This article originally appeared on Forbes.com.
The financial industry almost pushed the global economy off a cliff in 2008, and taxpayers had to bail out multiple banks. Now regulators in many countries are trying to keep banks—particularly the systemically important ones—from ever getting near the cliff again. Regulators have mandated that big banks become resilient to stress over multiple economic cycles and that any bank overwhelmed by too much stress can be contained.
At most, only one-third of banks have adequately prepared for this transformation, Bain & Company estimates, and these banks are based mainly in the U.S., U.K. and Switzerland, where regulators acted sooner to impose stringent reforms.
Our analysis shows that investors have rewarded banks making the greatest progress toward a transparent, sensible business model and a resilient and resolvable structure. But most banks still have a long way to go.
Regulators demand a more sustainable business model.
Strategy now is viewed as part of the regulatory agenda. Regulators will frequently check the business model’s viability, and not just in the obvious areas of risk appetite, capital allocation and liquidity profiles. They will also assess whether banks regularly track backward- and forward-looking key performance indicators to help them steer the business. Essentially, regulators are testing whether banks can turn their strategies into sustainable business models over the entire economic cycle.
Successful strategy will focus on knowing where to play—what will be the bank’s profitable core businesses—and how to win based on core strengths that afford a competitive edge. This involves making choices to strengthen the readjusted core, combined with a coherent disposal of noncore operations.
The new regulations will force bankers to more explicitly consider trade-offs and asset-liability linkages. Whereas they once could blend businesses that performed differently at each stage of the economic cycle, they now must lean toward keeping businesses that have steady cash flows and returns that provide a surplus on the cost of equity. Most will have to shed any cyclical or volatile business, unless it is heavily overcapitalized to cover the downside risks and they can prove its viability.
This dynamic has already caused banks in the U.S. to increase the capital deployed against certain businesses after stress tests, or to exit some businesses altogether. HSBC, for instance, has exited certain countries; UBS has substantially reduced its fixed-income business; and Morgan Stanley has focused its wealth management business primarily on the U.S.
Bend but don’t break: The virtues of resiliency to stress.
Improving resilience remains a big opportunity for banks to regain the trust of investors and regulators. Resilience begins with sufficient capital buffers, which large global banks will need to increase within the next five years. Regulators also will be reviewing internal risk models when they suspect that these models are not conservative enough. Therefore, banks will need to actively collaborate with regulators on harmonizing risk measurement and establishing more comprehensive and fully consistent risk databases and reporting.
Reducing a bank’s complexity is the next frontier for resiliency, because large global banks, as they are currently constituted, cannot be managed well in times of distress. Many banks have multiple subscale businesses that create substantial complexity. So most global, systemically important banks have chosen to substantially reduce their risk-weighted assets and increase their Tier-1 capital.
The road to resolution readiness in the event of failure.
The toughest part of adapting to the new paradigm is resolution planning. This challenge will involve heavy analysis on the bank’s part and, if done poorly, can be quite costly and time consuming for senior management and the board.
If a bank faces a crisis, regulators will want to wind it down without taxpayer support or risk to the stability of the broader financial system. Most global banks have an intermingled legal structure that cannot easily be pulled apart—the nub of “too big to fail.” That runs counter to the common goal of ensuring that systemically relevant functions, such as payments, loans and customer deposits, will continue to run and be accessible if the bank is disrupted.
So far, regulators have identified banks’ legal structures as the most significant impediment to resolvability. A bank thus will have to redesign its legal entity structure, most likely around a holding structure capable of serving as a single point of entry for bail-in. Investment banking will need to be structurally separated from retail banking. The structure must also be transparent and obvious to regulators. Each of these steps should help to reduce systemic risk.
Although all major banks have to comply with the mandate to build recovery and resolution plans, the leaders do not view this as a purely compliance exercise. Instead, they see it as an opportunity to sharpen their individual strategies and business models, and remove excess complexity from their operations. Markets have rewarded these early leaders, while the more cautious lag further behind with each passing day.
Matthias Memminger and Jan-Alexander Huber are partners in Bain & Company’s Financial Services practice. They are based in Zürich and Frankfurt, respectively.