How Europe’s banks got into a pre­car­i­ous po­si­tion

The Pak Banker - - OPINION - Ben Wright

IF you wanted to choose a sin­gle word to sum up how Euro­pean banks got them­selves into such a fright­ful pickle it would have to be "op­tion­al­ity". To un­der­stand what it means or, more pre­cisely, what bankers think it means, we have to rewind to the 1990s when banks started to con­sol­i­date. The Fed­eral Re­serve has a bril­liant chart to il­lus­trate what hap­pened next in the US (see main im­age above). On the left it is 1995 and there are 37 banks; on the right, it's 2009 and they had be­come four: Wells Fargo, Cit­i­group (a se­rial con­sol­ida­tor), Bank of Amer­ica (which had just swal­lowed Mer­rill Lynch) and JP Mor­gan (which had re­cently be­come the proud owner of Bear Stearns).

The con­sol­i­da­tion of Euro­pean banks was by no means as pro­lific. But many lenders on this side of the pond had beefed up in or­der to com­pete with the Amer­i­can be­he­moths. Bar­clays had re­cently bought Lehman Brothers as­sets and the Royal Bank of Scot­land had just made its ill-fated pur­chase of ABN Amro. All of th­ese dif­fer­ent banks were es­sen­tially pur­su­ing the same busi­ness model: they all wanted to be global uni­ver­sal banks. What this meant was that they wanted to be all things, to all peo­ple in all parts of the world.

There was just one small snag. They couldn't all suc­ceed. Many busi­ness lines were so com­pet­i­tive that only the top two or three best firms made any money. In­deed, it was an open se­cret that there were some ar­eas in which no banks made any money. For a long time, firms would es­sen­tially is­sue in­ter­est- free loans to big com­pa­nies as a way of get­ting their foot in the door and, hope­fully but not al­ways, win­ning other, more lu­cra­tive work.

The mis­nomer for all this was "cross-sell­ing". But that im­plies that banks were sell­ing dif­fer­ent ser­vices to the same client. Too of­ten, many ser­vices were given away for free. And if none of those ser­vices was mak­ing any money, well, that was OK too be­cause the guys on the trad­ing floor were coin­ing it in and mak­ing enough to cover for the whole firm. Then came the credit crunch. And then came the reg­u­la­tions that were sup­posed to stop any­thing sim­i­lar hap­pen­ing again. Once im­ple­mented, th­ese started slowly but in­ex­orably al­ter­ing the eco­nom­ics of the whole bank­ing in­dus­try.

The peo­ple run­ning the big, global, uni­ver­sal banks were con­fronted with quite a predica­ment. They were all left sit­ting on busi­ness mod­els that were finely cal­i­brated to an ex­tinct re­al­ity. But how could they trans­form? What busi­ness lines were they go­ing to get out of? The ob­vi­ous an­swer would be the ones that didn't make any money. But their en­tire busi­ness model was pred­i­cated on be­ing all things to all peo­ple. It was like a gi­ant game of Jenga - pull out the wrong brick and the whole pre­car­i­ous ed­i­fice could come crash­ing down.

That's not to say that banks hadn't cut busi­ness lines in the past. The his­tory of the in­dus­try is lit­tered with firms that tried and failed and then tried again. Many in­vest­ment banks were fa­mous for fir­ing whole swathes of bankers and trader at the first whiff of a down­turn only to get caught out when things picked up again and hav­ing to of­fer even big­ger bonuses to staff up again. One Amer­i­can firm got caught out so of­ten that th­ese chop- and-change tac­tics be­came known as "do­ing a Mer­rills". But that was then and this is now. The dif­fer­ence is the amount of lev­er­age - the pro­por­tion of bank equity to as­sets - that firms are al­lowed to de­ploy.

In past cy­cles banks would be happy to get out of busi­ness, in the knowl­edge that they could de­ploy lev­er­age to bulk up again when the weather turned. But tougher lev­er­age ra­tios make it harder to turn on a strate­gic dime. Banks knew that if they got out of busi­ness, they'd be out for a long time. So in­stead, they waited. They knew that other banks faced the same predica­ment and would, even­tu­ally, have to call it quits. The pie might have shrunk, but banks hoped that, sim­ply by hang­ing in there, they'd get to en­joy a larger slice.

But what made a cer­tain sense to in­di­vid­ual banks amounted to col­lec­tive mad­ness. Be­cause no one blinked. In 2012, some four years af­ter the fi­nan­cial cri­sis, McKin­sey's an­nual re­view on the global bank­ing in­dus­try found that only 6pc of banks had cut their costs over the pre­vi­ous year - which, ad­just­ing for cur­rency vari­a­tions and round­ing er­rors, es­sen­tially means the in­dus­try had done the square root of noth­ing. They were, in the charm­ing in­dus­try jar­gon that is so grat­ing on the ear, "hoard­ing op­tion­al­ity", or, in non-bank speak, keep­ing their op­tions open. They clung on to un­prof­itable busi­ness lines, hop­ing that some­thing, any­thing, would turn up. And they were right, it did. It was called quan­ti­ta­tive eas­ing.

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