Banks Told to Go For Radical Rethink

Banks need a radical overhaul to boost profitability against the backdrop of tougher new rules and a grim economy - and they expect their customers to share some of the pain.

That is the view of bankers, investors and regulators meeting in Copenhagen this week to assess how banks need to adapt to meet new regulations that require them to hold more capital and to cope with the deepening euro zone debt crisis.

"Let's not waste a good crisis. Banks really need to focus on being quite radical in what they do," David Hodgkinson, chairman of Allied Irish Banks and a former senior banker at HSBC, said on Friday.

"It is easier to do things when times are tough than when you are in good times."

Bank bosses have been rethinking their business models since the global financial crisis erupted almost five years ago. However, many are now stepping up efforts as their return on equity (RoE), a key financial yardstick, is below their cost of capital.

Bankers at this week's meeting of the Institute of International Finance (IIF) were in little doubt that business models need to change further. But they also expected customers to share the pain in the form of higher prices.

"The economy and customers will take the real hit. It's our institutions, the economies and our families that will pay the price over the next few years," said Eugene Ludwig, CEO of consultancy Promontory Financial Group.

Rick Waugh, CEO of Canada's Scotiabank, said: "There is no doubt that with all the regulation, risk-based adjusted return on capital for a lot of products and services are underpriced and so the costs will go up."

He said the rise could be 0.25 to 1 percentage point.

It is already being seen. "There is a scarcity of balance sheet out there and we are seeing it reflected in the prices that corporates have to pay," said Jes Staley, head of investment banking at J.P. Morgan.

There appears little prospect of a return to bumper RoE levels seen in the decade before the crisis.

Average RoE for top investment banks is likely to fall to about 7 percent from 20 percent due to regulatory reforms, although mitigating action should lift it back up to about 11 or 12 percent, according to analysis by McKinsey.

J.P. Morgan's Staley estimated the average cost of capital for investment banks is near 12 percent.

Cutting costs, improving risk management, taking advantage of technological change and selling more products to existing borrowers should lift returns for successful firms, bankers said, although they admitted there were few quick fixes.

"What do we do to get a banking model that returns profit higher than the cost of capital? That equation is still pretty unknown...and banks are struggling to do that," said Christian Clausen, CEO of Swedish bank Nordea.

TOO MUCH REGULATION?

The first step to improve returns is to shrink. Banks have been aggressively reducing loans and quitting business areas that deliver low returns or lack scale.

The aim of new regulations is to create a bigger safety net to protect taxpayers from having to bail out banks. But bankers say too much regulation is increasing pressure to cut lending, hurting economic recovery.

Holding more capital depresses returns for bank shareholders and has left banks struggling to attract investors to provide capital, especially in Europe.

"If you fail to do that (deliver attractive returns) the economy itself will splutter," Hodgkinson said.

Europe's banks are aggressively "deleveraging" to shore up their capital base and ease strains on their funding and liquidity. The International Monetary Fund estimated European Union banks would deleverage by $2.6 trillion in the next two years, slicing about 1 percent from growth this year alone.

"Deleveraging is no panacea long-term for the banking system. Either you are getting rid of good quality assets that weaken the overall risk profile of your organization, or you are getting rid of poorer quality assets that actually burns capital," Hodgkinson said.

That has prompted renewed calls for regulators to ease back on their reform agenda, or to coordinate it better.

New rules to create "living wills" so a troubled bank can be wound up or restructured without needing a taxpayer bailout could also dictate the industry's new shape, as it brings together capital, liquidity, funding, legal structure and other issues and will influence the cost of bank balance sheets. (Reporting by Steve Slater; Editing by Erica Billingham)