The Shape of Things to Come

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

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

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

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

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