Podcast – Patrick Jenkins and guests review the week in banking

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Welcome to Banking Weekly from the Financial Times, with me, Patrick Jenkins. Joining me in the studio today are Martin Arnold, our Banking Editor; Caroline Binham, our Financial Regulation correspondent; and Emma Dunkley, our Retail Banking correspondent.

We're also joined this week by guests from Accenture. That's David Parker, who is head of UK and Ireland Banking; and US Banking Editor, Ben McClanahan, has been talking to Tom Michaud of Keefe, Bruyette & Woods.

This week we'll be discussing the red flags in Sweden's mortgage market. We'll also be looking at branching back as the latest way banks are looking to cope with Brexit. And, finally, that interview in the US Ben McClanahan talking to Tom Michaud. of KBW.

First though to Sweden, and Martin, UNR colleague, Richard Milne, have been looking at the Swedish mortgage market. There's red flags, according to one of the biggest banks there.

That's right. Johan Torgeby, the relatively new Chief Executive of SEB, one of Sweden's larger banks, says that there are many signs that the decades long boom in Swedish house prices is coming to an end, and the market is turning. And he cites the fact that, first of all, residential house prices fell in September 1.5%, the first fall for several years. He cites the fact that household indebtedness has reached levels that he says are unsustainable, and also talks about the impact of regulation, which is forcing mortgage holders to amortise the debt, to repay the debt, as well as paying the interest.

So that's a change that's been introduced recently, because of regulation. And also the supply of new homes, apparently, in Sweden is catching up with demand. There's been a surge in new home building. And so that's having an impact on the market, as well.

And there's an expectation that interest rates are set to start rising again from their deeply negative levels in Sweden of minus 0.5%. So lots of reasons why this is happening.

I must add that the SEB boss, and also Anders Bouvin, the Chief Executive of Handelsbanken, and another big Swedish lender, both say that while they think the market is turning, they think it's a healthy thing, because they think it does need to come down.

But they are also trying to reassure investors that the banks themselves going to be fine, because the average loan to value ratio of their mortgage portfolios is very low, about 50% of the value of the properties. They say they've been stressing their mortgage customers to see that they could afford for interest rates to rise from negative levels all the way up to 7% in base rate.

So those kind of comments are the sort of thing you're hearing from Swedish bankers. But a lot of people are watching the Swedish housing market, because people still remember the 1992 house price crash that did cause a banking crisis. And, as a result, the Nordic banks and Swedish banks share prices have underperformed this year compared to the sector.

Now you mentioned the early '90s crisis in Sweden. That was something that prompted regulators in the country to toughen up the rules. The country's got among the highest capital requirements in the world, actually. Is that what gives these banks the confidence that they can sail through this issue?

And I just wondered as a counter view on that, although they do have very high capital levels, I think they also have among the lowest risk weightings on mortgages around. So that's a worry, isn't it?

You're answering your own question.

I am.

But yes, exactly. So they do have seemingly very high capital levels, in the high teens, which is higher than any other big banks in Europe. But, when you dig into it, the weighting they attach to their mortgage books is extremely low in risk weighting terms, because they say they haven't had losses on their mortgage book for decades.

And Handelsbanken's boss, Anders Bouvin, told me that even in 1992, the provisions they took on their mortgage book were equivalent to 0.32% of the overall mortgage book, and they didn't need to use any of them. There were no defaults on mortgages. Even in that crisis, because what they say is that it is a full recourse mortgage market.

In other words, even if you hand back the house, if the house doesn't cover the full value of the loan, they can go after your other assets, the lenders. So that means that people just do not default on their mortgages. The last thing that people will default on is the roof over their heads, according to the bankers. So that gives them a lot of comfort.

It's not really the capital. It's more the stress testing that they've been doing on their portfolios. I mentioned earlier the fact that they have very low loan to value ratios as an average. And they also point out that Sweden's housing market may look toppy, but there isn't that added speculative element of buy to let lending, which you have for instance in the UK. They don't have that as a feature of their market.

Well, the UK will definitely be watching the Swedish market unfold over the next year or so, because I think it probably does hold a lot of lessons for us and our top head market. Anyway, thank you for that insight, Martin.

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Our second topic for the day is a look at something we're calling branching back. This is a complicated set up, which is designed, we think, to cope with Brexit planning. And Emma, you led the story on this the other day. Take up the challenge of explaining this in 60 seconds. (LAUGHS)

It might take slightly longer than 60 seconds, Patrick. So currently, US banks have a base in the UK, in London, from which they serve their clients in the EU. And this is under a passporting regime. But under Brexit, is unlikely that this passporting regime will remain in place.

So, as a result, these US banks have to create subsidiaries in the EU in order to continue serving these clients. Now the subsidiaries require a certain amount of capital, and staff, and expertise. And a lot of these US banks are, therefore, under a degree of pressure to move resources from London to fill these new EU subsidiaries within a tight time-frame. But also to fill these subsidiaries with local staff, for example.

As a result of the pressure, some US banks are seeking to turn their London operations into a branch out of the EU subsidiary as a way to continue using some of their London-based resources to serve their EU operation.

Now, the banks, we believe, that are looking at this as a potential plan for a worst case exit scenario, whereby there is no passporting, include Morgan Stanley, Citi, and Bank of America, Merrill Lynch, in various guises.

OK. Just to clarify, to make sure I understand this, as well as our listeners, the status quo is essentially that most US banks-- let's focus in on the US banks, because they're the biggest players here. Most US banks have their big subsidiary operations for Europe based out of London. And then they use these so-called passporting rules, along with branches located on the ground in the EU 27, to sell their services out of London, through those branches, and into that European market.

And what you're saying is that several of these banks are now looking at kind of flipping that. Having subsidiary operations in one of the other centres, Dublin, or Frankfurt, or Paris, or whatever, branching back into London.

Exactly. And just to emphasise that, this is being considered as a temporary measure, whereby the ultimate aim is to ensure that the subsidiaries do have sufficient talent, in terms of staffing and in sufficient capital, so that they can continue to use existing resources in London, and alleviate some of the pressure of trying to hire local talent in the new base, be it Frankfurt, or Paris, for example.

Let me bring David Parker in from Accenture now. David, you've been involved in planning for this. And I just wonder what exactly does it achieve? Because, as Emma says, it's a kind of short-term idea. But if it's just flipping current arrangements on their head, surely that's no solution in any way, really, because it's going to fall foul of the end of passporting, even if it's reversed.

I think it comes back to the fact that there's a lot of uncertainty about at the moment. There's-- you know, you've reported on a regular basis. And anything that gives an option to mitigate some of the uncertainty is inherently pretty attractive. So as Emma says, having something that, you know, equals potentially a mitigation of the transition risk over a period of time is something that is well worth looking at.

And to your point, none of us know exactly right now what will happen around passporting, depending upon the outcome of the negotiations. And none of us know exactly that line that regulators will take in terms of a branch operating back in London from a European subsidiary. How much of the operation would be allowed to be in London versus in the subsidiary's home market. But the fact that it could be an option to retain some of the activity, some of the stock, some of the critical skills, actually in their existing location whilst going through a transition period, it does it give flexibility against the uncertainty.

OK. From your point of view, the key then is, I suppose, what regulators think of this arrangement, as well as what politicians think of this idea?

Yeah. That's right. I mean, you know, clearly anyone who is setting up a subsidiary in a given market, the regulator is going to want to satisfy itself that the bank can operate, in effect, three lines of defence. That they've got the appropriate controls in place, particularly for [INAUDIBLE] trading, or, you know, those types of activity going on back in the branch. So the regulator is going to have to satisfy itself that the level of risk associated with the operation is being managed effectively within its jurisdiction, even if some activities are still taking place back in a branch elsewhere.

But just to be clear, that the whole idea of branch versus subsidiary, the benefit of that, the reason it's been done London subsidiary, branches everywhere else, up to now is because it's more capital efficient, rather than multiple subsidiaries everywhere.

That's right. And also, over time, clearly, London has built up a sort of concentration of expertise and skills, not just in sort of front office, but also in back office. And recreating those skill pools in all other jurisdictions, at the scale required, will not be an easy thing to do.

And it does I think raise the possibility of multi-client utilities, actually outside of the banks themselves, being a potentially more attractive option.

This is the arrangement where certain operations would be pooled within third party operations, like, I suppose, know your customer compliance kind of functions, or something like that.

Absolutely.

Let me bring Caroline in for a final word on this. So what we're talking about here is not a kind of solution that will solve everything almost regardless of what happens on the political stage, but rather, a short-term way of managing the transition risk over the next two or three years.

Yeah. I think it has to be heavily caveated that this plan very much relies on regulatory sign off on both sides of the Channel. And we've heard in recent months both the SSM, that's the Eurozone top banking supervisor, and then the PRA in the UK, give increasingly explicit warnings that they are not going to tolerate just boilerplate operations on either side of the Channel. They're going to want senior staff, a decent amount of capital.

The Bank of England basically put all foreign firms on notice that they were going to have to draw up worst case contingency plans to subsidiarise. Ditto, SSM has made similar sounding warnings. And I think you're getting a kind of splintering, again, of the post-crisis consensus that we had around regulation. And each jurisdiction beginning to have to think that they're going to have to look after their own interests.

The current system is predicated upon regulatory corporations. So the other big thing about a subsidiary is that where you subsidiarise is where you take your direct regulation from, whereas, as a branch, the regulator in the host country relies on the home country regulator essentially setting standards in capital and liquidity.

So a lot is going to be dependent on how regulators, both in the UK and the rest of the EU, work together and cooperate. And, again, it's not really within their gift, at the moment, to make promises, because that's very much dependent on the endpoint of the Brexit negotiations.

Well, it's definitely one to watch. Thank you for that, Caroline. And thank you, David, for joining us.

Well, let's go to a final item for the week. US Banking Editor, Ben McClanahan, has been talking to Tom Michaud, who's the head of Keefe, Bruyette & Woods. That's the US investment bank boutique, which has a specialism in financial services.

Tom, thank you very much for joining me. And let's begin with the third quarter earnings season, which is just in the rear-view mirror now, and perhaps looking back more broadly. What were the similar themes emerging? How have the big banks, in particular, been doing?

So when you think of the biggest banks, these would be the eight global SIFI in the United States. They had a very steady quarter, I think, which just shows another step in their progression as they recover from the global financial crisis. They've been growing loans. Credit cost was low, too. Not really a very important matter to the quarter. Their trading businesses were under a lot of pressure. They benefited some from higher rates.

But I think the key issue is not the quarter, but it's some of the big issues that are on the horizon. In particular, with the biggest banks, it's regulatory reform, it's tax reform, and it's higher interest rates.

Right. And hopefully you stand to boost profits.

Absolutely. And the biggest banks, those big eight, versus the rest of the industry, could benefit the most from regulatory reform, in particular.

So let's start with financial regulatory reform. We've got a lot of churn at the top of the regulatory agencies. Are there any clear directions now emerging from the big banks?

I think so. Since Dodd-Frank was passed in 2010, there's been no examination or review of it. Even Barney Frank, one of the authors, has been calling for amendments to the Dodd-Frank Act. And I think that the new collection of agency heads are going to do a review of how these rules are being implemented. And I also think it's inevitable that Congress will take a Congressional review of the areas that they're responsible for.

That's a high bar, isn't it? For Congress to agree on anything these days.

Well, I think they will do it; I just don't know when. But there seemed to be some portions of Dodd-Frank where there, from my observation post, seem to be almost unanimous. And I think, in particular, one of those issues is the $50 billion threshold for when CCAR begins, in the special area of stress testing that the Fed runs.

And what do you think will happen to that threshold?

I think it's inevitable that it will move. There'll probably be one of two things that'll happen. Either it will be moved to a much higher number, like maybe $200 billion. Or there are proposals that I personally like very much, which are centred around regulating banks based on their complexity, rather than their asset size.

When you think about it, an economy does better when banks want to grow and grow responsibly. But when artificial barriers are put in place that cause banks to not want to grow, I think it has a growth constraint, and causes a growth constraint, on the economy.

I can see that in theory, yes, not moving through one of these barriers, it could be an incentive not to do a deal. But have you seen that in reality, over the past few years? Have banks sort of been stalled--

One thing I can tell you is that every bank that crosses $10 or $50 billion, probably has a meeting in their boardroom where their boards of directors talk to their management team about what's the best path to cross that threshold. It could be organically grow through it, or it could be to sell the company. And I'm sure they have the conversation. And depending upon their skill set and situation, they make a decision.

Now the question is, does that make sense to have that happen in the industry? But that's the responsible thing for these managements and boards to do, to consider all the options. So if you do do over those thresholds, if you make examinations more sort of risk-based, what does that mean for the consolidation within the US banking industry?

I think, well, in some ways, you might see more of it. Because I think that $50 billion is a barrier for banks wanting to merge where their company would then go through $50 billion. But, at the same time, too, you could argue that the $10 billion dollar threshold has encouraged consolidation, because there were many banks that were 8 or 9 billion that wanted to merge with a company that already built the systems to be 10 billion, rather than spend the money to build it on their own.

So I think it would have-- it could be a powerful force in both directions. But I do think that the horizon for consolidation is one that is still pretty rich, and that you will still continue to see consolidation.

Which could be good news for KBW.

That is one of our core businesses. We do-- this year, we've been quite successful. As of today, we've advised on 10 of the top 12 bank mergers in America, and it is a business that we have a very good franchise in.

Let's talk about Volcker, quickly. I mean, in what ways should that rule-- which I should remind people is the effective ban on banks punting with their own money. And what would that mean for the industry if it were to be somehow loosened?

I think it would be a positive for the industry participants. I think it would be revenue positive. I also think it would be good for the markets, because liquidity is down in many different markets. And I think a lot of it is because the broker trading desks are not as active as they once were.

I don't think any industry participant wants to see aggressive risk-taking. But, right now, the rule is written so loosely, and it is enforced by at least five different regulators, that the incentive is to not even try. And I think that our economy would do better if that rule were more specifically designed.

Would it necessarily pose a risk to financial stability if you want to loosen the reins a bit?

Well, when you own securities, you could make money and you could lose money. And I think that the industry's got pretty good risk control. And I think that it could be done in a responsible manner to put in a little bit more definition that would allow them to be somewhat active.

But I have not really seen many proponents who say, don't have a Volcker Rule. The general principle's a good one. The question is, can you define it better, so the banks are more confident in participating in trading? Because, right now, they're not very confident, because the rule doesn't really give them the pathway to do that.

And you can do that without changing Dodd-Frank?

Correct. That is just something the regulators can do on their own. And, like I said earlier, there are at least five different regulators that have a say in it. And these regulatory bodies, many of them are just now getting their new leaders, or don't really have their new leaders yet. The question is, can they even do it?

OK. This returns to some of those catalysts for profits. Who talked about tax. That's a whole different question. But the higher interest rates we're beginning to see, aren't we? Some higher net interest margins moving through the system, which boosts, naturally, returns.

Correct. And that is really important, because a typical bank in the United States gets two-thirds or more of their revenue from spread income. Now the bigger banks, it's less. The big eight. Now I'm talking about the whole industry.

The banking industry was not built for zero interest rates and a flat yield curve, which, at times, we've had something like that recently. So, to the extent, we get some normalisation, we no longer have an accommodative monetary policy, get back to neutral, maybe, that will be positive for bank earnings.

Now, I think, the expectations were that the Fed was going to be even more hawkish. But now the Fed seems to be moving more slowly. So we do expect margins to improve, just not as quickly as we once did.

And you are assuming that deposit rate stay more or less pinned to zero, which is where they've been for the past few years?

Well, what I think the story that's unfolding is that the value of deposits is going up.

Right.

Deposits are going to be more valuable in the future than they were in the recent past. That's number one. And then number two is we've been tracking a ratio called the deposit beta, which is how quickly banks are being forced to move with the Fed funds rate.

We would expect that the deposit betas are going to go up every quarter sequentially, as long as rates are going up. And what you'll see is the better core-funded banks will probably have a better position than the banks that either have a 100% loan to deposit ratio, or don't have core deposits.

Even the banks with the very low loans to deposit portfolios, the Chases, the Bank of Americas, will they be forced into jacking up rates a little bit?

They will. They will. It's going to go up. It's going to go up. And what we haven't seen before is the fact that we've got more online access for deposits. So I think competition is going to pick up. And I think savers in the country are going to start to see higher rates in their bank accounts.

Right.

I think it's coming.

Another vector for profits, of course, is credit costs. I think in the third quarter, there was little signs outside of some auto portfolios, some credit card portfolios, that things were beginning to turn. What do you see the prospects for--

First of all, I think it's remarkable that credit costs have been this low for this long. If you were to take a step back and make a judgement about the industry, in my opinion, the industry is under-earning on interest rates, and it's over-earning on credit. Because credit costs have just been so low. So we keep watching at my firm for signs that something's changing.

And we really see nothing on the horizon that's causing us to get very nervous about a sudden spike in credit costs. It will happen at some point in the future. I think a lot of it is driven by the economy. The economy is cooperating at the moment. The US economy is growing. We've had some acceleration in the recent quarter. The world's economy is helping. We now have, essentially, the whole world growing. So a lot of it will be economic dependent for credit costs.

And where do you see the breaking point, if there is one? Assuming that the economy keeps ticking on at this--

It is hard to say.

Is it student loans? Is it car loans?

In my career, I've seen it be the consumer. I've seen it be real estate. I've seen a be commercial lending. I think it's hard to say. Also, too, remember we are in a very conservative regulatory environment. The regulators have been all over the banks.

So I think that the regulated entities have had generally conservative underwriting. That doesn't mean every bank will be the same. But there's been a lot of regulatory review, so I haven't seen a lot of speculation happening in the banking sector. Doesn't mean credit costs won't go up, they will. But I haven't seen any particular area, right now, from my vantage point, that that alarms me.

So let's bring it back to the big banks, finally. You've still got, despite all these favourable winds you're talking about, it's still pretty underwhelming returns at Citigroup, at Bank of America, struggling to make returns above the cost of capital.

That-- that--

So how soon can that improve?

That's going to be the fun story to watch over the next couple of years, which is that the regional banks have been able to do what I call the great migration. They've migrated from a low ROE to a high ROE. They've been able to adjust with the environment, and they're not required to hold as much capital the biggest eight.

Now, the biggest eight, which is the global SIFIs, they should carry more capital, because we saw what happens when they don't. They are, in many cases, systemically important. So I can understand why they carry as much as they do now.

But the US regulators are requiring them to carry more capital than their global counterparts. I think, and my firm thinks, that that's likely to change, and that they will be able to return more capital to shareholders, and they'll be able to lever a little bit more.

As they do that, their return on equity should go up. So if you look at their return on equity now, it's about, let's say, 10% for a round number. I don't think it's impossible to think that that number goes to 12% to 14%. And, oh by the way, pre-crisis, that number was high teens or low 20%, if you look at this on a tangible basis.

So it will still be well behind where we were pre-crisis, but it should be better than where we are today.

Tom Michaud, thank you very much for joining me.

Thank you.

Well, that's it for this week. All that's left for me to do is to thank Martin, Caroline, and Emma, here in the studio; Ben and his guest in the US; and also our guest here, David Parker, from Accenture.

Remember, you can keep up to date with all of the latest banking stories at ft.com/banking. Banking Weekly was produced by Fiona Symon and Amy Keen.

Until next week, goodbye.

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