In the Land of the Giants, Choice Is Reinvention or Extinction

The idea that the banking business, especially at the largest banks, is back to normal is dangerous.

Granted, most of the giants reported better-than-expected profits for the second and third quarters, but the performance was not based on sustainable factors — not for all of them or even most of them.

Barbara A. Rehm

And yes lots of people, particularly policymakers, are busy assuring us that the large banks can and will meet the higher international capital requirements from the Basel Committee on Banking Supervision.

But in the wake of the Dodd-Frank Act and Basel III, the executives of the largest banks will have to reinvent their companies to generate the returns needed to ensure survival.

And those who don't will no longer be able to count on the regulators for cover.

Think back to fall 2008 when Hank Paulson, then-Treasury secretary and co-captain of the government's bailout squad, avoided exposing the industry's weak links by insisting that every one of nine large companies accept a government infusion.

But the crisis has passed, and a different dynamic is taking hold. Regulators will allow winners and losers to emerge. The first sign: the decision by the Federal Reserve Board to let the strongest banks raise their dividends early next year.

Who will the winners be? Those banks that take a fresh look at everything they do and how they do it.

"They'll be the ones that say, 'Let's take this place apart and figure out where we are making money,' " said Bob Clarke, a former comptroller of the currency who is now a senior partner at Bracewell & Giuliani LLP.

Toos Daruvala, head of the Americas banking and securities practice at McKinsey & Co., is consulting with many of these banks on this idea. He put it this way: "Banks need to imagine the future, impacted by deleveraging, Basel III and Dodd-Frank, and work backwards." Exactly.

We are not talking about tweaking what you have. We're talking about blowing it up and consciously deciding where to put capital to work — and where to bail.

The large banks will need to rethink each business line, each product, each geography — everything. The strongest survivors will turn themselves inside out over the next five years.

Some executives are complaining about how hard it is to make these sorts of decisions given all the "uncertainty." It is their institutions that will be left behind.

Even without detailed rules, every bank executive knows that the cost of capital is rising and returns are falling, so now is the time to find the right mix of businesses to boost revenues.

Some executives contend they are already on this path. And to varying degrees, that's true. But Daruvala benchmarks banks for a living, and he said the gap between the best performers and the average performers is enormous.

Kevin Buehler, co-founder of McKinsey's Global Risk Practice and co-leader of its corporate and investment banking practice, said that's because change does not come easy, especially in large, diversified companies.

"It takes a real performance mind-set throughout the organization to change behavior," he said. "It is quite challenging to change well-entrenched behaviors.

"It won't happen without real management leadership."

Buehler said the single most important skill CEOs need today is the ability to balance risk and return.

"They have to make intelligent choices that are not overly conservative or foolishly aggressive — and these aren't necessarily the same changes one would have made two years ago," he said. "The CEO has to lead the business in a way that focuses on capturing the next growth opportunity."

Growing is among the most vexing challenges banks face today. The industry's return on equity has historically been in the 10-12% range and it jumped to 15-20% during the 2000-07 time frame. A McKinsey analysis forecasts ROE will drop to 7% at the largest banks if executives don't take dramatic action. (And yes, we understand McKinsey gets paid for helping companies plot these actions.)

Returns in the range of 7% would not cover the cost of the industry's capital, which has averaged between 10% and 11%.

A slow economy, consumer deleveraging and low interest rates will weigh down returns, as will the Basel Committee's capital and liquidity rules. Dodd-Frank will take its bite as well, both in terms of higher compliance costs and limits on fee income. McKinsey forecasts bank revenues could decline by 30% from precrisis levels.

From an external analysis of the industry, McKinsey estimates the industry is $650 billion short of the $1.4 trillion in capital needed to meet the Basel III standards. To reduce the denominator, the consulting firm expects banks will shed some $1 trillion in assets over the next few years.

Indeed, McKinsey does not see the biggest banks getting any bigger. In fact, it suspects some member of the trillionaires club will shrink. While the Basel III requirements do not take effect until later in this decade, the large banks are scrambling to hit the thresholds earlier.

Daruvala expects half of the big banks to reach the Basel III minimums by 2012.

And when they do, they will gain regulatory freedom and credibility with investors, which both translate into advantages over their competitors.

"There will be winners and losers," Buehler said. "There will be a set of institutions that are well capitalized, highly profitable, have shed noncore businesses and have the economic and regulatory flexibility to take advantage of distressed competitors."

That will present a moment of truth for the regulators, who have given every indication since Dodd-Frank was enacted in July that they will let the strong soar and the weak fall. No one knows if they will blink or not, but the executives running these companies today better not bet on it.

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