Trends and opportunities

The largest banks in the world have significantly improved their capital position in the years since the crisis. While there is lingering debate in some corners that banks are still not sufficiently capitalized, it is undeniable that the dangerously thin buffers of the pre-crisis era — where the Common Equity Tier 1 (CET1) capital ratio was below 4% for some banks — are gone, as banks have raised additional equity over the last decade to penetrate their capital.

Resilience has also been supported by the development of recovery and resolution plans (RRPs) as mandated by regulators globally. While it is true that the cost of compliance has risen dramatically since the crisis, at the start of 2018 we believe the industry has crested the peak of regulatory-driven investments in systems and talent. Although compliance costs are set to remain elevated, when compared to the costs in 2007, we believe the cost of adapting to the post crisis prudential regulatory framework has stabilized and is set to decline. Further, most bank shave resolved most legacy conduct issues. Litigation expenses are falling and although banks continue to reshape their footprints, they are also signaling that the associated restructuring costs will soon rise.

Bankers’ expectations for growth are supported by EY’s annual review of the publicly stated strategies of 30 major banks around the world. Controlling risks and protecting against internal and external threats remain important, but the greatest emphasis is on improving financial performance through growth and optimization.

Q: Combined, the growing optimism of bankers and the notable shift in strategic focus would seem to suggest that a stronger global banking industry may be headed for a period of sustainable double-digit ROEs. We believe that without a significant change in the industry, this is unlikely.

Evidence that banks’ cost bases are more flexible or scalable than they were pre-crisis is not compelling. Our analysis of the world’s largest 200 banks shows that while their aggregate costs have fallen by a little more than 10% in the last five years, they are still more than 25% over their 2008 cost base. Average cost-to-income ratio shave barely changed. Further, our Global banking outlook survey reveals that most bankers anticipate that costs will continue to increase over the next three years, as the moderate savings in regulatory change programs are reallocated to growth initiatives and cybersecurity spending. On average, bankers expect a 2.1% cost increase over the next three years.

At an industry level, should banks be unable to contain costs and improve capital efficiency, we estimate that revenues would need to increase by 2.4% by 2020 to maintain 2017’s average ROE of 11%. It is widely perceived that an increase in central bank interest rates will solve the industry’s weak revenue growth problems by boosting interest income, but this may just be palliative. Estimates suggest that following three US Federal Reserve rate hikes in 2017 and an expected three additional increases in 2018, net interest income for the largest US banks could increase by 5% in 2018 and 2019. Similarly, the European Central Bank’s recent stress test found that a 200-basis-point rise in interest rates would provide a 10.5%boost in net interest income by 2019. All else remaining equal, we calculate that this would lead to ROE increases of 6.4% and 3.1% for US and European banks, respectively.

When assessing the accelerating competitive challenges, banks are facing increased competition from a range of new market entrants, including digital banks, FinTechs, institutions offering high-touch and high-tech branch services, e-commerce and telecommunications firms, and in some markets, platform banking providers. Such competition has emerged in response to rapidly changing customer expectations and behaviors, and are forcing banks to invest in customer technology to prevent customer leakage and preserve their value chain.

In recent years, the ability of banks to maximize financial performance through growth and optimization has been hampered by regulatory change programs and compliance demands. However, our Global banking outlook survey reveals a remarkable shift. Today, it is evolving risks that are preoccupying banks, making cyber risk the most evolving one. Our Global banking outlook survey reveals that enhancing cybersecurity has become the top priority for banks in the coming year. However, as bank leadership teams focus on investing in people and technology to enhance cybersecurity, they are likely to face an array of new problems, such as how to find the right talent when there is a cybersecurity skills shortage and how to integrate cyber experts into their organizations. Hiring people with the right cyber skills is one thing; helping them develop the right business and risk skills for a banking environment is another. Artificial intelligence (AI) and advanced analytics will play a key role in the prevention of cyber-attacks, reducing conduct risk and improving monitoring to prevent financial crime.

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Mitigating such external and internal threats is critical to both business continuity and limiting operating losses. However, unless banks collaborate more with their peers, or make better use of the ecosystem, the required investment in advanced technologies to address these issues will be substantial and could strain banks’ ability to invest in improving financial performance through optimization and growth initiatives. Managing reputational and conduct risk remains a high priority.

As EY’s most recent Global Regulatory Network executive briefing observes, “on the bottom line, culture does indeed count,” and believes that improving culture is critical for limiting the sizable downside risks of poor organizational behaviors. 5 Banks are also looking for new ways to manage the risks associated with financial crime and anti-money laundering compliance and are increasingly using advanced technologies, such as advanced analytics, machine learning, robotics and automated intelligence, to support these efforts. Although policymakers have finished rewriting the rules in response to the crisis, banks should not expect compliance requirements to loosen.

In fact, pressure on banks is likely to increase, as regulators around the world each implement their own particular version of the Basel reforms, and as regulators set the rules under which banks must deal with the challenges posed by new technologies. In addition, the post-crisis global regulatory alignment is fragmenting as certain jurisdictions begin to consider varying degrees of regulatory relief. This is particularly evident in Europe, where some structural reform proposals have been rolled back; in the UK, which is currently negotiating the terms of its exit from the European Union; and in the US, where the Trump Administration appears poised to repeal large parts of the Dodd Frank Act. Additionally, increased regulatory scrutiny, because of incidents such as the Panama Papers and Paradise Papers, are leading to tax reform across jurisdictions to mitigate tax evasion.

To successfully insulate themselves against the impacts of future downturns on financial performance and business continuity, banks must complete the transition from regulatory-driven transformation to innovation-led change. This will require banks to avail the ecosystem externally and become more digitally enabled. They will need to make meaningful investments in end-to-end processes and infrastructure aimed at driving real efficiencies across the entire organization, as opposed to spending their innovation dollars on tactical projects and frontend customer interfaces. In other words, they will need to become more digitally mature.

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