Forbes.com

Europe's New Supervisory Regime Reaches Deep into Banks' Strategic Choices

Europe's Single Supervisory Mechanism will have big strategic implications for banks.

Par Paolo Bordogna and Jan-Alexander Huber

First published on février 02, 2015
min


This article first appeared on Forbes.com. Tensions between Greece and its creditor nations such as Germany may be dominating the headlines in Europe right now, but a quieter development could matter just as much for the eurozone’s big banks. Late last year, the Single Supervisory Mechanism (SSM) overseen by the European Central Bank (ECB) took effect. SSM serves as more than an added layer of regulation. It will cause bankers to shift from simply worrying about compliance to thinking about the new risks and opportunities raised by a lack of capital, liquidity and profitability. We estimate that more than 100 new regulatory requirements and guidelines will be implemented over the coming months and years. They will induce changes in all aspects of banking, from the underlying business model, strategy and profit-and-loss statement to the balance sheet and governance structure. Large banks engaged in capital market activities will experience the most radical changes, as they will need to ring-fence their retail banking activities to shield them from the risks in other businesses. A few banks, such as UBS, have already begun that process. Departing from traditional after-the-fact analysis, the SSM emphasizes forward-looking scenarios based on how a bank performed in initial stress tests. The new regime thus has major implications for strategy, operations, governance and talent. Implications for strategy. Borderline banks cannot afford to deteriorate further and will need to ensure survival through a comprehensive plan for evaluating the impacts of management decisions. Healthy banks, on the other hand, have earned regulators’ trust for the moment. They potentially have more leeway over which managerial moves they can make. Many of them should be on the lookout for good M&A opportunities. For all banks, ECB regulators will frequently check the business model’s viability and sustainability. To date, most banks have played a portfolio game, blending businesses that performed differently at each stage of the economic cycle. This logic will no longer apply. Looking ahead, banks can only afford to keep businesses that have steady cash flow and returns that provide a surplus on the cost of equity. They won’t be able to keep a cyclical or volatile business unless it is heavily overcapitalized to cover the downside risks. In turn, many businesses may need to be wound down or spun off. In light of the higher capital requirements, regulators will closely scrutinize asset-based business, such as real estate, ship and aircraft financing and infrastructure. Higher capital buffers complicate life for banks. Fewer than 6% of all banks in Germany, for instance, earn their cost of capital, Bain & Company estimates. Some banks with weaker capital positions and returns on invested capital will depart from these businesses, while hedge funds and other shadow bankers will likely play a greater role. Less volatile businesses, like deposits and consumer financing, will increasingly depend on achieving economies of scale to fill the capacity of expensive platforms. Banks will also have to invest to become more transparent in reporting performance metrics to regulators. These imperatives could spur a new phase of M&A for banks that compete in scale-driven businesses. Implications for operations. Operational complexity will increase in the wake of the SSM. For one thing, simulation tools will become more prominent in supporting key decisions and negotiating with regulators. Also, we expect that supervisors’ broader scope during bank visits will lower the credit threshold in files they will scrutinize. These changes give banks a motivation to accelerate initiatives to digitize more information and processes. If banks can provide real-time access to client data, they will become more transparent to regulators and improve both effectiveness and efficiency in compliance. Being able to access digital data quickly will allow banks to frequently assess the viability and sustainability of a business. Implications for governance and talent. The new regime implicitly broadens the roles and responsibilities of the chief risk officer and chief financial officer. We expect closer cooperation between these two in strategic areas like the risk appetite framework, business plan and capital allocation. They will take the lead in determining which assets and organizational units should be in or out of a specific business. Banks must ensure that the risk office operates truly independently from the business units, as well as from audit and compliance functions. That independence should be clear to regulators. The SSM will also entail a shift in the type of staff skills and experience banks need. Banks striving to earn their cost of equity will need to reduce costs, which likely will mean reducing staff in certain areas. At the same time, they’ll need to upgrade functions dealing with supervisory authorities, which may mean hiring more risk analysts, lawyers with economics training and others who can develop new reporting and advanced simulation tools.Strategy, not compliance. Anticipation, not reaction. Functional cooperation, not silos. Digital, not manual. With the advent of the SSM, these will be the hallmarks of banks that stand the best chance of thriving in Europe in the years ahead. Written by Paolo Bordogna and Jan-Alexander Huber, partners in Bain & Company’s Financial Services practice. They are based, respectively, in Milan and Frankfurt.

This article first appeared on Forbes.com.

Tensions between Greece and its creditor nations such as Germany may be dominating the headlines in Europe right now, but a quieter development could matter just as much for the eurozone’s big banks.

Late last year, the Single Supervisory Mechanism (SSM) overseen by the European Central Bank (ECB) took effect. SSM serves as more than an added layer of regulation. It will cause bankers to shift from simply worrying about compliance to thinking about the new risks and opportunities raised by a lack of capital, liquidity and profitability.

We estimate that more than 100 new regulatory requirements and guidelines will be implemented over the coming months and years. They will induce changes in all aspects of banking, from the underlying business model, strategy and profit-and-loss statement to the balance sheet and governance structure. Large banks engaged in capital market activities will experience the most radical changes, as they will need to ring-fence their retail banking activities to shield them from the risks in other businesses. A few banks, such as UBS, have already begun that process.

Departing from traditional after-the-fact analysis, the SSM emphasizes forward-looking scenarios based on how a bank performed in initial stress tests. The new regime thus has major implications for strategy, operations, governance and talent.

Implications for strategy. Borderline banks cannot afford to deteriorate further and will need to ensure survival through a comprehensive plan for evaluating the impacts of management decisions. Healthy banks, on the other hand, have earned regulators’ trust for the moment. They potentially have more leeway over which managerial moves they can make. Many of them should be on the lookout for good M&A opportunities. For all banks, ECB regulators will frequently check the business model’s viability and sustainability. To date, most banks have played a portfolio game, blending businesses that performed differently at each stage of the economic cycle. This logic will no longer apply. Looking ahead, banks can only afford to keep businesses that have steady cash flow and returns that provide a surplus on the cost of equity. They won’t be able to keep a cyclical or volatile business unless it is heavily overcapitalized to cover the downside risks.

In turn, many businesses may need to be wound down or spun off. In light of the higher capital requirements, regulators will closely scrutinize asset-based business, such as real estate, ship and aircraft financing and infrastructure.

Higher capital buffers complicate life for banks. Fewer than 6% of all banks in Germany, for instance, earn their cost of capital, Bain & Company estimates. Some banks with weaker capital positions and returns on invested capital will depart from these businesses, while hedge funds and other shadow bankers will likely play a greater role.

Less volatile businesses, like deposits and consumer financing, will increasingly depend on achieving economies of scale to fill the capacity of expensive platforms. Banks will also have to invest to become more transparent in reporting performance metrics to regulators. These imperatives could spur a new phase of M&A for banks that compete in scale-driven businesses.

Implications for operations. Operational complexity will increase in the wake of the SSM. For one thing, simulation tools will become more prominent in supporting key decisions and negotiating with regulators. Also, we expect that supervisors’ broader scope during bank visits will lower the credit threshold in files they will scrutinize.

These changes give banks a motivation to accelerate initiatives to digitize more information and processes. If banks can provide real-time access to client data, they will become more transparent to regulators and improve both effectiveness and efficiency in compliance. Being able to access digital data quickly will allow banks to frequently assess the viability and sustainability of a business.

Implications for governance and talent. The new regime implicitly broadens the roles and responsibilities of the chief risk officer and chief financial officer. We expect closer cooperation between these two in strategic areas like the risk appetite framework, business plan and capital allocation. They will take the lead in determining which assets and organizational units should be in or out of a specific business.

Banks must ensure that the risk office operates truly independently from the business units, as well as from audit and compliance functions. That independence should be clear to regulators.

The SSM will also entail a shift in the type of staff skills and experience banks need. Banks striving to earn their cost of equity will need to reduce costs, which likely will mean reducing staff in certain areas. At the same time, they’ll need to upgrade functions dealing with supervisory authorities, which may mean hiring more risk analysts, lawyers with economics training and others who can develop new reporting and advanced simulation tools.Strategy, not compliance. Anticipation, not reaction. Functional cooperation, not silos. Digital, not manual. With the advent of the SSM, these will be the hallmarks of banks that stand the best chance of thriving in Europe in the years ahead.

Written by Paolo Bordogna and Jan-Alexander Huber, partners in Bain & Company’s Financial Services practice. They are based, respectively, in Milan and Frankfurt.