New Skills Required
By: Scott McDonald
From the Golden Era to the Era of Management
From the early 1990s until the early 2000s running a bank seemed easy.
This was the golden era of banking. Interest rates were trending down,
allowing credit to grow faster than GDP. And, for much of the period, yield
curves were steep. Economies around the world grew, unemployment was
low and, as a result, so were credit losses.
In this environment, it was hard not to make big money in banking.
Much of the profit came from maturity transformation (borrowing
short-term and lending long-term), the growth and liquefaction of the
credit markets, and sticky, high-margin retail deposits. In the golden
era it didn't seem to matter who ran a bank, as long as they had
strong deal-making skills and the discipline to avoid over-paying for
acquisitions. Exceptional management of growth and costs might lift
return on equity from 16% to 20%, but 16% was pretty good in any case.
In the early 2000s the long run of interest rate declines ended, and banking
became a mature business in most parts of the developed world, making
it harder to grow and maintain returns. Bankers rose to the challenge:
they increased the velocity of the credit business through innovative
securitisation, increased leverage, were aggressive acquirers and introduced
new high margin products for retail and institutional customers. But many
bankers did not rise to the challenge of saying no to bad or marginal loans,
pricing adequately for risk, maintaining reasonable leverage, and taking the
hard decision to reduce capacity in the financial system when macro-factors
required it. The illusion that managing a bank is easy was dispelled.
We know what happened in 2007, although we will spend years discussing
exactly why and restructuring the foundations of the financial system
so that it doesn't happen again, in the same way, soon. It would have
been hard, if not impossible, to take the bold steps required to address
the challenges and keep investors happy (and your share price strong)
with the global economic imbalances feeding demand for hard-currency
fixed income instruments, loose monetary policy at many central banks,
and competitors continuing to pursue high-margin growth. But the worst
excesses were avoidable.
For the immediate future, and this will probably last at least 10 years,
managing a bank will require different skills. Credit will be tighter and less
liquid, and rates cannot fall further; indeed, at the short end of the curve,
they simply will have to rise, fl attening and perhaps inverting the yield
curve. The inevitable result will be lower growth in the financial sector. In
our recent work on the state of fi nancial services1, banking CEOs told us
that expectations for the growth of profi ts had fallen by nearly 40% across
the industry. We think it could be even worse.
Credit losses will be higher – both those coming from the structured credit
assets still in the system, but also those normal credit losses driven by the
recession, and which typically lag a fi nancial crisis by two to three years.
Regulatory scrutiny will also be extraordinary, including the imposition
of higher capital and liquidity requirements, which in combination with
lower profitability is going to depress returns to shareholders across the
industry. Some banks with capital to deploy – either because they avoided
the worst excesses, or have found government and other sponsors to help
them through – will have higher margins, driven by reduced competition
and more sensible pricing of risk, to counter the general decline in
For investors in financial services, the new era will require careful
selection of investments, rather than allowing for industry bets.
The distribution of returns and valuations between banks will be stark.
You could argue that given stronger regulation of risk and capital and
lower expected growth, bank management should be easier. Regulatory
capital may, in the future, exceed economic capital so bankers would only
need to optimise within regulatory constraints rather than defining their
approach to risk and return. But it's not that simple. Regulation will evolve
and be influenced by bank leaders and investors still need to understand
a bank's approach to risk. The activity around new risks will once again
outpace regulatory control. Bank leaders will need to start preparing for
the next crisis that the new regulations will not prevent.
In this context, I offer seven suggestions for the leaders of the world's banks.
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© 2009 Oliver Wyman Limited