Panic over? After a turbulent two years, the global financial services industry is starting to reshape itself for the future.
The fevered capital raisings and asset sales that were required to patch up tattered balance sheets and save banks from the abyss are, it seems, largely over. For some of the “too big to fail” institutions, notably Citigroup and Bank of America, there are still businesses on the block as the largest of the large banks continue their efforts to shrink after the credit crisis.
But banks are now focused on what the many new rules and regulations mean for the industry. While much of the detail is still to be hammered out, banks face higher capital requirements and greater oversight at a time when profitability is under pressure.
“The divestiture pressure on big banks has dissipated but the impact of new regulations is still unclear,” says John Binnie, a managing director at Moelis & Company, the merger advisory firm. “Consensus has not yet formed around capital and liquidity standards.”
With interest rates seemingly stuck at zero and the US and European economies ailing, the attitude of the industry remains cautious. “There is still a significant amount of uncertainty in this environment,” notes Mark Burton, a senior managing director at Evercore Partners, the investment bank. “And there appears to be considerable emphasis from the regulators on banks to demonstrate that they can withstand all sorts of challenging economic scenarios.”
Last month, the US Federal Reserve said the largest banks would have to undergo another so-called “stress test” before they would be allowed to pay dividends to investors or buy back shares. Moreover, bankers argue, regulators continue to take a sceptical look at dealmaking in the sector.
Deals in the US finance sector have totalled only $29.4bn so far this year, the lowest since data provider Dealogic’s records began in 1995. With deal volumes down about 80 per cent on 2009 – when the statistics were bolstered by bail-out transactions – regulatory changes could provide a further drag on mergers and acquisitions activity.
“The regulatory environment is extremely difficult and complicated,” one banker says. “Broadly, except in distressed situations, they don’t make it easy to do deals.”
The flow of distressed deals continues. The sale of Delaware-based Wilmington Trust to M&T Bank in November, revealing a shocking deterioration in the former’s loan book, caused renewed jitters about whether more banks were experiencing severe late-cycle credit problems.
As the industry slowly recovers, however, even healthy banks could come under pressure to explore other options. “Boards are asking management teams to show them what they expect to achieve on a standalone basis, based on credit quality and earnings power,” says Brad Whitman, co-head of financial institutions M&A at Barclays Capital. “You have to factor in regulatory costs, higher capital requirements from Basel III [the global banking regulations] and that net interest margins are tighter these days.”
The valuations of banks that have yet to repay the US Treasury’s investment under the troubled asset relief programme have lagged behind those of banks that are now clear of government support, Mr Whitman points out. “As some banks start to pay dividends again, the difference between the weaker and the stronger will become even more apparent,” he says.
Most experts believe consolidation among the US’s 8,000 banks will be slow to get going. But institutions in the US and beyond are already rethinking their business profiles in the light of regulations such as the Basel III rules or the Dodd-Frank regulatory reform legislation in the US.
The Dodd-Frank act’s so-called “Volcker rule”, which aims to separate banks’ higher-risk activities, including proprietary trading, from their deposit-taking core, has thus far had limited effects, say bankers.
The nine US-based proprietary traders who recently left Goldman Sachs to join KKR, the private equity group, are one exception.
However, the Basel rules, which will force banks to hold more capital against riskier assets, could prompt significant asset sales. Morgan Stanley estimates that the top 12 wholesale banks alone may have to sell or let run off about $1,300bn of risk-weighted assets under Basel III.
That process will come hand in hand with a strategic look at what businesses banks want to be in.
“The financial services theme is going to be one of repositioning portfolios and rearranging businesses,” says Gary Parr, vice-chairman of Lazard, the investment bank. “A number of banks still need to raise capital, while others want to refocus and have concluded they are in too many businesses. And for the large institutions that will fall into the too-big-to-fail category, what that means remains a big uncertainty.”
Barclays Capital’s investment banking division estimates that the top 35 US banks could find themselves short of $100bn-$150bn in equity capital under the new Basel rules, with most of that set to hit the largest six institutions.
In reality, banks have several years to comply with the new regulations, something that Barclays reckons makes this shortfall manageable.
But Jamie Dimon, chief executive of JPMorgan Chase, has raised the prospect of banks accelerating their efforts to conform to Basel III, to help demonstrate their strength. As part of the bank’s third-quarter results presentation, Mr Dimon said JPMorgan could make tougher decisions on selling assets and get to a core equity capital ratio of 10 per cent by the end of next year, without raising equity.
Advisers point to hedge funds and other specialist non-bank investors that could pick up the higher-risk loans and securitisations that banks will want to shed under the new regime.
Meanwhile, the pressure to raise capital could lead to sales of fee-based businesses, such as asset management, trust or custody, where banks do not believe their market position is strong enough to compete.
“Banks are going to need to earn capital, retain capital and downsize,” says Mr Parr. “They are going to look very different and there is still a lot to be done.”