Striving for profit – how can a ring-fenced bank ensure financial viability?
Within the next three years, the UK banking landscape will be significantly different, perhaps unrecognisable. This is due to a number of factors: the emergence and growing popularity of challenger banks; the rise of Fintech in the world of banking and payments; and the separation of UK retail banks from their investment and global banking operations.
The latter is due to ring-fencing legislation which is causing the UK’s five biggest and most influential retail banks to redesign and rebuild their operating models. The five banks in scope, Lloyds, RBS, HSBC, Barclays and Santander, are required to comply with the regulation as they have core deposits that exceed the £25bn threshold. Smaller banks including TSB, the Co-operative Bank and Virgin Money will also be impacted if they surpass this threshold by 2019.
Ring-fencing mandates that impacted banks isolate retail activities from the riskier parts of their business by 2019; this is resulting in significant costs and structural changes. It has been described as ‘crucial’ protection for high street bank customers, as the bank holding customer deposits will be able to survive independently from the investment bank.
The time and resource being invested in ring-fencing and the capital implications that the legislation brings may negatively affect the growth of the UK ring-fenced banks, or even result in them being financially unviable in the long-term. Irrespective of ring-fencing, it has been widely acknowledged that UK banks need to work harder on profitability. In 2014, not one of the five banks achieved a return on equity (RoE) of above 8%. Barclays’ RoE figure dipped from 23.8% in 2009 to 5.1% in 2014. Ring-fencing is likely to decrease this further, with a three-fold impact affecting profitability. How banks address the challenge is fundamental to their future viability.
The first impact on profitability is an increase in costs. The PRA has estimated that restructuring back-office functions such as IT, HR and other support services could cost banks up to 5% of their operating budget initially, and 3% annually thereafter. This ongoing cost will largely be the result of lost synergies between the ring-fenced bank and the rest of the group.
The second impact is that there will be fewer opportunities for banks to pursue revenue generation opportunities. Assuming ring-fenced banks are successful at raising funds, they will be unable to invest surplus deposits through the traditional channels of their investment banks. They may, therefore, need to place these funds with the Bank of England, potentially earning negligible returns.
The third impact to profitability is capital requirements. Ring-fenced entities will be required to hold extra capital buffers to protect the bank from uncertainty, which could amount to as much as 3% of the ring-fenced bank’s risk-weighted assets. The Bank of England has warned that between them, the banks affected could be required to hold an extra £3.3bn additional capital. Some banks will have greater exposure, depending on the business model they select and the relative size of their ring-fenced and non ring-fenced operations.
Banks will need to consider strategies to mitigate the inevitable impact on profitability. There are a number of approaches they could take.
One approach is to pass the cost onto customers, which it is widely thought they will do. Banks may attempt to increase the profitability of customer accounts by lowering interest rates on deposit accounts and charging for current accounts, resulting in the end of ‘free’ consumer banking in the UK. This approach is likely to be damaging. Banks risk losing loyal customers and reducing revenue further. Additionally, as the ring-fenced bank will bear the cost of branches, ring-fencing may be another driver to their already prevalent closure. Lloyds is in the process of closing 150 branches over three years, and RBS branches have decreased from 2,200 to 1,600 since 2010. Cost cutting in relation to ring-fencing may see this figure decrease further.
An alternative approach is to take the hit on profits but reduce dividends to maintain capital levels. This would stabilise the capital position of the ring-fenced bank but impact share price and inadvertently reduce shareholder value.
Ultimately, both approaches are short-termist survival strategies that would be damaging in the long run.. So what else can banks do?
A more forward looking option for banks is to use the opportunity to build efficient, streamlined operating models and harness nimble, cost-effective technologies. We are seeing some of the challenger banks leverage Fintech solutions to create digital, integrated banking platforms and robust customer service layers. If ring-fenced banks followed suit, this strategic approach should enable them to improve the cost effectiveness of their operations. They could avoid increasing customer charges, maintain dividend payments, and potentially improve customer service.
The UK’s banks need to look to the future. Rather than viewing ring-fencing as another regulatory mountain to climb and box to tick, they should use it as a catalyst to consider the long-term strategy, impact on their customers, their brand and ultimately the longevity of the organisation. They should plan how best to build efficient, sustainable and streamlined operating models and ensure the burden of ring-fencing is not felt by customers. Those that put the effort in now and think strategically to the future may be the last banks standing on both sides of the ring-fence.