape of the industry cover operating costs and a lack of appetite to emerging. Our key projections: take capital write-downs associated with asset sales. We anticipate these factors will continue 1. New competitive structures slow to to drag on restructuring. Nevertheless, balance emerge … but setting down long term sheet restructuring will accelerate, driven by roots … and capital formation in danger of a potentially very significant inflection point drifting out of the core banking sector created by the Asset Quality Review (AQR), the focus by regulators on Capital Requirements Unexpectedly, change to the competitive Directive (CRD) IV leverage ratios and by environment has been slow. The crisis and subsequent response have actually reinforced investors increasingly pricing leverage into barriers to entry. However, new competitors, valuations. We also predict substantial technical small today, are beginning to accumulate and optimisation of banks’ balance sheets to take incumbents would be wise not to discount place in the coming twelve months. the medium term threat. More dramatically, significant equity value is being created at 4. Smooth withdrawal of public capital and the periphery of the industry by non-banks funding … decoupling to gather pace delivering infrastructure and information based European Central Bank (ECB) funding has services. Banks need to wake up quickly to peaked and governments are beginning to plan this trend to avoid significant transfer of value for share sales. As banks’ solvency is improved by outside the traditional banking ambit. the introduction of capital buffers and leverage 2. Increasing role of non-banks in financing ratios, the decoupling of sovereign and bank … and opportunities for some banks in risk should accelerate, somewhat offsetting making it happen the slow progress of a Europe-wide resolution authority and the lack of clarity around resolution The risk to banks of large scale disintermediation and ‘ring-fencing’. We do not underestimate has been exaggerated. If anything, banks now the risk of discontinuities in funding markets, need to push for more disintermediation to enhanced by recent loading of government debt overcome their own balance sheet constraints, on banks’ balance sheets. However, the balance by accelerating the deepening of bond markets of information points to a base case of orderly, and bringing more investors into loan markets. if very gradual, decoupling. Banks will face Banks that can learn to partner effectively with strategic choices about how aggressively to non-bank lenders will generate disproportionate use the decoupling levers at their disposal. 5. Improving returns and valuation … but That said, we anticipate a handful of banks only for some will push for more equity-like earnings growth and, if successful, will be rewarded with higher Returns are at historic lows, with further valuations. We see grounds for caution for the downward pressure from regulatory change many banks implicitly following a hybrid strategy, to come. These returns are highly correlated such as a convertible bond strategy or a bond with country, driven by factors such as funding strategy juiced with some yield enhancement. costs, GDP growth and non-performing loan (NPL) ratios. Valuation has taken a similar 7. Sharper operating models will emerge … path, overwhelmingly driven by country and partnerships and outsourcing key sovereign. However, as NPLs begin to normalise and the decoupling of sovereign and bank risk The battleground for much of the industry will progresses, there will be more opportunity for be cost effectiveness. Costs have risen across idiosyncratic bank strategies to affect returns and the big incumbents by an average of €3.5BN valuations. Capitalisation and cost management each since 2006, despite waves of attempted will be key. Well-capitalised banks will be able cost reduction. More radical thinking has to take to make targeted strategic choices to optimise root, built on bigger spend, channelling more their portfolios, while effective cost reduction technology-focused capex and accelerating will deliver higher returns in the low-growth branch consolidation to generate substantial environment. As a result we expect to see greater and sustainable returns. In particular, we expect divergence of performance and reward as bank supply chains to emerge where much more of strategies reassert their significance. The logic the cost base of the industry is sourced from of technology-led consolidation will become utilities or third party specialists. New entrants powerful, but concerns over creating larger and emerging markets players could appear as banks will deter M&A. A European stability the early winners here. mechanism and single supervisor may change this and put medium-sized deals in developed 8. Better customer service … at least for those Europe back on the agenda further down the line. willing to pay

6. ‘Utility’ banking increasingly attractive … Most European banks have been forced to though there will be rewards for the few concentrate on their home markets. As the who can grow earnings power need to squeeze out gains from market share We take a different view to much of the negative increases and conduct regulation stamps out the commentary about regulators forcing banks to scope to exploit price elasticity, the focus on the become utilities. If delivering stable earnings customer experience has become paramount. with a predictable risk profile, drawing out core We see senior banking executives obsessing, as market operating profits and returning excess never before, about how to make the customer capital through a high dividend policy is a experience more satisfying and hassle-free. utility, then for many banks this will become an The flipside is in more sophisticated use of attractive vision to embrace, and will be rewarded segmentation, giving higher levels of service by investors looking for bond-like returns. only to those able and willing to pay for it. INTRODUCTION

The financial crisis of 2008 has been followed by have converged as country-specific factors a long economic downturn and a sovereign debt such as GDP growth, funding costs and NPL crisis in the Eurozone. You might expect European rates have driven returns. Only a handful of banking to have undergone tumultuous change: banks have bucked this trend and delivered declining revenues, swathes of bank failures, noticeably better returns through strategic consolidation and a significant shift of market portfolio selection, better footprint or strong share to non-Europeans, new entrants and execution. Second, idiosyncratic differences non-bank competitors. of strategy and execution are making little difference to market valuations. Investors need Such expectations have been thoroughly very strong evidence to materially distinguish confounded. Industry revenues have rebounded valuations for banks in the same country. and stabilised well above their 2008 low. Although RoEs have declined sharply, only a handful of This will not go on forever. As regulatory reform small European banks have been wound up. settles and NPLs start to normalise, decoupling Bank balance sheets have remained the same is likely to gather pace, putting more emphasis size they were pre-crisis and the competitive on bank-specific factors in driving returns. landscape has not materially changed. We already see evidence of investors starting Neither non-Europeans nor new entrants have to take more notice of certain factors, such significantly dented market share. And, while as leverage and dividend policy, in valuation. there has been some shift of lending towards Sooner or later individual performance will capital markets, disintermediation and the growth reassert itself in returns and this will be reflected of so-called shadow banking has been muted. in market valuations.

Of course, there are grounds for concern – the European banks will have to contend with three most obvious being the role of government main challenges in 2014. The first challenge intervention in creating this remarkable is strategy selection, where banks have two stability. Otherwise-insolvent banks have been broad options. One is a bond-like strategy, recapitalised and the monetary policies of the where maximum dividend capital is returned ECB and national central banks have allowed to shareholders and the business model is banks to fund themselves at low cost. However, designed to deliver revenue that grows at while the risk of ‘zombie banks’ is real and credit roughly the same rate as GDP within a ‘safe zone’ extension is still sluggish, in the larger non- of core markets. The other option is an equity- peripheral European economies dependence on like strategy, positioning for more growth and governmental support is declining. Especially for earnings upside by investing in new industry the larger banks, private funding is now easier sub-sectors, client segments or markets, or in to find. Banks are rebalancing their government emerging markets simply targeting the white bond portfolios and governments are increasingly space for growth. We raise concerns about the thinking about withdrawing their capital. wisdom of various ‘hybrid’ strategies we see in the market today. Nevertheless, banks’ fortunes remain tightly bound to their home countries in two ways. The second challenge is getting deleveraging and First, the RoEs of banks from the same country decoupling right. Whilst limited deleveraging has been seen to date, and there will continue to “You might expect be drags on balance sheet restructuring, we do anticipate some modest acceleration as new CRD European banking IV leverage targets and the AQR start to impact banks. The withdrawal of liquidity support and to have undergone the introduction of regional stability mechanisms, tumultuous change: resolution authorities and insurance schemes will also naturally encourage decoupling of banks declining revenues, from their sovereigns. Getting the capital plan right, managing regulatory balkanisation, timing swathes of bank the disposal of assets to free up capital for growth failures, consolidation and determining how far to pursue measures such as issuing bail-in capital and restructuring and a significant shift legal entities will be a difficult balancing act for most CFOs. Some banks will be able to exploit the of market share to opportunity to pick up assets at knock-down prices. non-Europeans, new The third challenge is effectively channelling entrants and non- enough investment into new technology and operating models to deliver radical cost bank competitors. reductions while improving the way customers are served. As of today, we still see too many Such expectations banks planning against short payback horizons, have been thoroughly making incremental changes to cost structures and continuing to play by yesterday’s rules confounded.” on customer propositions, when more radical action is required.

We discuss these challenges in Section 3 of this report. In Section 1 we describe the current condition of the European banking industry and in Section 2 we look at what is determining the fortunes of leaders and laggards. As our analysis shows, the idea that European banking is in terminal decline is wrong. The sector has proved surprisingly resilient. But the focus needs to shift beyond ensuring its salvation to discerning its future direction. Senior executives, whose attention has been directed toward regulatory compliance, must return to the question of strategy. THE SHAPE OF THINGS TO COME

NOTES:

Europe: Throughout the report, unless explicitly stated Insurance: Includes both life and non-life insurance otherwise, ‘Europe’ includes countries in the EU28 products (inclusive of bancassurance) offered to (excluding Cyprus and Malta), Switzerland, Norway, households and institutions. For insurance companies, Russia and Turkey. revenues have been estimated as follows to allow for like-for-like comparison with banking revenue: Life Corporate and Institutional Banking (CIB): Includes insurance revenues = Profit before tax + administration products and services offered to mid-cap (annual and acquisition cost, Non-life insurance revenues = turnover ≥€25MM) and large corporate clients across Gross written premiums (net of reinsurance) – claims + capital markets, investment banking, lending and investment income. transaction banking. Sample: The sample of banks used within this report Retail and Business Banking (RBB): Includes all consisted of 100 European banks selected based on products and services related to retail customers (with total revenue size and to provide a sufficient number of a net worth <€1MM excluding primary residence) banks within each assessed region. For each separate and small and mid-sized corporates (annual turnover analysis the greatest number of banks possible has <€25MM), excluding bancassurance and distribution been used, based on the availability of data. Sample is fees for asset management. available on request.

Wealth and Asset Management (WAM): Includes private banking services offered to high net worth segment (defined as individuals with a net worth ≥€1MM excluding primary residence) and asset management for institutions.

1. INDUSTRY CONTEXT: THE GREAT SURVIVAL

1.1. SURPRISING RESILIENCE

The demise of the European banking sector is in most European countries are healthy1. Aggregate overblown. Despite the banking and sovereign debt revenues have bounced back well above the 2008 crisis- crises, the banking revenues across the region and driven dip.

EXHIBIT 1: EUROPEAN BANK REVENUES HAVE SHOWN SURPRISING RESILIENCE EVOLUTION OF BANK REVENUE IN EUROPE, BY REGION, 2008-2012

€BN 900 CAGR ’08 – ’12: 4% CAGR ’08 – ’12 800 %

700 Turkey 14 Russia 15 600 E. Europe 1 500 Greece -10 Italy 1 400 Nordics 8 300 Benelux 9 Switzerland 4 200 Iberia 1 100 Germany & Austria 4 France 4 0 UK & Ireland 1 2008 2009 2010 2011 2012

Source: European Central Bank (ECB), Swiss National Bank (SNB), Central Bank of Russia (CBR), Banking Regulation and Supervision Agency - Turkey (BDDK), Statistics Norway, Oliver Wyman analysis

This resilience has four principal causes: continued CONTINUED FINANCIAL DEEPENING spending on financial services in maturing economies, a muted challenge from foreign players and new As economies mature, spending on financial services entrants, limited disintermediation and support increases, not only in absolute terms but also as a from the public sector through low rates, liquidity percentage of GDP – at least up to a point of ‘saturation’. provision and, in some cases, equity investment. It’s not clear that this point has been reached, even in The reduction in public sector support gives rise to some of the most mature European markets. Revenues a potential source of volatility, and thus we cover it have outgrown GDP over the last few years in several in the next section where we consider concerns. European G20 economies, though not all. However, large parts of Europe, such as Russia and Turkey, are far from full maturity. Since 2008, asset growth in Turkey has been 16% CAGR, and in Russia, 13%. These regions have been significant contributors to the overall revenue growth of the European banking sector and are 1 With the notable exceptions of Greece and Ireland likely to continue to remain so, despite recent volatility.

EXHIBIT 2: REVENUE GROWTH POTENTIAL EXISTS, PARTICULARLY IN MATURING MARKETS BANK REVENUE BY SEGMENT AND REGION, 2012

% of GDP 7.5 4.6 4.7 5.0 6.4 3.9 4.9 4.0 4.4 8.4 5.5 4.7 Per capita € 2,300 1,500 1,400 1,300 2,300 400 1,000 1,900 400 5,200 400 800

€BN 160

140 At average per capita* 120

100 Insurance

80 Wealth & Asset Management 60

40 Corporate & Institutional 20 Banking Retail & Business 0 Banking Italy Iberia Russia Turkey France Austria Greece Nordics Benelux E. Europe Germany & Switzerland UK & Ireland

Source: International Monetary Fund (IMF), Eurostat, Central Intelligence Agency (CIA) fact book, Oliver Wyman analysis * “At average per capita” is calculated by estimating additional revenue that could be expected if region achieved average European per capita revenues

MUTED CHALLENGE FROM FOREIGN PLAYERS AND NEW ENTRANTS

Competition from new entrants has been muted by national location of lending or investment seemed the high cost of entry and expansion, especially given increasingly irrelevant. The crisis put a stop to this. recent regulations. Retail entry requires scale, both Non-domestic banks have withdrawn from the worst- for distribution purposes and to reduce the unit cost hit countries, such as Greece, and private savings have of brand-creation. Servicing large corporates has flowed from those nations into safer countries, such traditionally relied upon a relationship model, with as Germany. The anticipated tapering of the Federal weak lending economics offset by better returns Reserve bond-buying programme is also seeing elsewhere. However, specialist segments (e.g. financial investors retreat from riskier assets, adding recent sponsors) have attracted entrants. Traded markets in impetus to this trend, particularly in emerging markets. Europe continue to face a raft of shifting regulation, such as the financial transaction tax and bonus caps, Similarly, the threat from non-traditional competitors which makes investment payback uncertain and wards has not proved as great as might have been expected. off significant investment by new or foreign players. Many corporates and investor groups remain reluctant to launch or become banks, put off by the associated ‘Euro convergence’ prior to 2006 encouraged an risks and regulation. Those that have entered banking expansion of cross-border banking across Europe. The have largely pursued niches, such as payments, or

entered via partnerships with banks and insurers. strengths in gaining approval in a tough regulatory These players have remained small. For example, Tesco environment. Starting with clean balance sheets and Bank’s loans to customers total approximately £5.5BN, with the potential to scale, we expect these challengers less than 0.5% of the UK Personal Lending Market. could make an impact on the market and enhance competition over time, though more on a seven to ten After a brief flurry of digital-only entrants, such as year horizon. ING Direct, Digital is now just another channel that customers expect all suppliers to offer. Current trends As a result, not only have total banking revenues within favour multi-channel offerings, which banks are better- positioned to provide. Europe remained resilient, so too has European banks’ share of this market (see Exhibit 4). Banks capture ~75% Whilst there are several players that have successfully of financial services revenues in Europe and European entered the market, these remain small in relation banks capture ~88% of that total banking revenue: that to the banking sector and it seems unlikely that this is, European banks capture 70% of the total financial would change substantially in the near term. However, services revenue available, a figure which has not these smaller players have demonstrated particular shifted materially in five years.

EXHIBIT 3: POTENTIAL BANK DISRUPTERS – NEW ENTRANTS

COMPETITION TYPE EXAMPLES COMMENTS

Retailers Sainsbury’s Bank, Tesco Bank, Carrefour ••Financial services targeted at existing Banque, Financiera El Corte Inglés, ICA Banken consumer base to support principal retail offerings; another element of becoming a ‘one-stop-shop’ for customer needs ••Vanilla product offerings (little appetite to take on extra risk / capital requirements)

Brand-led offerings/new entrants/ Virgin Money, Ikanobank (Ikea), Metrobank, TSB ••More appetite to grow beyond existing carve-outs customer base ••Key challenge is getting to scale

Car manufacturers Volkswagen, Audi, Peugeot, Ford ••Relatively stable and limited market presence to support sales; limited footprint (especially in city centres) from which to establish branch structure ••Significant expansion not expected

Online/digital-only ING Direct, AXA Banque ••Digital-only players being squeezed as digital channel becomes accepted norm, expected of all players

Non-traditional service providers Paypal, Zopa, Kickstarter ••Successful, although small, in single- product offering ••Expansion into other products likely to only ever be ancillary to main offering

Source: Oliver Wyman research

EXHIBIT 4: EUROPEAN BANKS CAPTURE THE VAST LIMITED THREAT FROM DISINTERMEDIATION MAJORITY OF BANKING REVENUES IN EUROPE, AND A SIGNIFICANT PROPORTION OF THE TOTAL FS REVENUE The assets of European banks have traditionally TOTAL EUROPEAN REVENUE, 2012 represented a much larger proportion of GDP than the €BN banking sectors of other mature economies. This is not 1,200 because more financial activity occurs in Europe but because financial intermediation has been dominated 1,000 by bank balance sheets. This remains true today - the proportion of transfers from savers to borrowers 800 Insurance intermediated by banks has been shrinking very slowly.

600 Wealth & Asset Management The assets of the European banking sector have not changed materially in absolute terms since the crisis. 400 Corporate & However, while banks’ assets have remained flat, they Institutional Banking are losing share to faster-growing non-banks, such as 200 insurers and pension funds (see Exhibit 7). Retail & Business 0 Banking We expect further growth – for example savers will European FS European European revenue banking banks' continue to switch to asset managers in search of yield, revenues European and non-banks look likely to provide additional funding revenues in specialist sub-sectors such as Commercial Real Estate Source: Oliver Wyman analysis Finance and Leveraged Buyouts, as evidenced by recent EXHIBIT 5: FINANCIAL INTERMEDIATION IN EUROPE Collateralised Loan Obligation activity. Nevertheless, these IS DOMINATED BY BANKS competitors continue to have a small share of the market BANK ASSETS AND FINANCIAL ASSETS AS A PROPORTION OF in traditional banking products and services, and do not GDP, BY GEOGRAPHIC REGION, 2012 currently pose a significant threat to the banking sector.

BANK ASSETS/GDP FINANCIAL ASSETS/GDP Moreover, banks are still the principal arrangers and 4.0 11.25 underwriters of such non-bank financing, facilitating 3.5 10.00 the flow of money from investors to borrowers. Thus the banking sector remains an important element of 3.0 8.75 the value chain for this growing part of the market. 2.5 7.50 Some of the trend is cyclical. Large European and multi- 2.0 6.25 national corporates have traditionally relied on bank Financial 1.5 5.00 funding rather than issuing bonds directly into the capital assets/ GDP markets. Since the crisis, however, banks’ funding has 1.0 3.75 come under pressure and they have become more 0.5 1.25 Bank reluctant to use their balance sheets. Simultaneously, assets/ corporates have been offered cheap credit in capital 0 0 GDP Europe Australia Canada Japan United States markets – often cheaper than for equivalently rated banks. They have thus increasingly issued bonds to yield-hungry investors struggling in a low interest rate Source: IMF, World Bank, ECB, Economist Intelligence Unit (EIU), Federal Reserve, Federal Deposit Insurance Corporation (FDIC), environment – though this has typically been distributed Oliver Wyman analysis by banks. 2012 was the first year that European Note: US bank assets have been increased by a constant factor of 55%, based on estimates from the FDIC, to compensate for differences between GAAP and corporates financed a greater proportion of their term IFRS accounting rules debt in the bond market than US corporates did.

EXHIBIT 6: ABSOLUTE LEVEL OF EUROPEAN BANK ASSETS HAS REMAINED REMARKABLY STABLE EVOLUTION OF EUROPEAN BANK ASSETS, 2008-2012

CAGR ’08 – ‘12 -6 -5 -1 -3 1 1 2 16 4 13 6 3 0 %

€TN 50

0 Italy 2008 2012 Iberia Russia Turkey France Greece change Nordics Benelux Total net Total & Austria E. Europe Germany Switzerland UK & Ireland

Source: ECB, CBR, BDDK, SNB, Statistics Norway, Oliver Wyman analysis Note: ECB defines European bank assets as the total consolidated assets of domestic banking groups and stand alone banks, foreign (EU and non-EU) controlled subsidiaries and foreign (EU and non-EU) controlled branches of European countries, therefore assets of European branches or subsidiaries of European banking groups based outside their home country will be double counted

“The threat of the shadow banking sector to earnings and intermediation has proven overblown. As leverage constraints kick in, the banks have every incentive to find ways to finance their issuer clients without consuming balance sheet.”

EXHIBIT 7: BANKS ARE LOSING SHARE TO FASTER GROWING NON-BANK SECTORS BREAKDOWN OF FINANCIAL SECTOR ASSETS BY SUPPLY-SIDE SEGMENT, 2008-2012

TOTAL ASSETS BANKS’ SHARE €TN % 75 100 Banks' share 60 80 Retail MFs

45 60 E&F*, SWF**

Hedge funds 30 40

Pension Funds 15 20 Insurers

0 0 Banks 2008 2009 2010 2011 2012

Source: ECB, EuroHedge, SNB, BDDK, Statistics Norway, CBR, Oliver Wyman analysis * Endowments and foundations ** Sovereign wealth funds † Retail mutual funds

EXHIBIT 8: NON-FINANCIAL CORPORATES (NFCs) HAVE EXHIBIT 9: 2012 WAS THE FIRST YEAR EUROPEAN INCREASINGLY ISSUED DEBT DIRECTLY TO CAPITAL CORPORATES FINANCED MORE OF THEIR TERM DEBT MARKETS, RATHER THAN RELYING ON BANK FUNDING IN THE BOND MARKET THAN US CORPORATES NFC DEBT OUTSTANDING BY ASSET CLASS, IN EU27 BONDS AS A PERCENTAGE OF CORPORATE TERM DEBT COUNTRIES, 2007-2012 ISSUANCE*, 2007-2012

€TN % 10 80

8 60

6 40 4

Debt 20 2 securities Europe

Loans (ex. 0 overdrafts) 0 US 2007 2008 2009 2010 2011 2012 2007 2008 2009 2010 2011 2012

Source: Dealogic, Oliver Wyman analysis Source: ECB, Oliver Wyman analysis * Term debt includes DCM, syndicated loans and facilities

We expect the role of non-bank balance sheets in sovereign wealth funds and pension funds to invest financing to grow in Europe. However, the threat of the in loan markets, as it has become clear few of these shadow banking sector to earnings and intermediation investors have the origination or credit capabilities to has proven overblown. As leverage constraints kick do so without banking support. Furthermore, as the in, the banks have every incentive to find ways to securitisation markets start to re-open this will become finance their issuer clients without consuming balance a source of new fees for the banks. In short, this has sheet. Banks make attractive underwriting fees from become less a case of defence for the banks, and more a issuing bonds, and this will get better as the high question of which banks are well positioned to support yield bond market deepens in Europe. Banks have their investor clients in making it happen. found themselves encouraging insurance companies,

EXHIBIT 10: POTENTIAL BANK DISRUPTERS – NEW FUND STRUCTURES

TYPICAL ASSET NEW FUND STRUCTURE EXAMPLES COMMENTS SIZE (€BN)

Specialist funds set up by ••Allianz GI infrastructure fund ••Either closed or open-ended funds 0.5-1.5 external asset managers ••Cerberus Leveraged Loan Opportunity Fund ••Focus on specific asset classes ••Open to institutional investors ••Multiple funds launched, but mixed success in terms of deployment of capital

Client-specific segregated ••JP Morgan Asset Management ••Bespoke investment mandates tailored to 0.5+ mandates managed by ••Macquarie Infrastructure Debt individual investors external asset managers Investment Solutions ••Popular model for investors with insufficient scale to build lending capabilities internally, but with specific risk appetite and requirements

Debt funds set up by banks ••Various funds launched, but few successes ••Challenge to raise capital due to perceived N/A conflict of interest ••Successes usually where funds established within independent asset management division (see above)

Strategic partnerships ••Natixis and CNP Assurances ••Originating bank typically retains a portion Varies between banks ••Société Générale and AXA to keep skin in the game, while distributing and investors the remainder to the investor ••Strategic partnership allows closer understanding of underwriting criteria and processes

Direct lending by ••Allianz ••Development of direct lending capabilities 1-10 non-bank investors ••Aviva within investors, particularly large insurers ••Typically based on recruiting experienced teams from banks, sometimes with initial participation in syndicated facilities to build experience

Source: Oliver Wyman research

1.2. GROUNDS FOR CONCERN

Although banking revenues have been remarkably Most European governments have no desire to be long- resilient since 2008, there are causes for concern. Chief term investors in the sector. However, they have so far amongst these are dependence on the state, reduced been unable to exit because most banks are in no position access to attractive markets and a shift in value to areas to repay their state investors and RoEs are generally not traditionally within the ambit of banks. below the level at which governments could regain their investment. Thus, only about 10% of the original capital injected has been repaid, meaning that total public sector DEPENDENCE ON THE STATE ownership of European banks now stands at 17% of total 2 State injections of tax-funded capital, intended to equity . While there is some fresh activity in this space, avert economic calamity by ensuring that banks could such as the recent announcements regarding Lloyds continue to play their role intermediating credit flows, Banking Group, there remains a long way to go. have provided vital support to banks in recent years. We By comparison, the US Federal government injected calculate that since 2007 European banks have raised $250BN3 of capital into its banks through the €700BN of capital, of which €350BN has come from Troubled Asset Relief Program (TARP), which at its the public sector. While maintaining critical solvency, height amounted to 17% of total equity, an equivalent this has also prompted some banks to hold assets they proportion to Europe today. Almost all of this has would otherwise have been forced to sell. been repaid, however, so that the outstanding TARP capital now amounts to 1% of total US bank equity. The Banks have also taken steps to reduce the risk-weighting relative health of the US banking system, with early and of their asset portfolios. As a result, the assets of our aggressive write-downs, is an interesting counterpoint sample of banks actually increased over the period. For to the European system and one that policy makers many banks, this would have been impossible without should constantly challenge themselves against. the state support they received. Beyond capital support, there has been extensive In fact, total state support approved for the EU financial monetary and funding support. Central bank balance sector since the Lehman default totals more than €5TN, sheets exploded over the last four years as asset equivalent to 40% of GDP. Of this, €1.5TN had been used purchase schemes, Quantitative Easing (QE) and by the end of 2011, with guarantees forming the largest collateral windows were used to restore confidence and part of this aid. While these guarantees revitalised bond keep interbank markets functioning. Although these markets, enabling banks to issue bonds and raise funds, balance sheets have now begun to shrink, central banks they also led to sovereign stress (especially in Ireland) remain committed to providing liquidity to the debt and helped create a sovereign-bank feedback loop, markets. The support provided by central banks has which still plagues the market, and which we examine contributed to favourable funding conditions for banks; further in the next section. the withdrawal process will be difficult to manage and will likely take significant time. Nevertheless, the process has started and we remain hopeful it can continue without severe discontinuities.

2 It should be noted that not all of the principal injected is expected to be repaid due to insolvencies 3 Source: SIGTARP Quarterly Report to Congress, July 24th 2013

EXHIBIT 11: HALF OF THE CAPITAL PROVIDED TO THE EXHIBIT 12: CENTRAL BANKS PROVIDED SIGNIFICANT EU BANKING SECTOR HAS COME FROM THE STATE LIQUIDITY SUPPORT, THOUGH THIS IS NOW REDUCING CAPITAL RAISED BY EU BANKS, BY SOURCE, H2 2007-H1 2013 TOTAL ASSETS OF ECB AND BANK OF ENGLAND, 2007-H1 2013

€BN €TN 250 4.0

200 3.0

150 2.0 100

1.0 50 State BOE

0 Private 0 ECB H2-2007 2008 2009 2010 2011 2012 H1-2013 Q1 Q1 Q1 Q1 Q1 Q1 Q1 ‘07 ‘08 ‘09 ‘10 ’11 ‘12 ‘13

Source: European Commission, Company reports, Company websites, Factiva, Source: ECB, Bank of England, Oliver Wyman analysis Oliver Wyman analysis

EXHIBIT 13: BANKS HAVE IMPROVED CAPITAL RATIOS THROUGH RAISING CAPITAL AND REDUCING RISK- WEIGHTING OF THEIR ASSET PORTFOLIOS EVOLUTION OF CAPITAL, ASSETS, RISK WEIGHTING AND CAPITAL RATIO, 2007-2012

Risk weighting* % 39 35 38 37 35 34

TOTAL ASSETS, T1 CAPITAL T1 RATIO 2007 = 100 % 160 16

140 14

120 12

100 10

80 8

60 6 Tier 1 capital ratio 40 4

20 2 Tier 1 capital

0 0 Total assets 2007 2008 2009 2010 2011 2012

Source: Bankscope published by Bureau van Dijk, Company reports, Oliver Wyman analysis * ‘Risk weighting’ is Total RWAs / Total assets

BALKANISATION IS PUTTING PRESSURE ON BANKS TO PULL OUT OF POTENTIALLY ATTRACTIVE MARKETS AND BUSINESS LINES

Rising fixed costs and trapped capital and funding resources and boost group-wide returns. For example, are encouraging many banks to exit markets in which Nordea has agreed the sale of its Polish banking, they are subscale. While opportunities abroad may be financing and life insurance operations to PKO, and Erste attractive, many large banks are concluding that they has sold its Ukrainian subsidiary to FIDOBank. will be unable to achieve the requisite scale to succeed in an appropriate timeframe and are thus choosing Only banks that achieved scale prior to the crisis have been to exit. In other cases, such as AIB and KBC, foreign able to maintain growth strategies abroad. This includes disposals are a condition of state aid. European investment banks with long-established global scope (such as Barclays and Deutsche Bank) and banks Within Europe, the pre-crisis expansion of cross-border from countries with historic links to emerging markets, banking is thus now in reverse. Banks are cutting their such as Spanish banks in Latin America. foreign exposure and decamping for home. Over €1TN of assets have been repatriated since 2007. On one hand the discipline here can be applauded - it’s hard to argue with banks focusing on their core markets European banks have also retreated from non-European and what they do best. However, balkanisation carries a foreign markets. For example, their US assets have cost in less efficient trapped capital and funding. In some declined by 20%, driven in part by reduced onshore cases this is resulting in stronger banks exiting attractive presence of subscale investment bank divisions. This markets, where their capital should be able to make good withdrawal has been prompted by the increased returns, support local growth, assist in channelling needed regulatory burden driving up unit costs and a shortage foreign capital into markets and drive the cost of capital of US dollar funding for some. They are also beginning down through greater competition with domestic banks. to repatriate lending from emerging markets as interest rate and foreign exchange risks increase globally. This also raises a real concern for emerging economies This is all part of the same theme - banks are shedding starved of bank capital, which are now facing their own non-core international businesses in an attempt to focus crises as investor capital heads for home.

EXHIBIT 14: OVER €1TN OF LOAN ASSETS HAVE BEEN REPATRIATED SINCE 2007 EXTERNAL LOANS HELD BY BANKS, BY COUNTRY OF DOMICILE OF BANK, 2007-2012 €TN 12 % CHANGE ’07 – ‘12 % change ’07 – ’12: -13% 10 Turkey -27 Greece -8 8 Italy -9 Nordics 36 6 Switzerland -52 Iberia -10 4 Benelux -14

2 France -3 Germany & Austria -20 0 UK & Ireland -8 2007 2008 2009 2010 2011 2012

Source: Bank of International Settlements (BIS), Oliver Wyman analysis

EXHIBIT 15: DISRUPTER TABLE – VALUE CREATORS

2008 MARKET CAP 2012 MARKET CAP COMPETITION TYPE EXAMPLES (€BN) (€BN)

Payment networks Visa, Mastercard, Discover, Amex 50-65 165 - 205

Market data providers Bloomberg, Interactive Data Corporation, Dun & Bradstreet 20-25 30-40

Credit bureaus Experian, Equifax, SCHUFA Holding AG 5-10 15-20

Merchant acquirers WorldPay, First Data, Global Payments Inc. 10-15 15-20

Exchanges Deutsche Boerse, LSE 5-8 8-12

Utility platforms Markit, Atradius, Euler Hermes 4-7 7-10

Other (e.g. rating agencies, Moody’s, ICAP, Moneysupermarket.com 5-8 10-15 brokerage firms, client advice and offers)

Source: Oliver Wyman research

VALUE TRANSFER IS SHIFTING CAPITAL FORMATION TO NEW AREAS OUTSIDE TRADITIONAL BANKING

While banks have focused on managing their core balance- create value for themselves and for the banks in supplying sheet based businesses, a new wave of investment and infrastructure services to the banking sector at lower and significant capital formation has occurred outside the more flexible cost. The earnings streams released are regulated ambit of banks. As shown in Exhibit 15, there is a capital light, and rightly draw higher valuation multiples. diverse range of firms now using the information generated However, in some areas, we argue that the banks have in the financial services industry, or delivering services been under-focused on the value of the information they or infrastructure to the core banking sector. In 2008, the generate4. Many industry sectors such as telecoms, retail value of these firms was 16% that of banks. By 2012 this had and media have been transformed by the information grown to 23%. In part, this is due to the global exposure of revolution in the last decade, financial services far less so. many of these firms, which gives them access to the fastest growing regions. Payments firms are the stand out case - The risk to banks here is that their information assets having benefited from a large increase in card usage globally are exploited by innovators outside banking, while as the switch from cash gathers pace in emerging markets. they are occupied with regulatory remediation and Reinforcing this point, we note that on September 10th, cost streamlining. 2013, it was announced that Visa would enter the Dow Jones Industrial Average, while Bank of America would exit. The challenge, therefore, is for the banks to ensure that they get their fair share of participation in the value creation Some of this value transfer is rational. For example, in taking place across the infrastructure and information Section 3 we return to the growth of industry cost utilities, businesses that are likely to become a more significant which strip out the duplication in banks’ cost structures and feature of the financial services industry.

4 For further information please refer to “The State of the Financial Services Industry 2013 – A Money and Information Business”

2. RETURNS, LEADERS AND LAGGARDS

2.1. THE COLLAPSE IN ROE

Returns for European banks have collapsed, from highs in 2012. At the same time, other so called one-off costs of ~20% in 2006 to ~4% in 2012. This is a result of large have proved enduring, with restructuring costs and provisions for NPLs, a flood of other extraordinary industry fines contributing significantly over the period. charges (primarily for restructuring and conduct-related The combination of provisions for NPLs and these other fines), significantly increased equity-to-asset ratios and extraordinary cost items has increased 17x since 2006. insufficient reduction of operating costs. Finally, the increased capital required to satisfy The small growth of aggregate industry operating regulatory demands has further depressed returns. profits has been contributed almost exclusively Common equity in the sector has increased by 75% by banks with positive exposure to high growth in the last six years, on more or less static revenue. emerging markets or who are domestic players in emerging markets, in particular Russia and Turkey.

The cost base of the larger industry players has risen 30% in absolute terms since 2006, equivalent “Returns for European to a CAGR of 4% over the period. For the top 20 banks have collapsed, European banks the average increase in cost base was €3.5BN or 28%; for the top 50 banks the from highs of ~20% average increase was almost €2BN or 30%. in 2006 to ~4% in This is not because banks have been ignoring costs. On the contrary, most banks are on their second or third 2012. This is a result round of cost cutting. But the results have disappointed. This is partly because the rise in regulatory and of large provisions compliance costs has swamped reductions and partly for NPLs, a flood of because many of the programmes have targeted tactical headcount reduction (which is quick and cheap) rather other extraordinary than longer term platform overhaul, which is costly and often takes more than three years to repay. Alas, charges, significantly tactical cost reductions are rarely sustainable and the rise in compliance spend is here to stay. As a result, increased equity- operating costs have remained stubbornly high. to-asset ratios and While operating margins have been stable, provisions insufficient reduction of have been anything but. Provisions for NPLs have significantly reduced earnings, almost quadrupling since operating costs.” 2006. The largest 20 banks in Europe posted provisions of just over €1BN each in 2006 and close to €4.5BN each

EXHIBIT 16: ROE* HAS DECLINED DRAMATICALLY, EXHIBIT 17: INCREASED CAPITAL TO MEET REGULATORY FROM 20% IN 2006 TO 4% IN 2012 DEMANDS HAS FURTHER DEPRESSED RETURNS RELATIVE IMPACT OF DRIVERS OF ROE DECLINE, 2006-2012 ROE* DECLINE AND EQUITY EVOLUTION, 2006-2012

% ROE COMMON EQUITY 25 % 2006 = 100 25 200

20 20 160

15 15 120

10 80 10

5 40 5 Average common 0 0 equity 0 RoE 2006 Operating Rise in Increase Tax Rise in 2012 -5 -40 RoE margin loan in other reduction equity RoE ‘06 ‘07 ‘08 ‘09 ‘10 ‘11 ‘12 growth** losses extraord. cost items

Source: Bankscope published by Bureau van Dijk, Company reports, Source: Bankscope published by Bureau van Dijk, Company reports, Oliver Wyman analysis Oliver Wyman analysis * RoE is calculated as Net income /Average common equity * RoE is calculated as Net income / Average common equity ** Growth in operating margin almost exclusively contributed by banks with positive exposure to high growth emerging markets or who are domestic players in emerging markets

EXHIBIT 18: EUROPEAN BANKS’ OPERATING COSTS HAVE INCREASED 30% SINCE 2006 EVOLUTION OF EUROPEAN BANK OPERATING COSTS AND ASSETS, 2006-2012

2006 = 100 150 Total % change ’06-’12 Personnel 22 expenses

100 Other operating 39 expenses

Total operating 30 Other operating expenses expenses 50 Total assets 30 Personnel expenses No change in 0 operating margin Total assets 2006 2007 2008 2009 2010 2011 2012

Source: Bankscope published by Bureau van Dijk, Oliver Wyman analysis

2.2. A CAUTIOUS OUTLOOK

Looking ahead, we expect the continued implementation these countries, a return to normality must be some way of new regulation to drag further on returns. However, off. The timing will depend on the successful resolution we anticipate three positive tailwinds from normalisation of the European crisis, which will allow economic in NPLs, reduction in extraordinary items and improved stabilisation and a sustainable recovery. capital management. Effective cost management, which has proved challenging to date, will be a drag for some, A gradual improvement in NPLs feeds directly into bank but those that can make it work will see the benefits in returns. We estimate that, for every 50bps reduction their returns. in NPLs, RoE improves by 1%-1.5%, implying a full normalisation of NPLs in Europe could translate into 4%- The total cost of the regulatory programme is not yet 6% sustainable improvement in returns. fully visible in current returns. With implementation extending to 2018 (and beyond), this will lead to a Reductions in other extraordinary items also translate further drag on returns over the coming years. We directly into returns. They have cost the largest 20 expect this drag from five principal sources: the final banks in Europe €1BN per bank per year on average implementation of increased capital requirements, over the last three years. We expect the existing issues, ‘ring-fencing’ and resolution plans (which will increase such as derivatives and insurance mis-selling and index funding costs), the financial transaction tax in the manipulation, to continue to drag for at least one or Eurozone, conduct policy implementation (which two years. But if the industry can reduce the frequency will increase costs and reduce revenues) and the full of such events to pre-crisis levels (a big if), this would go-live on central counterparty clearing (which will translate into a 2%-3% benefit to returns. reduce revenues from market-making). There remain uncertainties on most of these issues, but we estimate that they will suppress returns by a further 2%-4% over the coming period. “Looking ahead, we The outlook for NPLs and their impact on returns is more expect the continued positive, though improvement will be gradual. implementation of Outside-in NPL estimation is hard – and no two crises are the same. However, using prior crises as a ready new regulation to drag reckoner suggests it will be some time before NPL levels normalise. Assuming Western European NPLs further on returns. have peaked, history suggests a further one to four However, we anticipate years before NPL levels normalise. However, NPL levels at banks in Western Europe over the first half of 2013 three positive tailwinds suggest the time to recovery could be even longer. In Eastern Europe, again assuming the peak has been from normalisation reached (given that GDP has returned to pre-crisis in NPLs, reduction levels), recovery may not come until after 2018. In the periphery5 it does not appear that the peak has yet been in extraordinary reached. Given the height NPLs have already reached in items and improved

5 Periphery includes Greece, Ireland, Italy, Portugal and Spain capital management.”

EXHIBIT 19: COMPARING NPL RATIO* EVOLUTION IN THE CURRENT CRISIS WITH THAT IN PREVIOUS CRISES SUGGESTS A RETURN TO NORMALITY IS STILL SOME WAY OFF

PREVIOUS CRISES CURRENT CRISIS % % 18 18

16 US 16 ’90s 14 14 Germany Not clear that peak 12 ’00s 12 in NPLs has yet been reached in periphery 10 Japan 10 ’00s 8 8 Periphery†† Spain 6 ’90s 6

4 4 Eastern Argentina Europe** ’00s 2 2 Belgium Western 0 ‘00s 0 Europe† T-1 T T+1T+2 T+3 T+4 T+5 T+6 T+7 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E

Source: Bank of Spain, FRED, IMF, World Bank, OECD, ECB, Oliver Wyman analysis * NPL ratio is total non-performing loans / total loans. Regional NPL ratio is a weighted average, using total commercial bank loan weights ** Eastern Europe includes Turkey and Russia. Czech Republic has been removed due to lack of data † Switzerland has been removed due to lack of data †† Periphery includes Greece, Ireland, Italy, Portugal and Spain Note: “T” is 1993 for Spain, 1991 for the US, 2001 for Argentina, Belgium and Japan and 2002 for Germany. The speed of decline was calculated using the CAGR of previous post-crisis NPL recoveries

As regulatory capital has become scarcer, banks have made in the meantime. In addition, many of these cost focused on making the best use of it. We expect this to programmes appear highly ambitious when compared partially offset the cost of increased capital minima and to past performance. thus have a small positive impact on returns. Across a sample of seven recently announced cost We believe that the aggregate impact of these items will programmes with target cost-income ratios, the get the industry to just above the cost of capital (circa average targeted reduction in cost-income ratio is 7%-9%). This leaves us with two big open questions. 10% over the next three years . This is greater than any such reduction observed across the same sample The first is what happens to operating margins. We since 1998 (see Exhibit 20). The largest decline in believe that for the most part, revenues will rise with GDP, which means margin improvement will be driven cost-income ratio over a three year period since 1998 by cost effectiveness. Banks have had several years to was 7%, between 2002 and 2005. During this period, contemplate cost reduction and yet they have been revenue growth outstripped cost growth by a factor unsuccessful in achieving sustainable reductions to of two (revenue CAGR was 11%). With revenues likely date. Many banks are undertaking significant cost constrained in the coming years, such a large reduction reduction and restructuring programmes, but these are in cost-income ratio will therefore require fundamental not planned to result in savings for some years to come. shifts in operating model to support the targeted cost Most programmes announced in the last year or so have reductions. However, it is unclear how these shifts will targets set for three to four years in the future (2015- be achieved given limited budget to invest in the types 16), with many requiring significant investments to be of programmes likely required.

EXHIBIT 20: COST PROGRAMMES WITH ANNOUNCED COST-INCOME RATIO TARGETS APPEAR AMBITIOUS WHEN COMPARED WITH PAST PERFORMANCE EVOLUTION OF OPERATING COST, TOTAL REVENUE AND COST-INCOME RATIO,1998-2015E*

OPERATING COST, TOTAL REVENUE COST INCOME RATIO €BN % 250 70

200 65

150 60

100 55

Total revenue 50 50 Cost-income

0 45 Operating cost 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E

Source: Company reports, Company websites, Capital IQ, Oliver Wyman analysis * Estimated cost-income ratio is based on a linear approximation of the stated 10% target reduction Note: Based on 7 European banks with publically announced cost savings programmes with a target cost-income ratio

Whilst we do believe that some banks will be global systemically important financial institutions successful in reducing cost-income ratios by 10%, (G-SIFI) size list, value creation becomes very hard for the industry as a whole this is not achievable. A at the large end of the M&A scale. Not to mention reduction of 3%-5% seems more credible. This would the minimal interest that regulators or governments translate into a further 1%-2% improvement in RoE, have in allowing banks to become larger. leaving the aggregate industry RoE at 9%-11%. This is an industry-wide view. Footprint, strategy and The second question relates to the interest rate management effectiveness will drive potentially high environment. Interest rates will rise, though the timing variations around these averages; we focus on some of this remains far from certain. The dynamics of rising of these drivers over the remainder of the report. rates are complex: most commercial and retail banks will benefit in the medium term, though there is a risk “Whilst we do believe of rising NPL levels in some economies. Some of the wholesale banking divisions may suffer on trading book that some banks will be inventories in the short term. We anticipate a long term positive with some transitional pain for some. Either way, successful in reducing the longer term imperative to reduce costs will remain. cost-income ratios by We also note that the most obvious means to improve system-wide returns would be significant consolidation 10%, for the industry and thereby reduced capacity, particularly in deals as a whole this is that are led by technology synergies. However, given the cost of capital associated with climbing the not achievable.”

2.3. SOVEREIGN INFLUENCE – THERE’S NO PLACE LIKE HOME TIGHTENED SHACKLES ON PERFORMANCE

While RoEs have deteriorated for all banks, their dispersion Banks from countries hit by a sovereign debt crisis shows an interesting trend. In 2006 average RoEs were have seen their cost of funding increase regardless high and so was their dispersion. The distribution of returns of their fundamental strengths. Bank credit default swap narrowed dramatically through 2010 as returns plummeted. (CDS) spreads have been increasingly driven by the CDS Since then, returns have remained low on average but the spread of the underlying sovereign. distribution has widened again. This ‘domestication’ of bank performance means that the The dominant factor explaining this dispersion is not link between GDP growth and RoE is now far stronger than it strategy but location. The country in which a bank is was before the crisis. domiciled, rather than its idiosyncratic features, has become the principal driver of its performance. This is because two of Only a few banks have managed to buck this trend with the most important drivers of bank performance – funding excellent strategic selection or performance. Those with less costs and NPL rates – now vary greatly across Europe, risky, more stable business models and higher exposure to overwhelming any bank-specific variation of strategy emerging markets have generally fared better, though some or execution. A good bank in a bad country does worse with these features have still struggled. than a bad bank in a good country. At the same time, and for the same reasons, variation in performance between banks from the same country is narrowing.

EXHIBIT 21: ROE* DISPERSION HAS HOWEVER, WITHIN REGIONS, ROE DISPERSIONS HAVE INCREASED ACROSS EUROPE WITH NARROWED AS THE SOVEREIGN INFLUENCE HAS LEADERS AND LAGGARDS EMERGING BECOME MORE DOMINANT

FREQUENCY FREQUENCY 30 12

25 10 Germany & Austria 20 8 UK 15 6

2012 Iberia 10 4

5 2010 2 France

0 2008 0 Switzerland

-5 2006 -2 Italy -20 -10 0 1020 30 40 -20 -10 0 1020 30 40 -20 -10 0 1020 30 40 ROE ROE ‘06 ’07 ROE ‘11 ’12 % % %

Source: Bankscope published by Bureau van Dijk, Company reports, Oliver Wyman analysis * RoE is calculated as Net income / Average common equity

EXHIBIT 22: THE RELATIONSHIP BETWEEN GDP GROWTH AND ROE HAS STRENGTHENED POST-CRISIS AVERAGE GDP GROWTH VS. AVERAGE ROE, 2006-2007 AND 2010-2012

AVERAGE ROE ’06 ’07 AVERAGE ROE ’10 ’12 % % 40 40

30 30

20 20

10 10

0 0

-10 -10

-20 Correlation = 21% -20 Correlation = 61% -5 0 5 10 -5 0 5 10 AVERAGE GDP GROWTH ‘06 ’07 AVERAGE GDP GROWTH ‘10 ’12 % %

Source: Bankscope published by Bureau van Dijk, Company reports, IMF, Oliver Wyman analysis Note: Chart shows relationship between bank RoE and real GDP growth in the bank’s home country. RoE is Net income / Average common equity

EXHIBIT 23: THE SOVEREIGN INFLUENCE EXHIBIT 24: EVOLUTION OF NPL RATIOS* HAS VARIED ON BANK FUNDING COSTS HAS BECOME WIDELY BY REGION INCREASINGLY DOMINANT CHANGE IN SOVEREIGN CDS AS A % OF BANK CDS NPL RATIO % % 160 20 Greece Italy 120 15 E. Europe** Iberia Italy Russia 80 10 Portugal UK & Ireland France Spain 40 5 Germany & Austria Benelux France Turkey 0 Germany 0 Nordics Q2 '07 - Q2 '09 Q2 '10 - Q2 '12 Q2 '12 - Q2 '13 ‘06 ‘07 ‘08‘09 ‘10 ‘11 ‘12 CREDIT SOVEREIGN POST ECB CRISIS DEBT CRISIS SUPPORT Source: IMF Global Financial Stability report, World Bank, OECD, ECB, Oliver Wyman analysis * NPL ratio is total non-performing loans / total loans. Regional NPL ratio is a Source: Thomson Reuters, Oliver Wyman analysis weighted average, using total commercial bank loan weights Note: Change in sovereign CDS as a % of banks’ CDS is calculated as the change in ** E. Europe includes Turkey and Russia. Czech Republic has been removed due sovereign CDS / the average change in the CDS of the country’s banks to lack of data

EXHIBIT 25: THE NUMBER OF EUROPEAN BANKS TRADING AT A DISCOUNT TO BOOK VALUE HAS INCREASED DRAMATICALLY SINCE THE CRISIS PERCENTAGE OF BANKS TRADING AT DISCOUNT TO BOOK VALUE, 2006-2012

% 80

0 2006 2007 2008 2009 2010 2011 2012

Source: Thomson Reuters, Capital IQ, Oliver Wyman analysis

THE LINK BETWEEN VALUATION AND LOCATION

Market valuations, like RoEs, have declined dramatically Strategic clarity also appears to have been rewarded in since 2006 with most banks now trading at a discount to recent months. For example, Deutsche Bank received their book value. a positive boost to its share price on announcing definitive action to raise capital and UBS’s restructuring As with RoE, the decline in bank value has been driven actions were positively received. However, we expect by country of domicile, largely reflecting the economic strategic or other idiosyncratic factors to remain muted strength of the government. Average market-to-book influences on valuations until the sovereign decoupling values (MTBVs) have declined with sovereign credit is further advanced. ratings. And, as with RoEs, the dispersion of MTBVs for banks from the same country has narrowed.

Because this approach to valuation gives little weight to variations in banks’ long-term strategies, the “There are signs relationship between current RoE and MTBV has that investors are become tighter. beginning to pay However, there are signs that investors are beginning to pay greater attention to factors other than geography, greater attention such as leverage. In our sample, banks with better leverage ratios have received a modest MTBV premium to factors other given RoE. Examining the relationship between average RoE and MTBV over the period 2010-2012 we found that than geography.” the average leverage ratio of banks receiving a MTBV premium was 6.1% compared with 4.9% for those below the trendline.

EXHIBIT 26: DIVERGENCE IN MARKET-TO-BOOK VALUES (MTBVS) HAS DECREASED WITHIN NATIONS AS THE STRENGTH OF THE SOVEREIGN HAS BECOME THE DOMINANT FACTOR EVOLUTION OF BANK MTBV INTERQUARTILE RANGE, BY REGION, 2007-2012

4 QUARTER ROLLING AVERAGE 1.4 Europe 1.2 Switzerland 1.0 Iberia

0.8 UK & Ireland

0.6 Nordics Germany & Austria 0.4 Turkey 0.2 Italy

0.0 France 2007 2008 2009 2010 2011 2012

Source: Thomson Reuters, Capital IQ, Oliver Wyman analysis

EXHIBIT 27: THE RELATIONSHIP BETWEEN ROE* AND MTBV HAS STRENGTHENED ROE AND MTBV DEVIATION FROM MEAN, PRE- AND POST-CRISIS

MTBV DEVIATION FROM MEAN ’06 ’07 MTBV DEVIATION FROM MEAN ’10 ‘12 3 3

2 2

1 1

0 0

-1 -1

-2 Correlation = 43% -2 Correlation = 73% -3 -2 -1 0 21 -3 -2 -1 0 1 2 ROE DEVIATION FROM MEAN ’06 ’07 ROE DEVIATION FROM MEAN ’10 ‘12

Source: Bankscope published by Bureau van Dijk, Capital IQ, Company reports, Thomson Reuters, Oliver Wyman analysis * RoE is calculated as Net income / Average common equity

2.4. DELEVERAGING AND DECOUPLING

WHAT NEXT ON THE DELEVERAGE STAND-OFF?

We noted in Section 1 that the banking sector’s balance The first factor is the new regulatory focus on CRD IV sheet remained largely undiminished over the last five leverage ratio. Many banks in Europe have become years, and potential buyers of bank assets have been highly leveraged. Using published figures for core tier 1 serially disappointed by the lack of opportunities. A equity and total IFRS assets to calculate a proxy for the stand-off has set in, where few sellers are willing to part CRD IV leverage ratio across our sample of banks, reveals with assets at the prices on offer. that a small but significant proportion of European banks do not satisfy the proposed 3% minimum leverage The most obvious explanation for this is the liquidity ratio, even on this basis. provided by central banks, coupled with incentives to buy domestic government bonds and to lend to The second factor is the impending Eurozone AQR, which other domestic borrowers. Additionally, the European may also accelerate deleveraging, particularly in the most credit intermediation market structure remains challenged economies. Spain presents an interesting case widely dominated by banks, leaving limited room study in this regard. The transparency and confidence for deleveraging levels comparable to US standards. introduced by a rigorous stress test carried out in 2012 Yet banks have two further reasons to avoid asset has resulted in a wave of asset sales, restructuring and reduction. First, as fixed costs have proved difficult to consolidation that is rapidly putting the banking sector bring down, banks have been very reluctant to lose on a more stable footing. assets that generate net interest margin to help cover costs. Second, tightly capitalised banks have been reluctant to incur accounting losses through asset disposals, preferring to work them out over time. We believe these conditions will continue to impact the scale of asset reductions in the deleverage programme in Europe. However, we anticipate that the stand-off will relax and we are likely to see a significant increase in balance sheet restructuring, driven by two factors.

“The banking sector’s balance sheet has remained largely undiminished over the last five years. A stand-off has set in, where few sellers are willing to part with assets at the prices on offer.”

THE DECOUPLING QUANDARY

The high degree of sovereign influence on returns the other end of the spectrum, pressure to push the and valuations raises important questions around decoupling agenda has been lower for struggling banks. decoupling. By decoupling we mean the scope for the performance, risk profile and valuation of the banks to Currently the linkage is very much two-way. Many separate from their sovereign, and indeed vice versa. banks own big government bond portfolios as part of their liquid asset buffers and more generally on the Banks and governments have a number of inherent balance sheet. This connection further strengthens the links. Banks have been large beneficiaries of the sovereign/bank credit feedback loop. The purchase of significant government liquidity and equity injections. these bonds by domestic banks has been crucial to the Government balance sheets are now directly exposed sovereign’s ability to refinance itself. to the performance of the banking sector through these injections. In addition, the broader economy is reliant on Decoupling is likely to gather pace – as more banks a functioning banking system to support growth, which loosen the sovereign ties pressure will mount on the in turn impacts government deficit positions. Both now slower movers. Laggards will start to bump up against seek to decouple their fortunes. Much of this is in the the timetable for finalisation of resolution plans and, in hands of the public sector. First, through central banks some jurisdictions, the deadlines for ring-fencing. managing an orderly withdrawal of public funding and The decoupling agenda is complex and will remain capital and tapering of QE, though these will be highly opaque and political. Nevertheless, it is a key strategic challenging tasks. Second, through the establishment theme across the industry. of the much discussed European stability mechanisms, resolution authorities and insurance schemes.

However, the banks have levers too, which we expect to come more forcefully into play. The ramp up of bail-in programmes, finalisation of Recovery & Resolution plans and push to get ahead of the regulatory agenda “The decoupling agenda on legal entity structure are all tasks we see as having a is complex and will material impact on decoupling and therefore on each bank’s ability to drive more idiosyncratic performance remain opaque and and valuation. political. Nevertheless, it Naturally the banks that have led on these initiatives have been those for whom decoupling offers the is a key strategic theme greatest immediate upside - typically those either in across the industry.” economies with outsized banking sectors relative to GDP (where regulators have been keen to encourage decoupling), or where banking stability outstrips sovereign stability, limiting the costs of the move. At

EXHIBIT 28: TIMEFRAME FOR IMPLEMENTATION OF RECOVERY AND RESOLUTION DIRECTIVE (RRD) AND BASEL III REQUIREMENTS

2013 2014 2015 2016 2017 2018 2019

Recovery ••By end 2013: ••By 31st Dec: ••Bail-in tool and Major EU Member States implemented Resolution cross-border required to Directive banks to provide transpose RRD (RRD) recovery plans requirements into national law (with the exception of the bail-in tool)

Capital ••Start of phase-in ••Higher ••Start of phase- ••Conservation levels of higher capital minimum capital in of gradual buffer fully requirements requirements conservation implemented fully imple- buffer (0.625% (2.5%) mented (excluding rising to 2.5% conservation by 2019) buffer)

Leverage ••Start of test ••Public disclosure ••End of test ••Ratio becomes ratio period; begins, but ratio period; final mandatory supervisory not yet mandatory adjustments to reporting tracking but ratio based on requirement not disclosed test phases

REQUIREMENTS or mandatory

Liquidity ••(Observation ••Introduced as ••LCR set coverage period began standard at 60%, at 100% ratio (LCR) in 2011) increasing by ••Mandatory 10% each year reporting BASEL III SELECT III BASEL until 2019

Net Stable ••(Observation ••Introduced Funding period began as standard Ratio (NSFR) in 2012)

Sources: BIS, Oliver Wyman research Note: Timeline is not comprehensive of all regulatory requirements to be introduced, but is intended to highlight those which will potentially have greatest impact on reducing sovereign-bank coupling. All dates are 1st Jan, unless otherwise stated

3. THE CHALLENGES FOR BANKS

Banks face three key challenges moving forward: 1. Choosing between a bond-like or an equity-like strategy 2. Getting deleveraging and decoupling right 3. Channelling investment

3.1. A BOND OR EQUITY STRATEGY

The outlook across Europe is challenging for bank CEOs. The term ‘utility’ in banking has been used with Although economic conditions are beginning to improve largely derogatory tones, a clipping of banks’ wings and the drag from loan losses and other extraordinary by regulators and governments. However, if what we items should reduce, continued implementation of describe as a bond-like strategy is close to a utility regulation and a weakened economy will continue to bank, then this arguably provides a clear, attractive and test bank management for some years to come. laudable strategy and one which the market will reward if successfully executed. In this context, bank CEOs should choose between a conservative and a risky strategy. They can hunker down An equity-like strategy involves investing capital to in home markets and focus on delivering operating support growth and increase earnings potential, efficiencies and gaining market share. This strategy will extending services to new segments or new countries, deliver low and stable, bond-like returns. Alternatively, or moving into ancillary lines of business. It rests on they can take a more buccaneering approach, investing convincing shareholders that significant earnings should in new markets to deliver earnings growth. This will be retained and re-invested. deliver more volatile, equity-like returns. Most banks will think of themselves as doing something The bond-like strategy involves reducing risk weighted in-between – a hybrid of some sort. For example, assets (RWAs) to cut capital requirements, cleaning up delivering operational efficiency ‘at home’ while the balance sheet, managing NPLs well, creating a leaner investing selectively to build growth in new areas – like a bond with some yield enhancement. Alternatively, bank and cutting regulatory jurisdictions. The benefits they may adopt a ‘convertible bond’ strategy. That is, should be largely distributed to shareholders through a they may aim to follow the bond strategy by focusing significant dividend programme. Revenue growth will on efficiency in core activities for one or two years be unlikely to outstrip GDP growth, but the operating until capital is less constrained (perhaps on account efficiencies, transparency of earnings drivers and regular of retained earnings), at which point they will begin dividend payouts will be positively valued by the markets. to invest in earnest in growth opportunities.

Sentiment is warming to this strategy. Dividend We advocate care with these hybrid strategies. Banks announcements in recent months (positive or negative) risk getting caught between two stools. A bond-like have had a more material effect on share prices than strategy that doesn’t have adequate retained capital might have been expected. To some extent this strategy to deliver dividends, or continues to deliver negative represents a move ‘back to the future’, as banks aspire to unexpected news to the market, is likely to be received provide an attractive home for low-risk capital searching badly by investors. That may not matter much if the for reliable dividends. bank is state-owned, but it pushes re-privatisation

farther into the future. Likewise, an equity-like strategy The key question underpinning equity-like strategies that rests on retaining capital for investment but does is where and how to access growth and high returns. not deliver RoE and earnings growth will be punished We might expect banks will seek opportunities in in the market. Finally, delivering on a ‘convertible bond’ portfolio business selection. To some extent this is strategy will require timing of unlikely perfection. true – for example, a high component of wealth and asset management in the business portfolio tends Relevant to this, we have found the market today is to drive up returns. However, achieving sufficient punishing banks heavily for operational risk losses, in scale in these businesses to drive a banking group’s particular relating to conduct risk. A conduct risk loss returns is not easy. Across most banking business has four times the impact on market valuation than the lines it is noticeable that there exists a wide spread same credit or market risk loss6. The markets will be far in performance across banks with attractive and less forgiving of unexpected results from a bank which unattractive pockets, and strategic choices that deliver follows a bond-like strategy, compared with a bank good and bad returns. pursuing an equity-like strategy, where volatility has already been priced into the valuation.

EXHIBIT 29: ROE ACROSS BUSINESS LINES REVEALS A WIDE SPREAD IN PERFORMANCE

ROE STANDARD BUSINESS LINE RANGE (2012) RETURNS PERFORMANCE COMMENTARY

Retail & Business 5 - 25% ••Widely diverging fates across Europe, highly linked to geographic location Banking (RBB) ••Whilst RBB operating profit has been relatively stable, credit environment has driven significant losses in periphery dragging down returns; core has maintained returns broadly above cost of equity ••Maturing markets have on average experienced good returns driven by increasing market maturity and stronger GDP growth

Corporate & Institutional 8 - 20% ••Fixed income instruments, currencies and commodities (FICC) has been highly volatile, but has had a strong Banking (CIB) up-tick in returns in 2012 due to increased government-led liquidity; RWAs continue to be challenged by regulation ••Beta-heavy equities and Investment Banking Division (IBD) returns have been challenged by declining profitability through to end-2012 (driven by dampened revenue pools with sticky fixed cost bases) but look set to be better prospects - even though overcapacity remains in part of the business ••Wide skews exist between banks; future performance will be strongly dependent on the strength of the cyclical recovery, as well as the ability to respond to the regulatory agenda, make clear participation choices and to take out fixed costs

Wealth & Asset 15 - 40% ••RoE high due to loyal customer base and relatively light capital requirements, though considerable variation Management (WAM) observed between banks ••Returns unlikely to change substantially in coming years, as slight tightening of excess equity is balanced by small decrease in income as price, regulatory change and product mix continue to have a somewhat negative effect; cost remains the easiest lever that management can pull to improve returns

Insurance 10 - 15% ••Retail Property & Casualty (P&C) is a very price transparent market; high levels of competition tend to keep forward-looking RoE’s within a narrow range with relatively few players making “supernormal” levels of return −− On a year-by-year basis, ex-post returns can evidently vary substantially due to volatility (e.g. impact of floods on home insurance profits); looking ahead, level of return unlikely to change substantially ••Life Insurance RoEs vary more widely, due to product mix and variations in accounting treatments; appetite for banks to own life manufacturing operations has varied, partly driven by regulation and partly by the level of sophistication of the respective domestic life insurance markets

Non-core N/A (generally negative) ••Non-core typically contains fairly heterogeneous portfolio of assets (often with a skew to legacy CIB and large corporate assets) being run-off, and centrally-held charges

Source: Oliver Wyman research and analysis

6 For further information please refer to the joint Oliver Wyman – Morgan Stanley report “Wholesale & Investment Banking Outlook – Global Banking Fractures: The Implications”

By the same token, emerging markets no longer present to stay focused on operational excellence to continue to the golden opportunity to boost returns they once did. deliver high returns to justify their ratings. Where banks As shown in Exhibit 30, returns have been dramatically can’t do this there may be selective opportunities to higher in emerging Europe than in developed Europe consolidate domestically. (19% RoE vs. 2% RoE in 2012). However, valuations Tapping growth will not be easy over the next cycle. Euro reflect this, making further forays expensive. Coupled convergence, globalisation, demographic shifts, financial with this, recent volatility in some of these markets has deepening in emerging markets and deregulation were raised warning signals that growth in these markets is some of the macro dynamics that drove above sector not necessarily just a one way bet. In fact, conditions growth for some banks over the last 15 years. In a world raise the question of whether international banks of highly constrained capex, successful equity-strategy may start to divest and monetise emerging markets banks will need sharp insights on the big themes in which banking businesses. Banks in emerging markets need to invest over coming years.

3.2. GETTING DELEVERAGING AND DECOUPLING RIGHT

Deleveraging and decoupling will provide significant increase their assets, mainly in the form of loans. At challenges. If you dig below the stability of the sector- the same time, some of the less well capitalised banks wide balance sheet, significant changes in balance have been forced to reduce in size, mainly by shedding sheet size can be seen at individual banks. Some of the trading securities positions. best-capitalised banks have seized the opportunity to

EXHIBIT 30: BANKS IN EMERGING* EUROPEAN MARKETS ACHIEVED SIGNIFICANTLY HIGHER ROE** AND MTBV THAN THEIR COUNTERPARTS IN DEVELOPED MARKETS IN 2012 WEIGHTED AVERAGE ROE WEIGHTED AVERAGE MTBV % 20 1.4

1.2

15 1.0

0.8 10 0.6

0.4 5

0.2

0 0 Developed Emerging Developed Emerging

Source: Bankscope published by Bureau van Dijk, Capital IQ, Company reports, Oliver Wyman analysis * Eastern Europe, Turkey and Russia are considered emerging economies ** RoE is calculated as Net income / Average common equity Note: Weighted average calculated using average common equity weights

EXHIBIT 31: SIGNIFICANT CHANGES IN BALANCE SHEET SIZE ARE OBSERVED AT INDIVIDUAL BANKS INDIVIDUAL ASSET CLASSES’ CONTRIBUTION TO TOTAL ASSET CAGR, 2006-2012

AVG. T1 RATIO ‘06 15 13 8 8 9 % AVG. ASSETS ’12 190 240 590 550 460 €BN

% 18 16 Other 14 Cash and due from banks 12 10 Securities - other 8 Securities - trading book 6

4 Loans to banks 2 Derivatives 0

-2 Loans 1 2 3 4 5 QUINTILE

Source: Bankscope published by Bureau van Dijk, Company reports, Oliver Wyman analysis Note: Banks have been assigned to quintiles based on CAGR for total assets 2006-2012. Chart does not normalise for bank acquisitions

Most loan assets that are sold by banks are bought strategic clarity on the target go-forward portfolio. by banks. For many, managing deleveraging will be This requires senior managers to set the appropriate a matter of ensuring that they have enough capital to risk appetite, select the right leverage level, time asset buy attractively priced assets from stressed sellers. For sales and capital-raising well, and deliver a strategy the banks under pressure to deleverage, the challenge optimised for capital, RWAs, assets and liquidity. Banks will be finding the right balance between capital-raising that handle deleveraging well and achieve good capital and asset-shedding, and between responding to levels with low leverage will be rewarded by the markets. regulatory change and pursuing a broader strategy. Decoupling will also pose difficult questions for Step one for most players is the technical optimisation most CFOs in the coming years. It is likely to involve of the leverage exposure (data cleaning, guarantees and issuing new kinds of capital instruments (most commitments, derivatives compression and securities notably, bail-in bonds), increasing their capital and financing transactions), as well as tactical measures liquidity ratios, and reforming their legal entity with limited impact on the top line (such as non-core structures. Bail-in capital and liquidity buffers are asset disposal, work on cash balances, minimisation of expensive, and legal entity restructuring is difficult balance sheet intra-period inflation, and tighter limits and potentially disruptive. How far these measures are and redeployment of resources towards the more taken will depend on regulatory timetables and the strategic clients). Beyond that, banks need to develop costs the bank is willing to bear for future stability.

EXHIBIT 32: A SIGNIFICANT PROPORTION OF ASSETS SOLD BY BANKS ARE BOUGHT BY BANKS BENEFICIARIES OF HISTORIC DIVESTMENTS, BY TYPE OF ACQUIRER BY NUMBER OF DEALS BY VALUE OF DEALS Total sample size Deals 38 3% 0% Value €46 BN

Other 13% 3% 20% Insurer 2%

16% 50% 7% 53% Investor

AM*/Broker 17% 16% IPO**/Share sale 66% still in 70% still in banking system banking system Bank

Source: Broker reports, Company websites, Factiva, Oliver Wyman analysis * Asset manager ** Initial public offering

3.3. CHANNELLING INVESTMENT

Cost management has been a significant challenge This shift from ‘owned’ to ‘rented’ is a big cultural for the sector in recent years. However, with revenues change and one that we think many banks will struggle likely constrained, the ability to manage down costs is with. However, it will be essential to deliver the required becoming increasingly important to deliver returns. In scale and sustainability of cost saving. Investment capital has become painfully scarce for many banks our view, more radical action is required to achieve this. in recent years. So much is consumed by building To materially improve efficiency, banks must start at the systems required to comply with new regulations that little is available for other purposes. Exacerbating the beginning. They need to define the service model this problem is uncertainty about regulatory and that they will offer customers and be brutal about economic developments, which has shrunk the time ensuring the operating model is delivering that and horizons over which investment returns are judged. no more. This will require selective investment in With the increased demands on capital created by areas where banks seek competitive advantage (e.g. Basel III, managers have become understandably service), and much greater use of shared infrastructure/ reluctant to spend it. Nevertheless, different banks are vendors for commodity activities that don’t provide making very different decisions today about how much meaningful differentiation (e.g. collateral systems). investment capital to spend and how best to spend it.

EXHIBIT 33: STRATEGIC SOURCING EXAMPLES

TREND DESCRIPTION EXAMPLE PLAYERS

Increased capabilities of ••Increasing scope and vendor capabilities across capital markets driving: ••Murex, Calypso, Sophis technology vendors −− Consolidation of IT service provider base front-to-back within a given ••Fidessa business where achievable ••Sungard −− Alleviated pressure for application rationalisation −− Increased outsourcing of application hosting to third parties

Asset monetisation ••Increased vendor investment interest in capital markets back office assets ••Cognizant, Tata Consulting opportunities ••Divestiture of offshore captives where challenges such as subscale Services (TCS), Accenture operations and high attrition rates make them unviable ••Limited opportunity timeframe as vendors seek to acquire critical mass and early mover advantages

Emergence of the utility ••Active discussions between banks, industry bodies and vendors across ••Banks/custodians: BNY Mellon, activities to create back office utilities State Street, JP Morgan ••Embryonic offerings but moving fast and clear advantages for early movers ••Central Securities ••Scope focus to date on data heavy capabilities (e.g. reference Depositories: Euroclear data, reconciliation, KYC) and post trade activities (clearing, ••Vendors: Syntel, Mahindra collateral management) Satyam, Broadridge

Capital Markets Business ••Finance services BPO sector growing at CAGR of 4.6% to $1.6BN in 2016 ••Accenture, IBM, Capco, Process Outsourcing ••Trend of combined IT Outsourcing (ITO) and BPO deals to leverage Broadridge, Genpact, TCS (BPO) maturing additional value ••Widening scope of BPO activities (e.g. to change activities, full post-trade processing work streams, HR)

Third party bank solutions ••Banks/brokers with mature capabilities in post-trade activities white- ••JP Morgan, Deutsche Bank, labelling service to smaller/less advanced brokers (e.g. client clearing) Goldman Sachs, Morgan ••Some white-labelling of front office capabilities (e.g. market access, trading Stanley, Barclays platforms, client portals)

Joint ventures (JVs) ••Explore JVs with other banks, vendors and private equity firms for servicing ••Numerous banks in for middle office/back carve outs discussions (confidential office services ••Leverage strengths of all parties/drive out cost efficiencies ••Scope across middle and back office functions (e.g. across trade processing, reference data management)

Source: Oliver Wyman research and analysis

Much of the investment is coming from high- diverge in their strategic flexibility. We are already return emerging markets banks – they will need to beginning to see examples such as UniCredit and demonstrate skill in investment that many European IBM announcing a joint venture to offer cloud banks lacked in the pre-2006 boom period. As core computing and infrastructure provision to other Europe starts to pull away, the option to invest is Financial Institutions as part of outsourcing the IT becoming available to the banks in these geographies estate and Société Générale outsourcing post-trade as well and, as a result, banks are beginning to processing activities to Accenture / Broadridge.

EXHIBIT 34: EUROPEAN BANKS’ CAPEX SPEND HAS DIVERGED SINCE 2006 AVERAGE CHANGE* IN CAPEX ACROSS EUROPE, 2012/2006

REV. CAGR ‘06 ’12 1 3 8 % AVG. ROE 2012** % 3 7 7 AVG. ASSETS 2012 400 360 280 €BN

% 250

200

150

100

50 CapEx/Revenue

0 CapEx < 85% 85% - 115% > 115% 2012/2006 CAPEX

Source: Bankscope published by Bureau van Dijk, Capital IQ, Company reports, Oliver Wyman analysis * Average calculated by taking simple average of individual changes in each group ** Simple average across group. RoE is calculated as Net income / Average common equity

Leading banks will be able to overcome the barriers to share in core markets is leading banks to launch or consider dramatic cost reduction and service flexibility that have significant investment programmes around customer- been created by legacy systems. The early movers in centricity, mobile services and digital banking. However, this regard will reap the greatest benefits both from the we see many of these investment programmes being resulting cost savings and also the value generated from driven by historic assumptions, such as “banking these partnerships. Laggards will find themselves unable is not interesting, therefore customer experience to compete on price or quality. We think this differentiation management is about reducing the pain”, “banking will be on three dimensions – use of simplification (for example in core IT), better use of strategic sourcing built products are pretty generic: the role of marketing is to around a clearer definition of non-core activities and cross-sell them” and “customer value management is enhanced use and development of market utilities. about extracting value from the customer”. Consequently, there is limited focus on creating customer engagement or For the leaders, the challenge will be realising the potential making interactions a positive experience, little innovation upside of their investment, ensuring that their new in product design, and the focus is rarely on value delivered. technology is translated into headcount and cost reductions and into improved services. The laggards will simply need The risk we would highlight here is particularly around to change tack on investment, investing more in strategic the effectiveness of investment. Given the returns, initiatives rather than regulatory compliance alone. capital and cost environment we have outlined in this Across the board, banks are rapidly becoming more research, the pressure is on to make every investment customer-focused. The pressure to squeeze out market count, and to get initiatives right first time.

The European banking sector has confounded expectations in weathering the crisis; however, banks still face significant challenges. Executive teams will have to remain focused on the onerous task of navigating deleverage and other regulatory change, cost management, sovereign decoupling and the competitive threats circling the industry. Nevertheless, banks are becoming more investable as the path to better returns becomes clearer.

The winners are likely to be more heterogeneous than today as bank strategy, performance and investment decisions reassert themselves in returns and valuation.

We remain acutely aware of the limitations inherent in prediction. However, we have looked to recent history in order to frame some of the known unknowns and to draw out a better understanding of the shape of things to come.

Copyright © 2013 Oliver Wyman 37 The ideas in this report reflect many contributions from across Oliver Wyman. The primary authors were Ted Moynihan, Matthew Sebag- Montefiore, Elinor Turner and Antoine Weckx, supported by William Gilbert, Elisa Haining and Shashank Khare. The authors drew on the contributions of many partners across the firm, but in particular wish to acknowledge the help of Serge Gwynne, Christoph Knoess, Alan McIntyre, John Romeo, Sumit Sahni, Nick Studer, John Whitworth, Johaan Wiggins and Barrie Wilkinson. Oliver Wyman is a global leader in management consulting that combines deep industry knowledge with specialized expertise in strategy, operations, risk management, and organization transformation. For more information please contact the marketing department by email at [email protected] or by phone at one of the following locations: The shape of

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