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December 16, 2016

At the 2015 Risk Minds International conference, A&M debated the need for banks to move from seeking regulatory compliance to finding the right business model. In our view, with regulatory uncertainty diminishing, it was time to transform bank strategy and business models to accommodate the new regulation and satisfy investors. We addressed performance improvement actions required to better answer investor expectations while complying with tougher regulatory restrictions.

In our presentation this year, A&M looked back at what happened in 2016, and looked ahead to the top prudential and conduct debates impacting bank strategy to identify the way forward for banks searching for a profitable franchise.

2016 Recap

2016 saw many developments in prudential and conduct regulation.

On the prudential side, banks were active throughout the year:

  • Passing through three stress tests in the U.S., U.K. and Europe
  • Observing the emergence of Basel IV
  • Distilling the impact of the minimum requirement for own funds and eligible liabilities (MREL) and total loss-absorbing capacity (TLAC)
  • Delivering returns on capital well below the cost of capital

On the conduct side, bank reputations continued to be tested by:

  • Severe market conduct events and losses impacting retail, wholesale and corporate banking activities
  • Leadership changes
  • New conduct regulations (e.g., Markets in Financial Instruments Directive (MiFID) II, Benchmarks Regulation, and packaged retail and insurance-based investment products (PRIIPs)), which have yet to be implemented

The 2016 bank regulatory environment shows continuing uncertainty and increased global fragmentation.

While Basel IV has added an unexpected and undesired degree of uncertainty to prudential regulation, banks are close to being fully compliant. However, bank reputation and conduct has only started to be reshaped and substantial progress remains to be accomplished.

Top prudential and conduct debates impacting bank strategy

Debate 1 – Lagging return on capital and bank profitability in the context of continued regulatory change and a challenging macro-environment

In the latest stress test results, we observed lagging profitability of the 51 banks analyzed with only one bank delivering return on equity (ROE) levels above the cost of capital under a three-year baseline scenario. These results are even worse than 2014 stress test results, in which only three banks covered the cost of capital under the same scenario. This explains why banks trade today on average at 0.7 times book value and demonstrate the need for business model transformation. Optimization tools that balance regulatory constraint and interactively assess the portfolio impact of business strategies are required for banks to choose their business model fitting path.

Debate 2 – NPLs and their impact on bank balance sheets – new SSM NPL guidance

An important issue that harms banks’ Common Equity Tier 1 (CET1) generation and profitability is the large stock of non-productive assets in countries such as Italy (17 percent) and Ireland (17 percent), in contrast with other countries such as the U.S. (2 percent). High nonperforming loan (NPL) European banks are required to accelerate the unwinding of non-productive assets as their prolonged run-off generates high operating, funding and capital costs while constraining new credit flows. New single supervisory mechanism (SSM) guidance in this area will accelerate NPL reduction through improved strategic planning and governance of this business activity.

Debate 3 – How to reshape risk culture?

Regulators view the conduct “crisis” as being just as serious as the prudential crisis, with serious failings across retail products, wholesale markets, financial crime and anti-money laundering. Indeed, conduct risk is now such an important issue that prudential regulators are asking whether it should be built into their prudential capital frameworks. Conduct regulators are moving from asking banks (and every other type of firm) to “do things right” (i.e., deliver compliance) to “do the right thing” (i.e., get good outcomes for clients and for the wider marketplace). “Doing the right thing” means embedding good conduct into firms’ DNA. Senior leaders are increasingly on the hook for the key judgements, while regulators have shown themselves willing to second-guess these judgements and impose their own view if necessary. Companies will need to be capable of quantifying the potential impact on the bank if a material loss event occurred, ensuring a coordinated process with a structured conduct and reputational risk governance put in place, and ultimately inserting a sound risk culture.

Debate 4 – Smart conduct compliance?

The response by legislators and regulators to the conduct crisis has been every bit as intensive as to the prudential crisis. But the implementation is not as advanced (e.g., in Europe, this includes MiFID II, Benchmarks Regulation and PRIIPs). Banks that do well will have smart implementation of the new regimes, both “horizontally” and “vertically.” Horizontally, they will be looking across business areas to identify the key risks and designing policies and processes that integrate all the new regimes. Vertically, they will be ensuring that this is all “owned” by senior management, which put in place incentives for executives and employees that align with the right behaviours, rather than compete with them, and supported by an effective control framework and relevant Management Information (MI). The banks that do not do as well will just hire more compliance people.

The search for a profitable bank franchise

The challenge for banks is double:

  • Prudential challenge: How to re-engineer business models to be profitable in the new regulatory environment (and very tough business cycle position).
  • Conduct challenge is exactly the same: Regulation will be driving up costs of using  existing approaches, against a background of loss of consumers’ confidence in sector and competition from new technology. Reputational risks from conduct events can destroy the franchise value. Banks need to re-engineer business models to be profitable in the new regulatory environment.

Prudential and conduct regulatory requirements drive bank strategy today. Banks can improve bank business models by focusing on aspects such as sound culture and governance, new performance measurement tools, upgrades in balance sheets and strategic planning processes, and industry consolidation.

Click here to download a full copy of our presentation.