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CONTENTS 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.