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26 July 2013Robert Mancini
The large financial institutions have been voicing their concerns of how regulation will have adverse impacts to the financial sector, including the overall economic recovery. In fact, many experts have predicted that bank profitability will suffer as a result of these regulatory changes. The argument does make sense: less capital to lend and increased liquidity buffers will limit the financial institutions ability to generate revenue via lending volume. However, the recent Q2 results from the US global banks are puzzling. The levels of profitability have surprised analysts. Large US banks such as Bank of America, Citigroup, Goldman Sachs, JPMorgan, and more have all posted unexpected results. So the results cannot be attributed to an anomaly such as a one-time tax write-off, etc. There is some market factor creating this type of outcome. Are banks generating more revenue? Have banks reduced their costs? Is it an economic factor? It is true that low rates are helping but it remains that banks are out-performing expectations. I don’t think we can attribute the performance to economic recovery – yet. Let’s start with the cost side. There has been a push towards improving the banks’ efficiency ratio over the last few years. In other words, reduce the costs so that the efficiency ratio is better than the industry average. The problem is that if most banks are simultaneously trying to reach better than average then it keeps moving that number resulting in continued cuts in spending. In other words, banks are chasing the efficiency ratio rather than trying to hit a specific number. This affects many areas including staffing, infrastructure, investment in technology, and much more. I believe the driver was the anticipated, and realistic, augmentation in regulatory staffing and technology investment. In the recent months, I have heard trends supported by vendors to support this movement as it relates to spending. The bottom line is that banks seem to have been spending less on an aggregate – at least domestically in the US market. If you have been reading press headlines lately, the reoccurring themes look like “Bank A Settles for $XXX Million”, “Bank B Will Cut XXXX Jobs”, etc. Now let’s review the revenue side of the equation. Banks are having, and will increasingly have, difficulty in sustaining lending revenue due the regulatory demands for more liquidity. The press headlines are even more alarming, “Bank C Plays Down EU Cap Fee”, “Bank D Sells X Unit Due to Losses”, “Bank E Reports Flat on Lending Revenue”, etc. Back to the vendor perspective, many IT software firms supporting financial services have reported an increase in activity from banks (spending) in emerging markets. This supports the broader observance that banks are retrenching in their domestic / core markets while cherry picking in the emerging markets. In essence, global banks are targeting high yielding clients in emerging market countries where the existing domestic banks lack the competitive capabilities. This is another factor which can contribute to higher profits and support the observations of technology investment in targeted emerging markets to satisfy specific capabilities. Regardless of the cause, this short-term gain from banks could hurt them in the long-term. The regulatory pressure for banks remains high including the negative attention. This type of performance makes it difficult for banks to formulate an argument that more regulation is hurting them. The recent performance can fuel the continued political debates on banks “gambling” in the marketplace to boost profits – whether it’s true or not. This may indeed lead to more regulation and add hurdles to banks in the spirit of sparing taxpayers from another crisis. Is this not a good time for banks to spend more money now to augment their competitive advantages in the global marketplace? This approach would serve the banks short-term and long-term best interest.