While the optimal business model of the future in banking has yet to be fully determined, a combination of regulation, consolidation and globalization are driving change. The final state of the regulatory framework has yet to be set in many instances. What is clear is that traditional roles in the financial food chain will be redefined. Banks will be forced to make difficult decisions to refocus their business portfolios on those areas offering the best returns.
While bank management teams are likely to focus on the operational effects of regulation, well-managed banks will resist the urge towards a purely inward focus, and instead acknowledge and embrace the coming change.
Operational improvements will help drive profitability. But as broader business models evolve, the void left by banks in many businesses is likely to be filled by asset management firms, hedge funds and other alternative investment vehicles – entities often referred to under the rubric of the shadow banking system. As these nonbank entrants fill the void, their needs will change and grow. Guess who is best suited to help these entrants thrive in their new roles?
You got it: the traditional banks themselves.
There is a significant opportunity for banks that intensify their focus on the services they deliver to their shadow banking brethren – in essence embracing them as increasingly important clients, rather than future competitors.
Let’s back up a bit. While the regulatory environment is the most talked about impetus for change in banking, in reality there are several drivers altering the financial landscape.
The financial crisis accelerated consolidation and left us with fewer, bigger banks. The remaining banking “factories” increasingly provide commodity-like, automated product offerings with little differentiation. As a result, for the last three years, the largest banks have focused on the cost side of the equation: efficiency, automation and the elimination of redundant systems, which will prove valuable in the long run.
Lacking efficiencies of scale, midsize firms have even greater challenges, and according to a March 2011 report by Oliver Wyman and Morgan Stanley, these banks will be forced to retain a narrow strategic focus to have a chance of outperforming for shareholders.
Add to the mix complex and often contradictory global regulatory regimes, Basel III capital guidelines, and the shaky fiscal health of an increasing number of governments, and the banks are left in a classic squeeze. The reduction in principal investment activities (due to the Volcker rule), the restructuring of previously high margin areas like over-the-counter derivatives and limitations to fees in certain consumer banking activities have shrunk the revenue base at the same time it must cover spiraling fixed compensation and capital costs. Importantly, new capital requirements are also making many key traditional banking businesses more costly.
The needs of individuals and corporate users of bank products remain significant. For instance, the capital demands of companies that finance themselves through borrowing and the issuance of stock will continue to grow due to the globalization of commerce and the accelerating importance of developing economies. Yet the Morgan Stanley/Oliver Wyman report suggests that the broader financial market has underestimated the downstream impact of new regulatory and risk capital requirements on these users of banking products, in the form of either higher prices for some traditional bank services and reduced appetite in other core areas like lending. As an example, under Basel III capital rules, financing to small and medium sized enterprises is likely to become particularly expensive for banks, and this lucrative business is already attracting nonbank entrants. Other businesses will become too expensive and will be exited altogether.
A central role the large traditional banks play is to arrange capital (from investors) to provide to those that need it (security issuers and borrowers). Hence, the asset management industry is and will remain among the largest client segments for the banking business. And asset management is undergoing its own changes. The regulatory environment is one facet. Large institutional asset management firms (think BlackRock and PIMCO) invest money largely on behalf of pension funds. So demographics, particularly in developed economies like the U.S. and Europe, are another factor – aging populations mean more pensioners, which mean more pressure to generate adequate returns in what looks to be a pervasively low interest rate, highly volatile investing environment.
Meanwhile, in alternative asset management segments such as hedge funds, investors have materially tightened their due diligence procedures as a result of lessons learned from the financial crisis and the Madoff fraud. Safety, transparency and risk management capability have come to the fore, benefiting the largest managers with the most established infrastructure, systems and performance records. And these investors are looking for their “approved” hedge fund investees to give them access to new strategies in geographically far-flung markets, so the manager needs to get more global than ever, either organically or through acquisition. Finally, capital is less sticky – contracts have become much more investor-friendly, and investor capital heads for the door quickly at the slightest sign of weak performance.
The result: The average hedge fund CEO no longer has the luxury of focusing solely on returns, which in this environment is challenging in its own right. He will continue to require efficient access to markets and good investing ideas. But his needs are growing to also include corporate-finance advice on M&A, strategic growth initiatives, capital retention, and, as the hedge fund market matures, succession planning. It’s not clear that many banks are correctly structured so as to maximize the engagement with and fully adapt to the expanded set of client needs.
With this backdrop, what does the future hold? It’s clear that the traditional banking world is going to reduce its presence in a number of businesses, some by choice and others through increased competition. Some well-capitalized new entrants will attempt to disintermediate traditional banks and gain a foothold in key consumer businesses, and harness technology to shift the way some institutional businesses are conducted. Boutique firms will continue to appear in niche segments where perceived expertise trumps scale.
Fundamentally, I would argue the larger opportunity for disintermediation is created for the nonbank asset management community. Whether you are an institutional money manager or a hedge fund, the chance to buy existing portfolios or business lines from traditional banks can offer significant returns. Entering other businesses – eliminating the banking middleman by providing capital directly to those who need it – will be attractive for those with the vision, credit expertise, technology and infrastructure to do so.
It may be jarring to suggest that traditional banks help a key group of clients take business from them, but that’s exactly what’s needed. Banks are going to need to make hard decisions to exit some traditional businesses. The question is how to do it to maximize what you get at the exit, and if you can do it in such a way that your remaining businesses can thrive, and gain market share.
Success for the banks that adopt this approach will require several ingredients. The first is client selection – choosing a group of important nonbank asset management firms that are best positioned to take on new roles in the new financial services landscape as a result of bank exits or perceived competitive opportunity. Once that choice is made, it is essential to map out the products and services that these nonbank, asset management target clients – be they large asset managers or niche hedge funds – are likely to need. Third is the creation of a dedicated, interdisciplinary, globally-coordinated “SWAT team,” specifically positioned to work across the traditional bank platform and comprehensively service the need.
Critical to this is staffing, which is often harder than it seems. The challenge is structural in nature. A typical bank-owned broker-dealer is set up in product verticals such as investment grade bonds, leveraged loans, or equities – where product specialists provide narrow focus but deep expertise along with ideas, execution and relationship service to asset managers that invest in these specific product areas. A number of banks also deploy a small number of relationship managers who focus on larger firm-to-firm matters with important clients, solve problems, and seek to facilitate business across product lines, although in practice these individuals often align by broad asset class, like fixed income or equities.
These traditional resources remain critical, but they are not sufficient. Why not assemble a team that draws from multiple disciplines – not just global markets experts, but also investment bankers who are experts in corporate finance, M&A and capital raising and even regulatory, tax, accounting and technology experts?
The banks that win will be the ones that create an empowered, multifaceted team that balances relationship building with technical domain expertise in a broader range of financial disciplines. Many have the right personnel and expertise to do so. The problem is alignment: these capabilities need to be lifted out of product-centric groups and instead be combined to service this focused group of asset management clients. The charge is straightforward: bring them an integrated suite of capabilities.
The final question is how such a client-focused group fits in the traditional banking organization. Careful thought should be given to structural reporting lines, so that the group is agnostic as to product discipline, and more importantly is empowered to act on behalf of the bank at the highest levels, and mobilize firm resources where needed. In this respect, an interesting approach is to align it with the internal strategy/corporate development function (typically this is a CEO-level report) so that internal strategic business decisions can be easily linked to a dialogue with those strategic clients that are likely candidates to buy or enter businesses that the bank has decided to scale down or exit.
The value of serving these nonbanks is twofold. First, it will facilitate the transition of businesses and portfolios while limiting the frictional impact of doing so. (If the buyer and seller of a business have a longstanding relationship, they are likelier to work together to minimize the disruptions that occur whenever a business is sold.) The approach will also create new opportunities for the banks to provide a different level of client partnership and an accompanying halo of “sticky” recurring revenue in existing product lines that will generate returns for years to come.
Kevin Harmon has held leadership roles in global fixed income capital markets for Credit Suisse and Bank of America Merrill Lynch, and has extensive knowledge of derivative markets in particular. He is the founder of Elvaston Management, a private investment firm in Westport, Conn. He can be reached at email@example.com.