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Action Matters

Restructuring is Key to Banks’ Survival in 2011 – U.K. & Ireland

After nearly three years of the financial crisis, the banking sector is in a period of sustained and radical change. Banks have continually found themselves at the eye of an elongated storm, which began as a banking industry issue, characterized by the run on Northern Rock in 2007. This, in turn, mutated into a sovereign issue, but is now firmly back to being a banking issue. With a raft of new regulation and continued uncertainty, it is clear that banks must now focus on what needs be done to safeguard not only their own individual futures, but that of the entire global banking system.

Earlier this year, the European Financial Institutions practice at Alvarez & Marsal (A&M) surveyed the financial services industry in both the U.K. and Ireland in order to gain a better understanding of banks’ priorities for the rest of 2011. A&M focused on the financial services communities in the U.K. and Ireland as, during the crisis, their respective governments extended significant financial support to the banks in each country.

A&M spoke to senior bankers, private equity firms, hedge fund investors and professional services firms active in the financial services industry in both regions. The results make for interesting reading.

Setting Priorities

The headlines show that the priorities for British and Irish banks for the rest of 2011 will be dominated by capital and liquidity issues. This year’s agendas reflect those of regulators, with over 60 percent of respondents from the financial services industries in the U.K. and Ireland citing sufficient liquidity and capital as being essential to funding bank operations over the course of the year. Some 44 percent of respondents predict an increase in U.K. and Irish bank asset sales as banks look to fund operations; while nearly 40 percent believe that banks will look to restructure their existing debt over the rest of 2011.

Respondents were also asked to predict from which sources banks would raise capital. While 37 percent believe that the respective governments will continue to provide capital injections – rising to 58 percent in Ireland alone – respondents were far more likely to believe that equity (86 percent) issuances would suffice, reflecting renewed confidence in the banking sectors on both sides of the Irish Sea. This is further reflected by the 65 percent of respondents who predict a renewed interest in the securitization markets.

All this shows that both the U.K. and Ireland will need to make considerable efforts during 2011 to continue to reform and restructure their respective banks and banking systems. As major trading partners, this process cannot be seen in isolation. What happens in one country will influence the market in the other, particularly given the exposure of the U.K. banks to the Irish property sector.

In the U.K., A&M’s research findings were recently given extra resonance by the publication in April of the Independent Commission on Banking’s interim report, in advance of the full set of reforms to be unveiled by the Commission in September. One of the most important ideas in the interim report, and one which will significantly alter the priorities of some of the banks A&M spoke to, is that the high street retail banking operations of the biggest banks should be placed in distinct subsidiaries.

The success or failure of this ring fencing will depend on the execution, but it is not entirely clear where the lines will be drawn in practice (e.g., small and medium enterprise banking and the transfer of capital between retail and investment parts of the bank). Northern Rock failed because it lent too much to customers and relied heavily on funding coming from the capital markets. Ring fencing retail activities might again lead to a greater focus on both.

Stepping Up the Pace

Another main driver of all banks’ planning is the Basel III core tier 1 capital requirements. With individual countries introducing their own rules, such as the ‘Swiss Finish’ and the ICB’s own recommendations for a higher base capital rate of 10 percent, the requirements specified in Basel III are rapidly becoming the lowest common denominator at only 7 percent. These heavy constraints on banks’ activities are yet another reason why their disposal programs must be accelerated.

The urgent priority in the U.K. and Ireland is getting banks into better shape through private investment. The controlled disposal in the U.K. of Lloyds branches and Northern Rock represents an opportunity to change the competitive landscape, while ensuring that the government and taxpayer maximize the value of their stakes in each bank. Encouragingly, A&M is seeing a high level of interest in U.K. and Irish bank assets, particularly from private equity and hedge funds. A&M’s research suggests that more of these assets will come onto the market as banks look to shrink their balance sheets and private investor activity will increase accordingly.

Against this backdrop of evolving regulation and potential asset sales, here are the immediate practical steps that should top the banks’ list of priorities:

• Banks need to reshape their business models, with increased focus on governance, risk management, and efficient delivery models that focus on what customers actually need
• Accelerate their restructuring plans, and make tough decisions on what is core or non-core
• Engage with investors, including the private equity community and do some deals. The market needs to set a clearing price from which future momentum can be built
• Where organizations are being slimmed down, senior management needs to look at how a platform for future growth can be rebuilt, rather than just burning what they originally had
• Put in place resolution plans that can be implemented in case a bank comes under stress (widely known as Living Wills)
• Accelerate the implementation of these plans.

This will be a pivotal year for the banking industry. However, it remains to be seen whether 2011 will go down in history as the point when the banking sector turned a corner after the worst recession in living memory. The great challenge now is for governments, regulators and banks to put in place the right framework to not just avoid another crisis, but to enable the whole sector to thrive.