Background

Over ten years after the onset of the financial crisis, many banking and capital markets (BCM) firms are still struggling to cover their capital costs, and are still being priced at well below their book values (Figure 1, shaded area). As they continue to face new regulatory, economic and competitive challenges, and now have to contend with the COVID-19 pandemic, we ask how BCM firms can get back to delivering value in the 2020s.

Figure 1: Bank Values reflect their poor Economic Spread Performance

Our answer, in short, is that they need to adapt their management disciplines, particularly in the area of Capital & Performance Management, to fit the complexities and realities of the post-reform world - a world of complex regulation, resource scarcity, tight margins, and unstable revenue and cost (including capital cost) drivers. They will probably also need to start by restoring their capital ratios following the impact of the pandemic.

A better decade ahead?

Will gradually improving economic conditions and the steady adjustment to firms’ cost structures deliver meaningful performance improvement this decade? With the financial reporting season for 2019 fresh in our minds, three things stand out in this context:

  • Although firms’ core franchises have become narrower and more clearly defined following a decade of reinvention and restructuring, some firms are only now coming to terms with what they need to ‘be’ to compete
  • For these firms, and others whose franchise strategies are already set, the focus is firmly on transformation to deliver a lower cost, more agile business model
  • In spite of these intentions, and presumably on the basis of all going to plan, target equity returns are being adjusted down to levels that barely exceed equity costs.

There is also a widening performance gap between leading and lagging firms, both between and within segments and regions, implying that some are transforming ‘smarter’ than others. Evidently, becoming viable isn’t just a matter of time, and chipping away at cost in the meantime.

COVID-19 – A preliminary prognosis

It is very hard at this stage to judge what the overall impact will be, but we can be confident of three things:

  • BCM firms will take a major hit to their balance sheets
  • Policymakers will conclude that capital requirements should increase further, in light of this
  • Firms will therefore need to recapitalise, and possibly make a fresh appeal to the market if they are unable to generate organic capital fast enough. The ability to chart a credible path to a viable future will be essential for this to happen in an efficient and orderly way

Renewed disciplines

By implication, in the 2020s, transformation needs to be accompanied by a renewed focus on value realisation (Figure 2). That is, firms need to transform in the right areas and the right ways if they are to generate satisfactory returns for capital providers, if only by a small margin.

Figure 2: BCM firms have shifted their strategic agendas through turbulent times

If that seems obvious, it is equally obvious that this isn’t currently happening across the board. And it is also notable that firms are still reporting big differences in the relative performance of their operating businesses.

Part of the reason for this is cyclical, as firms’ businesses are subject to different economic drivers and cycles. Part of the reason is that firms are still looking for the right market niches to target, and the right operating models to deploy, to be competitive in their chosen domains. And part of the reason is inconsistency and distortion in the basis of measurement itself, for example as regards cost and capital allocations (sometimes with large allocations to ‘corporate centre’). This is leading to poor investment and resource allocation decisions, and poorly targeted performance remediation.

Clearly, getting clarity on these matters, and managing performance on that basis so that all businesses make a positive contribution to value (allowing for franchise interdependencies, cyclical factors, investment payoff periods and the like), is crucial to realising value across the business overall (Figure 3).

Figure 3: Capital & Performance Management is crucial to realising value from transformation

New Capital & Performance Management disciplines

Capital management is a particularly fraught area, given the extent to which new regulatory capital requirements have upended industry economics (by replacing implicit government guarantees with tiers of costly loss-absorbing finance) and distorted the internal performance picture (by making regulatory capital, not economic capital, the primary focus as firms try to mitigate this cost). Capital is now a very different beast and must be managed accordingly. In particular:

  • Gone are the days of straight RWA optimisation, as firms now need to satisfy balance sheet requirements on several fronts at once according to risk, leverage, stress and liquidity constraints – as well as risk appetite - applied to parent and subsidiary entities alike. They also need to take full account of franchise synergies given how important these now are to creating and maintaining a competitive edge. Optimising this is challenging, and sophisticated analysis is needed to chart the right path.
  • Paradoxically, equity capital should no longer be treated as a commodity, to be used as sparingly as possible in the interests of boosting RoE. The economic cost of replacing implicit government guarantees with private finance is unavoidable, asymmetric (1)  and largely sunk by now, as evidenced by the greater marginal sensitivity of equity costs to economic risk and leverage in particular. It seems that the economic cost and thus residual value of banking activity lies increasingly in the riskiness of the activity itself, and not so much in how that activity is financed (2). Firms therefore need to move on from making regulatory capital efficiency and headline RoE performance their sole concerns (3). Instead, they need to make balanced choices between financial (RoE) and economic (economic spread and economic profit) goals as they transform their businesses, taking account of how the market now sets capital costs.
  • There is evidence that the market will reward this through the share price, as market price-to-book (P/B) ratios now correlate consistently better with economic spread performance than with headline RoE. Firms therefore need to articulate their transformation strategies to investors and other stakeholders in these terms. It isn’t enough to ‘sell’ the transformation story on its own, or just to promise improved economic performance. They need to go hand in hand.

Through our deep market experience and expertise in Capital and Performance Management (alongside related capabilities in strategy, corporate finance, risk and regulation), and with the aid of dedicated frameworks, methodologies and tools, we are helping BCM firms across Europe and beyond to realise value from their transformations.

For more information please see our paper on this topic Capital & Performance Management in the 2020s – Realising value from transformation, or contact us at ukfsnetwork@deloitte.co.uk.

(1) Meaning that it does not increase linearly with increased capital and reaches a point where only frictional costs remain.

(2) This is of course a foundation principle of Corporate Finance, which the peculiarities of banking had obscured for a while. Industry reforms have restored this foundation to a large degree.

(3) Not least because, with the whole industry mobilised in that direction, economic margins will likely tighten in ‘favoured’ activities and open up in others. Current industry orthodoxy is exploitable in this regard.