Banks steer difficult path through uncharted waters

It has been many decades since the world’s financial services industry was in quite the state of flux it is now.

There are new global rules on how much capital banks need to hold, what kind of capital it should be and how much liquid funding they need to keep in reserve. As a result, bank profits are likely to come under pressure, and their capacity to lend will become ever more constrained.

Two years on from the failure of Lehman Brothers, the artificial boom ushered in by low interest rates looks set to give way to a far more challenging environment.

But if the world is all at sea, the UK is at risk of drowning. With tougher regulatory standards than the norm, and a political agenda to break up the big banks running in the background, it will be tough for British banks to make the most of a recovering economy – assuming it does recover.

“There are large black clouds on the horizon,” says Bob Penn, regulatory law partner at Allen & Overy, the law firm. “What we don’t know is whether there will be a hailstorm or whether they will blow over and we’ll get blue skies again.”

Analysts fear that the keenness of UK regulators at the Financial Services Authority and the Bank of England to go further than the recent Basel III accord, which sets new global standards for banks’ capital and liquidity, will hold back UK banks.

“We believe that impetus towards co-ordination of financial sector reform has largely stalled and that the consensus among governments is that there is no consensus,” analysts at Nomura, the investment bank, wrote recently.

“Instead, individual countries look likely to do their own thing. This is likely to increase the trend towards prioritising economic recovery over financial sector reform and lengthening the timescale for reforms to be implemented,” they added.

“At the same time, it is also likely to accentuate the differences between countries and increase the competitive disadvantages of banks operating in countries with more hawkish regulatory tendencies, for example the UK.”

When they met in Basel earlier this month, the world’s top central bankers and regulators filled in the biggest blank in the ongoing regulatory reform process, revealing that in future banks would have to hold a core tier-one capital ratio – a key measure of financial strength – of 7 per cent, compared with the current level of just 2 per cent.

The UK, however, is known to want to go further and is expected to push its big banks to hold a minimum ratio of roughly 10 per cent. The FSA is also to implement tougher rules on liquidity – insisting that banks hold far more assets in near-cash instruments, such as government bonds – in 2011, well ahead of the delayed timescale for global implementation under the latest Basel rules.

This new framework will be a challenge for all the UK banks, but particularly the likes of Royal Bank of Scotland and Lloyds Banking Group – the two part-nationalised banks that had to be rescued with government money amid the financial crisis. These institutions still have billions of dollars’ worth of toxic assets on their balance sheets that threaten to suck up capital for years to come.

That said, the capital rules look manageable for the time being. But, as at other banks, executives at Lloyds and RBS – although they concede that these are understandable measures to scotch the threat of another crisis – complain that the cost of meeting the higher standards will have big inevitable consequences.

Crucially, the banks’ capacity to lend – a major area of political sensitivity – will be further constrained. Already over the past year or so, small businesses in particular have protested that they cannot get the bank finance they need at reasonable rates. With bank base rates at a record low of 0.5 per cent for months on end, how, they ask, can banks be charging such high interest rates on loans and overdrafts?

It is impossible to know in every instance whether a bank is being excessive with its terms, or whether a business is being unrealistic in its expectations. But with regulators demanding ever higher standards of financial solidity, banks’ frustration is that the cost has to be borne somewhere, and new lending is one of the few easily manageable areas where it can make the numbers add up.

At the same time the flow of liquid funding – available via the interbank and bond markets – is not what it was. The markets’ nervousness about lending to banks is far less acute now than in the first half of the year when the jitters caused by the Greek sovereign debt crisis threatened to spill over into the other Mediterranean economies, most worryingly Spain. But even so, some banks in Greece, Spain, Italy and elsewhere still cannot find new funds to lend out to customers, although the markets have so far remained fully open to British banks.

Bank lending, particularly to the small business market, is such a sensitive issue that the government has signed up RBS and Lloyds to another year of lending commitments, with specific published targets. The government would like to persuade Barclays and HSBC to sign up to similar pledges. But without the sway of a significant shareholding to bolster its urging, the banks have so far managed to resist.

If a diminished capacity to lend is one outcome of the new post-crisis environment, the other is diminished profits. Bank after bank in recent months has told investors that they should no longer expect the 20-30 per cent returns on equity they enjoyed in the sector’s heyday up to 2007. Although the past couple of years have been a period of booming profits, especially for investment banks, there is consensus that the golden era is past.

Investment banks have benefited from a less competitive market, as Wall Street giants such as Lehman Brothers, Bear Stearns and Merrill Lynch were absorbed into rivals’ operations. Meanwhile, the scant availability of bank lending has ironically been a boost to bank profits as the issuance and trading of corporate bonds – in some cases as a replacement for bank credit – has reached near-record volumes.

A natural slowdown in bond markets will be a brake on profits in the short term, while the new regulatory rules will hold them back thereafter.

Analysts and bank chiefs seem to agree now that the range of returns on equity that the sector will be able to achieve in future will be closer to 13-17 per cent, barely half the level of recent times.

Those broader shifts in regulation, lending capacity and profitability will be felt across much of the world, but piled on top in the UK are other threats.

Most fundamental is the work of the government-appointed Independent Commission on Banking. Led by Sir John Vickers, the former head of the Office of Fair Trading, the commission’s job is to decide over the next year how the structure of the British banking market should be changed.

Within that frame of reference there are two big sub-topics. The first is high-street competition, where there is one glaring question: should Lloyds – the now vast retail and corporate bank that, with brands such as Halifax, Bank of Scotland and Cheltenham & Gloucester, as well as Lloyds TSB itself, commands a market share of roughly 25 per cent – be broken up? The second is whether the big universal banks, which have high-street and investment banks under one roof, should be forced to split to reduce their potential impact on the taxpayer in the event of another financial crisis.

The members of the committee are no patsies, and many observers believe they are bound to return with reasonably tough recommendations. But the issue is a political minefield. On the issue of Lloyds, any effort to shrink the bank would be horribly counterproductive for the Treasury, which owns 41 per cent of the institution, and would risk the value of that shareholding being hit if the bank’s operations were in any way diminished.

The same applies, on the issue of splitting the universal banks, to the government’s stake in RBS. Potentially even more significant for London’s status as a global financial centre are veiled threats from the likes of HSBC, Standard Chartered and Barclays that they could look to shift their headquarters overseas if remaining in the UK meant they would be broken up.

Politicians, meanwhile, have stepped up their attacks of the industry, with Vince Cable, business secretary, recently lambasting the “spivs and gamblers” of the banking sector. Mr Cable told delegates at the Liberal Democrats’ conference in Liverpool that something has to be done to shine a light on the “murky world of corporate excess” and said that public anger about the banking industry was “well deserved”.

It will take some time before there is total clarity on the road ahead for Britain’s banks – the commission will not publish its final report until September 2011, and then the government will have to decide how to respond to those recommendations.

In the short term, there is the added uncertainty caused by the advent of a new chairman at HSBC and a new chief executive at Barclays. The ushering-in of highly paid investment bank boss Bob Diamond as the successor to John Varley at the helm of Barclays has raised hackles in Westminster, although some think the sensitivity of that appointment could be offset by the influence of Stephen Green, HSBC’s outgoing boss. Mr Green – soon to be Lord Green – becomes trade minister early next year with a seat, too, on the Treasury banking committee – the band of politicians who will decide how to respond to the commission’s findings.

All in all, the UK has been left in an unhelpful period of limbo that will last into 2012, says Allen & Overy’s Mr Penn. “We will hit a point in about 18 months when we have enough clarity to be able to say whether London will stay an attractive financial centre or not.”